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The CDC Tax Credit: An Effective Tool For Attracting Private Resources To Community Economic Development

Executive Summary

In 1993, Congress established a pilot program that provided a tax credit for community development corporations (CDCs) to help these nonprofit organizations promote economic development in low-income areas. Under the program, individuals and corporations may claim a credit on their federal income taxes for cash grants and loans made to 20 CDCs selected competitively by the U.S. Department of Housing and Urban Development (HUD). Congress directed that at least eight of the winning groups had to be rural organizations. Each CDC in the demonstration received $2 million in tax credits.

Each year for 10 years, funders who give grants, provide loans or make investments in these CDCs can claim a tax credit equal to 5 percent of the overall amount they provided. If the contribution is a grant, the contributor may claim both the CDC tax credit and the standard income tax deduction for charitable contributions. CDCs must use the money generated from tax credits to create employment and business opportunities for residents of their target areas.

In authorizing this one-time demonstration, Congress followed two well-established precedents. First, the lawmakers encouraged investment in an important national priority – community economic development – through the tax code. And second, Congress sought to gain experience with a pilot before extending the program to more CDCs.

The demonstration shows that the 1993 CDC tax credit can be a very good vehicle for promoting community development and that it should be reauthorized and expanded. The pilot was also useful in showing the modifications that could be made in the tax credit’s present structure to make it more effective.

Tax credits work well in today’s community development environment.

Until a few years ago, the promotion of community economic development in low-income areas had to be financed largely by public sector grants. Tax credits were not a preferred method of stimulating revitalization because most poor communities did not have a strong enough infrastructure of organizations, or sufficient development opportunities, to attract meaningful private sector investment or participation.

The emergence over the past two decades of thousands of nonprofit community development corporations and allied organizations in low-income areas has changed the equation dramatically and ushered in a new era in community development. With the help of a strong corps of national and in some cases local intermediary organizations, CDCs have developed a solid capacity to undertake community development in partnership with the private sector, even while remaining community-based and controlled. Now, tax credits can be an effective tool for promoting economic activity that engages significant private financial support and that is sensitive to community needs.

Tax credits’ most important advantage is that they engage the private sector directly in community building. The projects or activities undertaken in exchange for tax credits have private-sector discipline, and sponsoring organizations are held accountable for results. Well-structured tax credit transactions typically leverage private investment many times the amount of public funds foregone. Working with private sector partners on tax credit activities can be an excellent way for nonprofits to forge lasting relationships with banks, corporations and other investors whose participation is vital to effective community revitalization.

A prime example of the positive potential of tax credits is the Low Income Housing Tax Credit, enacted as part of the Tax Reform Act of 1986 and made permanent in 1993. The housing credit has increased the nation’s supply of affordable housing by nearly one million units. Housing credit projects have anchored revitalization activities in many communities and primed the pump for further redevelopment. CDCs that sponsor housing credit projects have grown stronger organizationally. The mutual respect and personal relationships created between CDCs and their private sector partners in housing credit transactions have often carried over into other joint community development activities.

The Low Income Housing Tax Credit has become the nation’s primary engine for affordable rental housing. Both Congressional leaders and the Administration support its expansion. The housing credit has generated 80,000 -100,000 units each year – plus an estimated 70,000 jobs, $1.8 billion in wages, and $700 million in tax revenues annually.

To be sure, tax credit programs have limitations. The approach is not appropriate for every group or all types of activities. In their initial years of operation, new tax credit programs are not always efficient, since the marketplace needs time to master their complexities. Nor does the use of tax policy to promote community development obviate the need for other grant programs that help community groups build capacity so that they can undertake this complex work.

But, just as the Low Income Housing Tax Credit has spurred substantial private investment in housing, a federal tax credit targeted toward CDC economic development activities can be an important tool for drawing private investment into low-income communities. The timing is right. The ground level network of strong organizations that can make effective use of a tax credit exists. The private sector has demonstrated a willingness to participate. And the neighborhoods themselves are ready, with many now able to sustain economic development over the long term.

Experience with the 1993 CDC tax credit offers valuable lessons.

The 20 CDCs selected to participate in the CDC tax credit demonstration had, as of mid-1998, used the credit to raise about $20 million in private-sector grants, loans and investments for their activities. The majority of those dollars came from banks, and grants accounted for a higher percentage than loans. The funds had been used for a variety of purposes, including economic development loan funds, small business promotion, CDC operations, commercial projects and other development-oriented activities.

CDCs’ experience with the 1993 credit also offers valuable lessons about how the credit could be improved. While a handful of CDCs have had no difficulty finding donors and investors, many have had to invest substantial staff time and resources trying to place their tax credits or design market worthy transactions. Of course, this is to be anticipated with any new program. By mid-1998 – with one year remaining before the CDC pilot tax credit program expires – about half of the eligible CDCs had met their $2 million CDC tax credit limit. As the expiration deadline approaches, CDCs are intensifying their efforts.

Of the CDCs that have raised significant amounts using the CDC tax credit, three received major technical and financial help from the Local Initiatives Support Corporation (LISC), a national community development intermediary. LISC pioneered an innovative limited partnership that made it economically worthwhile for major banks to make contributions and loans in exchange for the credits. Importantly, LISC’s complex limited partnership structure could not have been designed without the active participation of the banks, which were drawn to help because of the mutual trust and respect between them, the CDCs, and LISC.

As structured, the pilot CDC tax credit is primarily designed to attract grants to CDCs. The double benefit allowed for grants – the CDC tax credit plus the standard charitable deduction – is relatively generous. To make it financially feasible to serve low-income residents, CDCs almost always need some grant funds in their projects, combined with market rate loans, investments and other financing. Grants can also be extremely valuable in helping CDCs build their operational capacity. Consequently, a tax credit designed to generate a larger flow of grants can benefit CDCs by enabling these groups to expand both their community economic development activities and their organizational capabilities.

However, the institutions that CDCs have historically tapped for grants are almost exclusively tax exempt – primarily foundations, government agencies, and religious institutions. For these traditional funders of community development, the CDC tax credit is not a drawing card.

Armed with the CDC tax credit, CDCs could expand their grant raising activities among individuals and institutions with tax liability. But that would require marketing of a kind that has not yet accompanied the pilot credit. Apart from the very limited efforts of some individual CDCs and LISC, marketing of the 1993 CDC tax credit has been virtually non-existent. Without clear direction from the Internal Revenue Service about the tax treatment of grants made in exchange for the CDC tax credit, some potential contributors have shied away, fearing later consequences if their assumptions turn out to be wrong.

The CDC tax credit hasn’t been an easy vehicle for attracting bank loans or other investments, either. Without complex financial structuring of the kind provided by LISC, the rate of return on loans made to get the CDC tax credits is too low to entice a bank or other corporation to lend to CDCs, which are relatively risky, carrying higher than average transaction costs. Now that LISC has created a limited partnership structure, these problems should be easier to address. But more than one CDC leader described a process of finding a bank potentially interested in the credits – and then being shuttled back and forth between a bank’s loan division and its charitable department. Said one CDC executive director: “Some bankers we approached said the tax credits didn’t fit their investment profile and sent us to their charitable contributions division – which then told us it wasn’t a contribution either. And we went around and around.”

The 1993 CDC tax credit can be made more effective.

CDC practitioners offer the following suggestions for improving the effectiveness of the CDC tax credit in promoting economic development in low-income communities.

  1. Undertake a centralized marketing campaign to attract more grant dollars.

    Most CDC practitioners agree that a concerted marketing effort, with participation by the federal government, could draw in new grant dollars to CDCs from individuals and other tax-liable entities, particularly in a strong economy. To be successful, the effort would have to inform and excite a national audience about the positive track record of CDCs and ensure that the relevant federal regulators publicize clear formal guidance about the treatment of the CDC tax credits.

  2. Adjust the tax credit to better reflect today’s emerging market-based approach to community revitalization and to better attract more loans and investments.

    As structured, the pilot CDC tax credit still mirrors the old-style grant approach to community development rather than the decentralized investment orientation reflected in the Low Income Housing Tax Credit. HUD selects the winning groups, not the marketplace. The amount of tax credits that CDCs receive is fixed, not flexible. Continued high performance by the CDC is not required or even rewarded by the pilot CDC tax credit structure. In truth, not all of the 20 CDCs chosen by HUD for the pilot tax credit have exhibited the capabilities to handle complex financing. Nor is $2 million in tax credits necessarily the right amount for every organization. Such factors make the CDC tax credit less attractive to private sector lenders and investors than it could be with relatively slight modifications.

An alternative approach would be to modify the CDC tax credit so that it is better aligned with today’s market-oriented style of community revitalization. Such a tax credit would have the following features:

  • Is Market-Based. While the selection of the CDCs eligible for the 1993 tax credit was made through a competitive process, the competition was marked by a set of rigid rules. In short, the selection was based on a pre-determined number of winners and a pre-determined size of the tax credit. A market-oriented competition would reward CDCs that have demonstrated capacity and have specific projects or activities in mind. Winners of a more flexible selection process would not be limited to only 20 CDCs but may involve hundreds of CDCs with smaller tax credits, depending again on the identified project or activity. The amount of the tax credit should be determined by the specific financial needs of the project or the activity to be covered, not by a one-size-fits-all statute. Overall, this process would help ensure that the organizations that receive the tax credits have the capacity to effectively carry out the transactions and that their projects and activities satisfy a market threshold. A market-based competitive program for credits of varying amount is a natural outgrowth of the 1993 CDC tax credit demonstration.
  • Promotes Public-Private Partnerships. One condition of winning tax credits could be that CDCs must secure a contingent financial commitment from one or more private sector partners either to invest jointly with the CDC in any development project for which tax credits are being sought or to participate as a partner or mentor to the CDC for non-project activities to be covered by the tax credits. Such non-project activities might include programs to promote small business growth, home ownership or welfare-to-work transitions, or to enhance CDC operational capacity. The private sector partner or mentor requirement acts as a screen to help ensure recipient groups are capable. Even more important, it fosters the long-term relationships between nonprofits and private companies that have become so vital to community revitalization.

About a dozen states have enacted state tax incentive programs to promote investments, grants and donations of cash and goods and services to CDCs and related organizations. The state programs have encouraged strong partnerships between the corporate and nonprofit sectors. The best state programs are flexible, well targeted and easily monitored to avoid potential pitfalls in program administration.

Conclusion

The CDC tax credit has significant potential as a tool for community economic development. To realize every bit of this potential, Congress should modify the tax credit’s structure, and reauthorize and expand the 1993 program. Just as the Low Income Housing Tax Credit has spurred billions of dollars of private investment in affordable housing, a federal tax credit targeted toward CDC economic development activities could become a tool for drawing private investment into low-income communities. The private sector has demonstrated a willingness to participate in such transactions. CDCs have developed a solid capacity to undertake community development in partnership with the private sector without losing community control or endangering their local base. Tax credits can promote economic activity that is attractive to private investors and responsive to community needs.

The following paper provides an expanded explanation of the 1993 tax credit for CDCs and Congress’ original intent for the program. Based on interviews with the 20 CDCs qualified to use the tax credit, various community development intermediaries, and other practitioners in the CDC field, this paper reviews the experience of the tax credit program to date and makes recommendations on ways in which the program can be restructured and improved.

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