The mechanism
The New Markets Tax Credit was made a permanent part of the Internal Revenue Code, with a standing annual allocation authority of five billion dollars. It had operated since 2000 on a series of short extensions, and permanence is the largest change to the program in its history even though it altered nothing about how the credit itself works.
The mechanism is a subsidy delivered sideways. The federal government wants investment in businesses and projects located in low-income communities. Rather than lending or granting directly, it allocates credits to intermediaries, who use the promise of those credits to attract private capital, which then flows to the project.
The mechanism in outline
- 01Treasury, through the CDFI Fund, awards allocation authority to Community Development Entities by competitive application. Allocation is the right to generate credits, not money.
- 02An investor makes a Qualified Equity Investment into a Community Development Entity.
- 03The Community Development Entity deploys substantially all of that capital into a Qualified Active Low-Income Community Business, which may be an operating business or a real estate project in a qualifying census tract.
- 04The investor claims a credit totalling 39% of the qualified equity investment, spread across seven years: 5% in each of the first three years, and 6% in each of the following four.
- 05The investment must remain in place throughout the seven-year compliance period. If it does not, or if the business stops qualifying, the credits are subject to recapture.
The problem it was built to solve
The policy problem the program was built to solve is that capital does not naturally flow to low-income census tracts. Not because every project there is bad, but because the perceived risk premium, the thinness of comparable sales, and the absence of a deep lender market combine to make otherwise sound projects unfinanceable. Capital goes where it is comfortable.
A grant program would have required appropriations and a bureaucracy to pick projects. The credit outsources project selection to intermediaries who compete for allocation and then have to place it successfully, and outsources the funding to private investors who will not put money into something they expect to fail, because a failed project triggers recapture of their credits.
Permanence matters because of planning horizons rather than economics. Under short extensions, a Community Development Entity could not credibly commit allocation to a project whose closing might slip past the program's expiry, and a developer could not build a capital stack around something that might not exist in eighteen months. Both sides now plan on real timelines.
How the benefit reaches a developer
The developer does not receive the credit. They receive cheaper capital, and the mechanism is that the investor accepts a below-market return on the cash portion because a substantial part of their total return arrives as tax credits instead.
In most transactions this is arranged through what practitioners call a leveraged structure: an investment fund combines a relatively small amount of true tax-credit equity with a much larger leverage loan, makes the qualified equity investment out of the combined amount, and the credits are calculated on the whole of it. The practical result for a well-structured deal is that a meaningful portion of the project cost is funded by capital that does not behave like ordinary debt or ordinary equity, and in many transactions a portion is forgiven or unwound at the end of the compliance period.
How the benefit reaches an investor
The investor's return has three components, and they behave very differently from each other.
| Component | Character | What determines its real value |
|---|---|---|
| The credit | 39% of the qualified equity investment, delivered across seven years | Whether you have sufficient liability of the right character to absorb it in the years it arises |
| Cash distributions | Typically modest, because the credit is doing the work | The underlying project's actual performance |
| Exit | Negotiated at the end of the compliance period, often through a pre-agreed put | The documentation. This is settled at closing, not at exit |
The single most consequential question is the first one. A credit is only worth its face amount to a taxpayer who can actually use it in the year it arises. Passive activity rules, at-risk limitations, and the character of your income all bear on that, and a credit you cannot use is not a deferred benefit so much as a diminished one. Two investors can put identical amounts into an identical transaction and receive materially different economics purely because of their own tax profiles.
The second is duration. Seven years is a long compliance period, the position is illiquid throughout, and recapture exposure sits with the investor rather than with the sponsor who arranged the transaction.
For the investor
- 01Start with your own capacity, not with the deal. Before evaluating any transaction, establish what quantity of credit you can actually absorb, in which years, given your income character. That number sets what is worth looking at, and most investors discover it is smaller than they assumed.
- 02Price the credit on present value, not on face. Thirty-nine percent arriving across seven years is worth considerably less than thirty-nine percent today, and any comparison against an alternative use of the same capital has to be made on that basis.
- 03Treat the seven years as a genuine lock. Do not commit capital you might need. The compliance period is not a guideline and the recapture exposure is real.
- 04Read the exit documentation before you fund. What happens at the end of the compliance period is determined by documents signed at the beginning. If the exit mechanics are vague at closing they will not become clearer in year seven.
- 05Underwrite the project, not just the structure. Recapture is triggered by the business ceasing to qualify, which is usually a consequence of the project failing. The credit does not insulate you from the underlying deal, it ties you to it for seven years.
- 06Have your own CPA confirm usability for your facts before committing anything.
Used well, this is one of the more elegant pieces of tax policy on the books: it moves capital into places it would not otherwise go, it ties the subsidy to projects that must keep operating, and it aligns the investor's interest with the project's survival for seven years. But the elegance is in the aggregate. For any individual investor the question is narrower and entirely personal, which is whether you can use the credit, whether you can hold the position, and whether you would have wanted the underlying project anyway.
General information only. This article describes law and practice as we understand them at the time of writing. It is not tax, legal, accounting, or investment advice, it does not consider your circumstances, and it does not create an advisor-client or attorney-client relationship. Odyssey Strategic Advisors LLC is not a law firm and is not a CPA firm. Confirm any position with your own tax professional before acting on it. See our disclosures.