■ Is Individual Participation in the NMTC Program aPassive Activity? 1

■ Completing the FinancingPuzzle 2

■ NMTC Coalition Corner 5

■ About Reznick Group 6

In This Issue

Fall 2010

New Markets Tax Credit ConnectionHelpingYou Stay Connected

Is Individual Participation in the NMTC Program a Passive Activity?IRS Issues New Revenue Ruling on the Applicability ofthe Passive Activity Rules to NMTCBy: Dan King, Reznick Group

Through the Tax Reform Act of 1986,Congress enacted the passive activityrules under Internal Revenue CodeSection 469 in an attempt to preventtaxpayers from taking advantage ofcertain tax shelters. Congress was con-cerned that some taxpayers were usingtax losses and/or credits generated byinvestments in trades or businesses inwhich they did not materially participateto offset taxable income from earnedincome, such as wages or income fromtrades or businesses, in which they didmaterially participate. In addition to tradeor business activities, rental activitieswere brought within the scope of thepassive activity rules. The passiveactivity rules only allow passive activitylosses and passive activity credits tooffset income from passive activities.Any passive losses and passive creditsthat cannot be used are suspended

and carried forward until they can beused to offset passive income or untilthe passive activity is disposed. Materialparticipation, in general, is participationin an activity “on a regular, continuous,and substantial basis during the year.”Treasury Regulation 1.469-5T listsquantitative tests based on the hoursof participation which, if met, providea safe harbor that the taxpayer materi-ally participated with respect to theactivity. The passive activity rules applyto individuals, estates, trusts, closely

held C corporations, and personal service corporations.

Prior to the Internal Revenue Service(IRS) issuing Revenue Ruling 2010-16on June 8, 2010, it was unclear as towhether the New Markets Tax Credit(NMTC) was a passive activity credit.The NMTC is, under Section 469(d)(2)(A),subject to the passive activity rulesand may be suspended if the NMTCarises in connection with the conductof a passive activity. The IRS, throughRevenue Ruling 2010-16, established

Continued on page 4

Reznick Group New Markets Tax Credit Connection2

Public housing authorities haveactively participated in the New MarketsTax Credit Program in a variety of capaci-ties since the inception of the program.In the early years of the program, pub-lic housing authorities acted as lendersand developers, but those early trans-actions did not typically involve the useof funds from the U.S. Department ofHousing and Urban Development (HUD).

Generally, if a public housing authorityacted as the lender in a New MarketsTax Credit leveraged financing, the ultimate source of the funding for theleveraged loan proceeds was morelikely to be state or local grant or loansfunds. More importantly, the projectwas not an affordable housing project.

For example, in one of our early public housing authority representationsin a New Markets Tax Credit leveragedfinancing, a public housing authority in Oregon was both the lender and the

developer. The public housing authoritywas a subordinate leveraged lender andformed a 501(c)(3) tax exempt affiliateto act as the qualified active low-incomecommunity business. The tax creditinvestor was a conventional bank andalso provided the senior leveraged loan.However, the source of the subordinateleveraged loan proceeds was a grantfrom the city and the project involvedthe construction of a new public elemen-tary school to be leased to a schooldistrict. No HUD funds were used inthe New Markets Tax Credit transactionstructure and the project was not anaffordable housing project.

In recent transactions, HUD fundshave been used in the New MarketsTax Credit transaction leveraged struc-ture. Public housing authorities orredevelopment authorities often act as leveraged lenders and the source of the leveraged loan proceeds have

varied. Those sources have includedHUD Community Development BlockGrant funds, HUD HOPE VI funds, HUD108 guaranteed loans for brownfieldsredevelopment, and HUD BrownfieldsEconomic Development Initiative (BEDI)grants to enhance security of HUD 108loans. For instance, in a transactionthat closed in 2010, a redevelopmentauthority in Pennsylvania was the sub-ordinate leveraged lender and usedHUD 108 loan funds and BEDI grantfunds as the source of the leveragedloan proceeds. The senior lender andthe investor were conventional lenders.But, the project involved the construc-tion of a multi-story, mixed-use facilitywith retail space leased to a large, big box retailer.

Until recently, in most instances,affordable housing projects financedwith New Markets Tax Credits havebeen developed by nonprofit corpora-

Completing the Financing PuzzleLeveraging Public Housing Funds in New MarketsTax Credit TransactionsBy: Stephanie L. Franklin-Suber, Partner, Ballard Spahr LLP

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tions unrelated to any public housingauthority. One example involves the useof New Markets Tax Credits to provideworking capital financing for a Kentuckynonprofit corporation that providesaffordable housing and other housingservices in low-income communities.In this situation, a conventional lenderacted as investor and leveraged lenderand no governmental funds were used.In another example, New Markets TaxCredits were used to finance the reno-vation of a building in Washington, D.C.,owned by a nonprofit corporation for a mixed use facility with low-moderateincome rental housing and commercialspace leased to an early childhooddevelopment center.

However, this challenging economicclimate has offered new opportunitiesfor public housing authorities to expandtheir participation in the New MarketsTax Credit program. Public housingauthorities are not only lenders or devel-opers but also are forming affiliates toact as community development entities.By forming affiliated community devel-opment entities, the public housingauthority is able to launch its own NewMarkets Tax Credit programs as a wayof expanding its arsenal of financingtools available to combat the lack ofaffordable housing in low-income communities.

In one of the most exciting develop-ments in 2010, a public housing authorityin Illinois obtained formal HUD approvalto act as lender and developer in a NewMarkets Tax Credit leveraged financingof an affordable housing project thatinvolves the use of HUD public housingfunds. Typically, mixed-finance develop-ment of affordable housing is financedwith Low-Income Housing Tax Creditsand HUD Hope VI capital and operatingfunds, tax exempt bond proceeds,Community Development Block Grantfunds, and other types of federal, state, and local governmental funding.Although not intended as an affordable

housing development tool, this formalHUD approval has cleared the way forcreative New Markets Tax Credit models to finance affordable housingprojects.

In this precedent-setting transaction,HUD has formally approved the use of public housing funds as the source ofleveraged loan financing in a projectinvolving the construction of a newsenior citizen affordable housing facility with both public housing unitsand housing choice voucher units. Themixed-use facility will include a com-munity center, office space for affiliatesof the housing authority, a communityhealth center, and retail. In addition,the facility will be LEED-certified witha rooftop garden.

We represent the public housingauthority and, as currently structured,the transaction integrates the HUDmixed finance development regulatoryrequirements into the New Markets TaxCredit “80/20 rule” mixed-use leveragedfinancing structure. The type of govern-mental funding used in a leveragedNew Markets Tax Credit transaction canpresent myriad legal issues dependingon the program-specific requirementsof the applicable government grant orloan program. In this case, we haveembarked on a new adventure!

Initially, we had to determine whetherthe public housing authority could actas the leveraged lender under its stateauthorizing legislation. This particularhousing authority does not have thelegal authority to make loans to for-profitentities. As a result, the financing modelcontemplates that the public housingauthority will form a new 501(c)(3) tax-exempt affiliate to act as leveragedlender and a new 501(c)(3) tax-exemptaffiliate to act as the qualified activelow-income community business.Based on HUD mixed finance regulatoryguidance, a public housing authority“affiliate” is considered a third partycontractor rather than an “instrumen-

tality” controlled by the public housingauthority.

To date, we have successfullyobtained HUD approval of the publichousing authority’s use of public hous-ing funds as the source of leveragedloan proceeds as well as HUD approvalof the public housing authority’s solesource procurement of the leveragedlender affiliate and the developer affili-ate under HUD’s mixed finance devel-opment regulations. In order to fundthe leveraged loan, the public housingauthority will make a loan to the lever-aged lender affiliate. In addition, thepublic housing authority will use theHUD funds in conjunction with IllinoisTax Increment Financing dollars fromthe city. An intergovernmental agree-ment between the city and the publichousing authority was recently approvedby city council. Also, the public housingauthority is seeking, among othersources of funds, Federal Home LoanBank funds, Illinois Housing Develop-ment Authority Trust Funds, IllinoisEnergy Commission grant funds, andrenewable energy tax credits.

This transaction is scheduled to closein October 2010, and HUD approval ofthe transaction will be required prior toclosing.

Stay tuned! ■

Stephanie L. Franklin-Suber is a partner

in the Business and Finance Department

and contact partner for the New Markets

Tax Credit practice team within the Tax

Credits Group.

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connected with the conduct of a tradeor business. Presumably, it is becausethe taxpayer is making the QEI acquisi-tion as an investment to obtain theNMTC and is not in the business ofmaking these investments on a regularand continual basis.

While this new Revenue Rulingdoes not guarantee that the NMTC willnot be a passive activity credit to alltaxpayers subject to the Section 469passive activity rules, it does provideguidance as to how to make the deter-mination and should, in many cases,enable individual taxpayers to availthemselves of the NMTC benefits. ■

. . . Passive Activity continued from page 1

that the determination as to whetherthe NMTC was a passive activity credit was dependent upon whetherthe acquisition of the qualified equityinvestment (QEI) in a communitydevelopment entity (CDE) arose inconnection with the conduct of a passive activity.

Revenue Ruling 2010-16 provides twoscenarios as examples. In the first, anindividual acquires a QEI in a CDE, andin the second, a partnership acquires a QEI in a CDE and allocates the NMTCto its partners. In both situations, thefacts stipulate that the acquisition ofthe QEI is not in connection with theconduct of a trade or business. TheRevenue Ruling states that the deter-mination of whether the NMTC underSection 45D is disallowed underSection 469 does not depend on thetaxpayer’s interest or extent of partici-pation in the CDE’s trade or business.To be a passive activity, the activity of acquiring a QEI in the CDE must bein connection with the conduct of atrade or business in which the personclaiming the NMTC does not materiallyparticipate. The Revenue Ruling con-cludes that since the acquisition of theQEI is not a rental activity nor is theacquisition in connection with a tradeor business, it would not be subject to the passive activity rules. If it wasdetermined that the acquisition was in connection with conducting a trade or business of acquiring a QEI, thenext determination would have to bewhether the taxpayer materially partici-pated in the activity of acquiring theQEI. If it is determined that the tax-payer materially participated withrespect to the activity, then the creditwould not be a passive activity credit.

Revenue Ruling 2010-16 acknowl-edges that the term “trade or business”is not defined in either the code or the

regulations, and the determination ofwhat constitutes a trade or businessdepends on the facts and circum-stances of each case. Revenue Ruling2010-16 cites a Supreme Court case,Commissioner v. Groetzinger, 480 U.S.23 [59 AFTR 2d 87-532] that held thatthere are generally two requirements for an activity to constitute a trade or business: the activity must be con-ducted for income or profit and theactivity must be engaged in with someregularity and continuity. The new ruling, however, does not provide anexplanation as to why the taxpayers’activity of acquiring the QEIs is not

Reznick Group New Markets Tax Credit Connection5

New Markets Tax CreditLegislative Update

The Senate adjourned for Augustrecess without passing the tax extenderpackage that has been tossed back andforth with various extraneous provisionsadded and then removed amid Houseand Senate wrangling since December2009. The extenders bill, as passed bythe House (H.R. 4213) and reportedout of the Senate Finance Committee,includes $5 billion in credit authorityfor the New Markets Tax Credit(NMTC) for 2010 and a provision thatwould allow NMTC investments madebetween March 15, 2010, and January2012 to offset alternative minimum tax (AMT) liability. In the end, electionyear politics can be blamed for the lack-luster appetite that kept the Senatefrom passing this important legislation.

Chairman of the Senate FinanceCommittee Max Baucus (D-MT) hasalready stated his intention to bring thetax extender package to the Senatefloor as soon as Congress reconvenesafter Labor Day. The Senate has a longlist of pressing matters that will com-pete for floor time in the month-longwindow that Congress will be back atwork in the nation’s capital before theyhead home for campaign season. TheSenate calendar includes a small busi-ness bill that has also met resistancethis summer and next year’s spendingbills that need to be addressed beforethe beginning of the new fiscal year,which is fast approaching.

The NMTC Coalition has continued topress leaders in the Senate to advancethe tax extender package and providethe $5 billion for NMTC promptly sothat the 2010 round of allocations can bemade in a timely manner and generatecapital infusion in distressed areasstruggling to finance businesses andimportant community developmentprojects. Now is the time to contact

your members of Congress while they are in their home districts to invitethem to visit one of your projectsfinanced with the credit so they cansee the positive community impact of the program at work. Senators andRepresentatives will be home untilSeptember 13, at which time Congressis back in session in D.C.

In June, the Treasury Departmentreceived 250 applications requesting$23 billion in NMTC credit authority for the $5 billion that is authorized andpending in H.R. 4213 as passed by theHouse and reported out of the SenateFinance Committee. It is essential thatthe Senate move ahead with promptpassage of this tax extender packageto create and maintain jobs in low-income communities where an infu-sion of capital is most needed.

NMTC Coalition Releases 2010 Progress Report

In July, the NMTC Coalition released its2010 NMTC Progress Report, which isnow available on the Coalition’s website(www.nmtccoalition.org) and featuresseveral NMTC transactions, including acharter school in Florida, a rural healthcare facility in Oklahoma, a communityhospital in Louisiana, and several busi-ness investments in Michigan and Iowa.The report also includes findings fromthe Coalition’s most recent CDE survey.Over 70 CDEs with 175 allocation awardstotaling $10 billion in credit authority

responded to the survey. Highlights ofthe survey findings include:

■ Despite the worst economy in ourlifetimes, Community DevelopmentEntities (CDEs) raised over $3 billionin Qualified Equity Investments(QEIs) in 2009. Since the start ofthe recession in 2008, CDEs haveraised more than $6 billion for invest-ments in low-income communities;

■ Demand for the credit remainsstrong. Since 2003, over 1,800CDEs have applied for more than$200 billion in credits;

■ Investments in non real-estatebusinesses – especially communityfacilities and charter schools – areon the rise; and

■ CDEs continue to target NMTCinvestments to the poorest com-munities in America – especiallythose with high rates of unemploy-ment and median incomes below60% of area median.

Save the Date – 2010 NMTCCoalition Annual Conference inEarly December

Mark your calendars! The 2010 AnnualNMTC Coalition Conference at the HotelMonaco in Washington, D.C., will beThursday and Friday, December 9 – 10.A complete conference agenda will beavailable soon on the NMTC Coalitionwebsite. The opening luncheon will beginat noon on December 9th and theAnnual Membership Meeting and elec-tions will begin at 8 a.m. the morningof December 10th with the conferenceset to adjourn at noon that day. ■

Austin Matthew Malcom 512-499-1406

Baltimore David Norton, Managing Editor 410-783-4900

Baltimore Gary Perlow 410-783-4900

Baltimore Ira Weinstein 410-783-4900

Bethesda Don Nimey 301-652-9100

Charlotte Tony Portal 704-332-9100

Sacramento Beth Mullen 916-930-5750

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About Reznick GroupFocusing on the community development and real estate industries for more

than 32 years, Reznick Group is recognized as one of the nation’s leading advisorsto developers, managers, lenders, owners, investors, public finance agencies andother participants in the field. As a national leader in providing public accountingand business advisory services, Reznick Group is committed to providing clientswith outstanding service.

With professional and staff members serving clients nationwide, Reznick Groupprovides value by exercising the highest levels of integrity, quality and respon-siveness in providing solutions to help our clients meet their business objectivesin the community development and real estate industries. To learn more about theservices we provide and our perspective on issues that impact your business,please visit www.reznickgroup.com. ■

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