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Reinvestment Considerations for CDEs Repaid by QALICBs

Published by Ryan J. Rieger on Monday, August 7, 2023

Journal Cover August 2023   Download PDF

Q: What are the reinvestment requirements for community development entities (CDEs) when a qualified low-income community investment (QLICI) is repaid by the qualified activity low-income community business (QALICB)?

A: As interest rates continue to rise, both new markets tax credit (NMTC) and non-NMTC financing has become more expensive. This can often lead to cash flow constraints for QALICBs. Because of these constraints as well as other economic and business challenges, QALICB borrowers may be forced into the difficult decision to either sell the business or file for bankruptcy protection as the only solution to these cash flow limitations. To avoid potential recapture of NMTCs, it is important for CDEs to understand the reinvestment requirements for funds received from the QALICBs as stated in Treasury regulations, as well as standard language in loan and fee agreements that may impact the calculations.

Reinvestment Requirements

Treasury Regulation (Treas. Reg.) Section 1.45D-1(d)(2)(i) states “amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment must be reinvested by the CDE in a qualified low-income community investment no later than 12 months from the date of receipt to be treated as continuously invested in a qualified low-income community investment.” The regulation states that if the amount received by the CDE is less than the cost basis of the original QLICI and the CDE reinvests in accordance with this paragraph, then the amount treated as continuously invested is the excess of the original cost basis over the amount received by the CDE that are not reinvested. Amounts received by a CDE during the seventh year of the seven-year tax credit period do not have to be reinvested by the CDE to be treated as continuously invested.

There are also specific rules in the regulations for loans with scheduled, periodic principal repayments. Treas. Reg. Section 1.45D-1(d)(2)(iii) states these amounts need to be reinvested in another QLICI by the end of the following calendar year.

Factors that May Affect Redeployment Needs

When looking at the language in Treas. Reg. Section 1.45D-1(d)(2)(i), the following question has been proposed: What are amounts received by a CDE “in payment of, or for, capital, equity or principal?” Let’s look at some of the payments due from the QALICB to the CDE that may not be considered payments of capital, equity or principal.

For example, one expense that the QALICB would pay to the CDE that would not be considered a principal repayment is interest expense that may be accrued on the QLICI loan, as well as interest calculated at the default interest rate as defined in the QLICI loan agreement or promissory note. Also written into many fee agreements or loan agreements are asset management fee payments that must be made by the QALICB to the CDE, or reimbursement of operating costs that the QALICB is responsible to repay to the CDE. These interest and fee amounts are due from the QALICB to the CDE, but payment of these fees shall not be considered principal repayments on the loan. Therefore, when calculating the redeployment needs of a CDE, these costs may be reasonably paid using the proceeds received from the QALICB and would not be considered necessary in calculating the amount needed for reinvestment. To properly calculate the amount that must be reinvested, the CDE must familiarize itself with its own unique facts and circumstances as indicated in the closing documents of the specific transaction.

Example

We will use a real estate transaction with an original QEI of $10 million and a $9.8 million QLICI into the QALICB. In this example, the loan had a 3% interest rate that was one year past due. It also had language in the loan agreement that an additional 5% interest would be charged if the loan was in default. The QALICB was also one year past due on $50,000 of asset management fees that were to be paid by the QALICB, and the CDE had incurred $100,000 in legal, accounting and consulting fees that are defined as operating expenses that are to be reimbursed by the QALICB to the CDE in accordance with the fee agreement. The QALICB has been offered $2 million of bankruptcy proceeds and the CDE is attempting to calculate its expected amount continuously invested per Treas. Reg. Section 1.45D-1(d)(2). Below is the calculation of the amount of the proceeds considered repayment of principal, and the amount deemed to be continuously invested per Treas. Reg. Section 1.45D-1(d)(2):

Original QEI10,000,000
Original QLICI9,800,000
  
Past due interest - 3%294,000
Default interest - 5%490,000
AMFs50,000
Operating expenses100,000
Total costs owed to the CDE not considered payment of principal934,000
  
Total sales proceeds2,000,000
Net proceeds considered repayment of principal1,066,000
  
Expected amount deemed continuously invested per Treasury Regulation Section 1.45D-1(d)(2)8,734,000
  
Expected substantially all % upon repayment87.34%

 

In this example it has been determined that the costs due to the CDE by the QALICB of $934,000 are not considered payment of principal because they are costs due by the QALICB in accordance with various agreements in place. In addition, the $2 million of repayment proceeds is $7.8 million less than the original cost basis of $9.8 million. Per the Treasury regulation, this $7.8 million is also deemed to be continuously invested because the proceeds are less than the original cost basis by that amount. Therefore, based on the example above, the CDE would not be required to reinvest the principal repayment of $1,066,000 because its substantially all percentage remains above 85%. However, if the CDE has committed in its allocation agreement to investing greater than 85% of its QEI into QLICIs, they may still have a reinvestment requirement as required by Compliance Monitoring and Evaluation Frequently Asked Question #14, which states that to the extent a CDE reinvests repayments of principal as new QLICIs, the CDFI Fund will check compliance for all reported QLICIs against the requirements specified in the allocation agreement. In our example above, if the QEI usage percentage is 98%, the $1,066,000 would all need to be reinvested to maintain compliance with Section 3.2. This reinvestment requirement is not only related to the QEI usage, but all provisions of Section 3.2 of the allocation agreement, including types of QLICIs, service area, etc.

Conclusion: Understand Reinvestment Rules

While the goal of NMTC investing in businesses and developments located in distressed communities is to promote economic improvement through the growth of successful projects and businesses, it is also important to understand the potential consequences if the low-income community business is forced to sell or file for bankruptcy. By understanding the reinvestment rules, CDEs can protect themselves against potential recapture of NMTCs in the unfortunate scenario where this occurs. In addition to understanding the rules, CDEs should also be aware of their specific circumstances in each transaction, as well as work with reputable consultants, attorneys and accountants to provide the guidance they need in maintaining their compliance with the NMTC program and its regulations. If you have any questions on this topic, or need assistance with a similar scenario, please do not hesitate to reach out to your Novogradac contact. 

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