Cost Segregation and New Markets Tax Credit

The New Markets Tax Credit was established by the Community Renewal Tax Relief Act of 2000 to stimulate private investment in low income communities. The program provides tax credits to investors who make qualified equity investments in Community Development Entities (CDEs) that use the capital to provide financing to businesses and real estate projects in designated areas.

The CDFI Fund, an arm of the U.S. Treasury Department, allocates NMTC authority to CDEs through a competitive application process. CDEs are specialized organizations certified to use NMTC to finance projects in qualified communities. Once allocated NMTC authority, CDEs structure transactions with investors and project sponsors to deploy the capital.

Key program features

• Total credit of 39% of qualified equity investment over 7 years
• Credits allocated annually: 5% for years 1-3, 6% for years 4-7
• Must be used in qualified low income communities
• Compliance and asset requirements during 7 year credit period
• Complex transaction structures involving multiple entities

Since inception, the new markets tax credit has facilitated over $60 billion in investment in underserved communities, supporting real estate development, business expansion, and community facility projects that might not otherwise attract financing.

NMTC financing is only available for projects located in qualified low income communities, which are defined based on poverty rates and median income levels. Most urban and many rural areas contain census tracts that qualify, making NMTC broadly available for community development purposes.

A census tract qualifies as a low income community if the poverty rate is at least 20% or the median family income does not exceed 80% of the greater of metropolitan area median income or statewide median income. Additional qualification criteria apply to tracts in high migration rural counties and targeted populations.

Project sponsors should verify census tract eligibility early in planning using the CDFI Fund's mapping tools and data resources. Tracts qualifying as low income communities are identified in publicly available databases, and location within a qualifying tract is generally sufficient for NMTC purposes.

NMTC transactions involve complex multi entity structures designed to meet program requirements while delivering economic benefits to project sponsors. The typical structure includes the investor entity, the Community Development Entity, an investment fund, and the project operating company or property owner.

In a standard NMTC transaction, the tax credit investor makes a qualified equity investment in the CDE in exchange for NMTC allocation. The CDE contributes this equity to an investment fund which makes a Qualified Low-Income Community Investment (QLICI) to the project, typically structured as a loan at below market rates. The interest savings create the economic benefit to the project sponsor.

After the 7 year compliance period, the structure typically unwinds through a put call mechanism where the project sponsor has the right to purchase the investor's interest for a nominal amount. This transfers full ownership to the sponsor while the investor has received 7 years of tax credits totaling 39% of their investment.

The new markets cost segregation value proposition for project sponsors comes from the below market financing made possible by NMTC investor participation. While the investor receives tax credits worth 39% of their investment over 7 years, they typically accept little or no cash return, allowing this value to flow to the project through reduced interest rates.

The typical NMTC financing covers 20% to 30% of total project costs, with the remainder funded through conventional debt, equity, or other sources. The subsidized NMTC portion often makes the difference between a feasible and infeasible project in challenging locations.

Cost segregation provides independent benefits for the property owner in NMTC financed real estate projects. The nmtc and cost seg strategies complement each other because they benefit different parties and operate through different mechanisms: NMTC provides tax credits to investors and subsidized financing to the project, while cost segregation provides accelerated depreciation to the property owner.

From a tax basis perspective, NMTC financing is typically structured as debt from the property owner's viewpoint. The full project cost becomes the depreciable basis, unaffected by the favorable loan terms from NMTC. This allows cost segregation to be performed on the total project cost to identify components eligible for shortened recovery periods.

The property owner should implement cost segregation when the property is placed in service, which typically occurs during or shortly after the NMTC structure is established. The accelerated depreciation provides immediate benefit to the property owner and continues throughout and beyond the 7 year NMTC compliance period.

For understanding broader applications across multiple tax strategies, see Stacking Tax Strategies for Maximum Savings for comprehensive coordination approaches.

NMTC can finance both real estate development and operating businesses, with slightly different structures and cost segregation applications for each. For real estate projects, the focus is on building acquisition, construction, or renovation, and cost segregation applies to the property improvements.

Real estate NMTC projects include commercial developments, mixed use properties, community facilities, and affordable housing. The property owner entity receives the QLICI loan from the CDE and uses the proceeds for development. Cost segregation is performed on the completed improvements to accelerate depreciation for the owner.

For operating business NMTC projects, the financing supports business expansion, equipment purchases, or working capital in low income communities. If the business owns real property, cost segregation can be applied to those assets. If the NMTC financing includes funding for real property improvements, cost segregation analysis identifies components for acceleration.

Many NMTC transactions use leveraged structures where the CDE makes two loans to the project: a QLICI loan funded by the investor equity, and a leverage loan funded by conventional debt raised by the CDE. This leverage loan structure allows projects to access more total NMTC benefit from a given allocation amount.

In a leveraged structure, the investor might contribute $7 million in equity to the CDE, generating $2.73 million in NMTC credits. The CDE borrows an additional $3 million in conventional debt (the leverage loan) and lends the combined $10 million to the project. The project benefits from subsidized rates on the full $10 million while the investor receives credits on their $7 million investment.

For cost segregation purposes, the project's depreciable basis includes all costs funded by both the QLICI loan and the leverage loan. The financing structure does not reduce depreciable basis, so cost segregation applies to the full project cost regardless of how NMTC financing is structured.

NMTC can be combined with other tax incentives to create comprehensive benefit packages for complex community development projects. Common combinations include NMTC with historic rehabilitation credits, LIHTC for affordable housing, renewable energy credits, and various state and local incentives.

For historic rehabilitation projects in low income communities, combining NMTC and historic credits can make challenging adaptive reuse projects feasible. The historic credit provides 20% of qualified rehabilitation expenses while NMTC provides subsidized financing. Both can be claimed alongside cost segregation, though basis coordination is required because historic credits reduce basis.

Affordable housing projects can layer NMTC and LIHTC when developments in low income communities include affordable units. Each program has its own compliance requirements and allocation processes, but experienced developers structure transactions to capture both benefits. Cost segregation adds value by accelerating depreciation for the property owner.

For comprehensive multi strategy planning, review Complete Real Estate Tax Planning Guide which addresses coordination across multiple incentive programs.

NMTC structures are designed to unwind after the 7 year compliance period, returning full ownership and control to the project sponsor. The typical exit mechanism involves a put option held by the investor allowing them to require the sponsor to purchase their interest, and a call option held by the sponsor allowing them to buy out the investor.

The put call prices are set at nominal amounts, typically $1,000 or similar. The economic deal is that the investor receives 7 years of tax credits worth 39% of their investment and then exits for a minimal cash return. The sponsor benefits from 7 years of subsidized financing and ends up owning the project fully.

Cost segregation affects the project's tax basis at exit but does not affect the NMTC unwind economics. The accelerated depreciation reduces the property's adjusted basis, which affects future gain calculations if the property is sold. However, most sponsors hold properties long term after NMTC exit, making the immediate cash flow benefit from cost segregation more valuable than the deferred basis reduction effect.