For many bankers, the words “tax credit” conjure the specter of Community Reinvestment Act investments that don’t conform with their bank’s rigorous credit policies. Despite this reputation, many large banks have learned to embrace tax credits as a method to reduce tax liability and earn a competitive return on capital. Ancillary benefits include corporate goodwill and possible CRA credit.
Federal historic tax credits (HTCs) are an asset class that banks, insurance companies and other large corporates have been investing in since 1986. This asset class may provide banks CRA credit and is a permitted investment under the Volcker Rule and the Dodd-Frank Act. These credits are generated by qualifying real estate developments, but many developers can’t use HTCs personally. This creates a market whereby investors can partner with these developers and earn tax credits.
Traditionally, large banks and sophisticated corporations were the only institutions that strategically invested in HTCs. The primary reason for this was that the traditional HTC structure required that an investor accurately forecast capital gains six years in the future. Recent clarification from the IRS on this structure has modified pricing so that capital gains are no longer the primary consideration when structuring HTC transactions. This change makes HTC investing viable for a broader range of investors.
Given that the costs of running a bank continue to increase due to regulation, reducing federal tax liability at a discount is a simple way to cut down on expenses. One misconception of tax credit investments is that they are one option under an asset allocation model for bank capital (i.e. grow loans, build branches, scale wealth management). This is not the case, as a profitable bank needs to make quarterly tax estimates to the government and HTCs allow for reduction of those quarterly estimates. As HTC transactions are structured so that the bulk of an investor’s capital is not contributed until the credits are placed in service, these investments are cash flow positive in six to nine months.
HTC investments have two primary risks—construction completion and change of ownership during the compliance period. The tax credits are only earned when construction is complete and a real estate asset is placed in service. To mitigate construction risk, the investor only puts in 25 percent of their capital prior to the credit generating assets placing in service. Additionally, HTCs are at risk for recapture for five years after the property is placed in service. To prevent a change in ownership during the five-year period, the tax credit partner negotiates with the lender for a forbearance of foreclosure rights during the compliance period. The lender can take the property in the event of default, but they are unable to remove the tax credit partner, preserving the tax credits.
Banks looking to take advantage of HTC investments without burdening themselves with additional risk or administrative work can use an investment firm such as Twain to identify, source and close HTC transactions. These firms offer investment products that are structured to minimize investor risk by providing guaranties against certain credit risks, while maximizing returns by maintaining an active pipeline of investments. This allows bank investors to concentrate on growing their loan and deposit books while getting an added benefit from reduction in tax liability. Investors simply review each deal and contribute capital when called upon based on project milestones.