Tax increment financing: the developer's tax issues.

• Author: McGivney, Michael R.

In today's real estate market, large real estate developments and redevelopments are rarely executed without complex layers of debt and equity financing. While nontraditional capital can be obtained from private sources, often a financing gap is bridged by capital provided through federal, state, and local governmental programs intended to provide incentives for meaningful economic development in a depressed area. One tool increasingly employed is tax increment financing (TIF).

TIFs have long been used for financing public improvements, such as public infrastructure (streets, utilities, sewers, etc.), but have become increasingly used by private developers to construct nonpublicly owned property. A TIF is negotiated prior to any proposed improvements on the land and essentially allows the developer to use the real estate taxes on the increased value attributable to the proposed improvements to service debt on the property issued by the local government or development agency. Typically, the county and local municipalities agree to keep the current value of the property as the base value, and the increased value of the property after development over the base value--the incremental value--as the amount available to service the debt. The payments above the base value are considered service payments in lieu of taxes, or PILOT payments.

When a project is proposed, the first step is for a TIF to be authorized by a TIF ordinance adopted by a local governmental body, which creates a TIF district. Taxable or tax-exempt bonds are then authorized to be issued by the local government, and interest and principal payments on those bonds are sourced from and secured by the real estate tax assessments on the incremental value, which is the difference between the agreed-upon minimum value and the base value of the real estate located within the TIF district. Typically, developers guarantee a minimum assessment as security on the bonds. Those assessments are generally in force for a long period (e.g., 30 years). Most states and Washington, D.C., have passed legislation authorizing local governments to adopt TIF ordinances.

When a developer receives proceeds from a TIF bond for private improvements, the tax treatment of those subsidies becomes an immediate issue. Is the subsidy a grant, and, if so, are the proceeds taxable to the developer immediately? And are the increased real estate tax payments fully deductible? Or is the subsidy actually debt, and payments must be trifurcated among real estate taxes, interest, and debt reduction? These questions are not immaterial, as capital provided by TIFs to a project often can range from $10 million to more than $100 million.

As a Grant

When exploring grant treatment, one must first determine whether the grant is taxable or nontaxable, with large amounts of tax dollars at stake. If a taxpayer treats a grant as taxable, it will recognize income under Sec. 61. The taxpayer will use TIF proceeds to acquire, develop, construct, or improve...