United States: Tax Increment Financing – A Developer's Playbook

I. INTRODUCTION.

Project development carries with it its own set of challenges. When assessing a project, a developer is constantly calculating the risks and rewards. This becomes even more of a concern when a project is located in an economically distressed or blighted area. Where this occurs, the combination of traditional debt and equity frequently comes up short in covering the project's development costs, requiring a search for other sources of capital to fill the gap. Often a financing gap like this is bridged by federal, state, and local governmental incentives. One such incentive is Tax Increment Financing ("TIF").

TIF is a popular, sometimes contentious, economic development tool designed for state and local governments to finance public improvements or attract private capital into areas that would not otherwise be redeveloped but for public support.¹ By definition, TIF relies on the increase in tax revenues, known as "tax increments" which are produced from the redevelopment of real estate within a designated area.² It is this tax increment which is the difference between the old tax revenues (before redevelopment) and the new tax revenues (occurring after redevelopment) that is the source of the funding or reimbursement of a portion of a project's development costs.

TIF is viewed as a "win-win" for both the developer and the community. Developers, on the one hand, look to TIF for assistance when they cannot get their projects to pencil out financially while communities, on the other hand, see it as a golden opportunity to turn a damaged, nonproducing asset into something of value with social and economic gains. With the benefit of this tax incentive, a project is in the position of leveraging private investment by relying on future tax recoveries to repay capital expended on public infrastructure associated with development. Unlike other tax federal, state, and local incentives which are self-executing,³ there are a number of unknowns in TIF which are out of the control of developers, requiring them to spend their own capital upfront with only a possibility the incentive takes shape in the future.

II. BACKGROUND.

TIF is considered a self-funded, performance-based, financing tool. It is "self-funded" because it relies on the use of future revenue to pay current costs associated with the redevelopment of a nonproducing asset. It is "performance-based" because its success depends on the future tax revenues generated from the increased property values created by the development. It is a creature of statute with every state and the District of Columbia, with the exception of Arizona, having enacted some form of TIF legislation.⁴ Kentucky has enacted two TIF programs: a local TIF development area program which provides local-only incentives and a state TIF development area program which includes state and local benefits.⁵ Politically, TIF empowers state and local governments to fund economic development without having to raise tax rates or passing new taxes. Since it is funded by future tax revenue, it is not part of an annual budget process nor does it require voter approval. In the eyes of politicians, this is perceived as having great appeal to their constituents.

As a general rule, TIF pays a portion of public infrastructure improvements (streets, sewers, sidewalks, and parking lots) in an area in and around a new development. Some states allow TIF proceeds to be used to acquire real property (including eminent domain), pay soft costs attributable to planning expenses (legal fees, studies, engineering, etc.), reimburse direct expenses incurred in the demolition and rehabilitation of existing buildings, remediation of environmentally contaminated areas, and fund job training programs. Finally, some states allow TIF to directly subsidize private development expenses. In Kentucky, for example, tax revenue reimbursements will depend on the particular program. Tax revenues from a local TIF can be used only to pay approved public infrastructure costs and redevelopment assistance within a TIF district, which may include private development costs.⁶ Projects entitled to state reimbursement will cover only approved public infrastructure costs which are associated with acquisition, installation, and construction.⁷

While TIF is viewed as a practical means to an end, it has faced its share of criticism. As a rule, tax revenues are used to pay for basic services of state and local communities, such as police and fire protection, sanitation services, transit, and education. TIF focus on these tax revenues by freezing taxes on property in a designated area and then earmarking any additional taxes collected above the tax base due to increased property values to fund qualified projects specifically within the TIF footprint. Providing projects first priority to this long-term funding source results in placing private developers ahead of the existing needs of the residents, many of whom lack access to a quality life, be it meaningful jobs or home ownership.⁸ Critics contend this treatment results in taxpayers subsidizing private business interests at the expense of communities struggling to make ends meet and often leads to its gentrification.⁹ Finally, a common criticism voiced is that the politics involved with TIF lacks transparency often occurring without public comment or community input resulting in little accountability.¹⁰

III. UNDERSTANDING THE WORKINGS OF THE TIF PROCESS - A CLOSER LOOK AT KENTUCKY HOUSE BILL 321.

On April 9, 2021, Governor Andy Beshear signed into law House Bill 321. In the words of the Governor, "it [HB 321] is bipartisan legislation aimed to foster transformational change in the West End of Louisville".¹¹ The bill creates the West End Opportunity Partnership Development Area (the "TIF Development Area").¹² As a mixed-use redevelopment in blighted urban area, it encourages private investment in exchange for state and local TIF incentives.¹³ By law, 12 board members are appointed by the Governor to the West End Opportunity Partnership ("WEOP"), which, in turn, selects nine additional board members from interested community residents.¹⁴ As the public corporation¹⁵ assigned to oversee the management of, and investment in, the revitalization of the TIF Development Area, WEOP will focus on projects supported by residents and businesses within the TIF Development Area. In doing so, it is directed to: (i) encourage private investment in businesses and residential projects that will have a significant economic impact within the TIF Development Area; (ii) ensure all new housing projects include the creation of affordable housing for low-income families; (iii) provide a refundable income tax credit for residential property owners in the TIF Development Area who maintain the property as their principal residence; and (iv) ensure that all projects hire area residents for employment, both in short-term construction jobs and long-term employment in businesses locating within the TIF Development Area.¹⁶

In exchange for the investment of private capital in the TIF Development Area, a developer may seek reimbursement of up to 80% of incremental state taxes (real property, ad valorem, sales, corporate income, and limited liability entity tax)¹⁷ and Louisville Metro taxes (real property, ad valorem, and occupational license)¹⁸ generated within a project's footprint¹⁹ over a 20-year period.²⁰ A qualified project is entitled to receive, by way of reimbursement, up to 100% of the approved public infrastructure costs and costs related to land preparation, demolition, and clearance.²¹ Local incremental revenues from the TIF Development Area may be used to pay for project costs and/or redevelopment assistance as well as private costs related to the development in addition to public infrastructure costs.²² State incremental revenues, on the other hand, will only pay for public infrastructure costs and costs associated with land preparation, demolition, and clearance.²³ This is often referred to as a "pay as you go TIF",²⁴ which means a developer assumes the risk of investing its own capital in infrastructure costs and only gets paid after the project delivers and tax increments are being created. In this situation, the developer gets paid back over time but carries the risk that the tax increments generated over the course of the TIF Development Area may not be enough to cover the total eligible costs. However, the developer is still responsible for all costs associated with the project which more than likely includes third-party debt.

Before any reimbursement is available to a project, the TIF Development Area must be activated by way of a minimum statutory capital investment. Specifically, Metro Louisville and/or private investors must invest at least $20 million into the TIF Development Area before June 30, 2022.²⁵ If this occurs, Kentucky has pledged to make an additional $10 million capital investment. It's at this time that the property values will be set at the 2021 tax rate and any tax increments above the set values will be earmarked to finance a project. However, without the minimum investment, the Commonwealth has the right to withdraw its pledge and terminate its obligation to provide incremental revenues.²⁶

With this background, attention turns to a developer's project, itself. To qualify for incentives, any property, asset, or improvement located in the TIF Development Area²⁷ must first satisfy the following criteria. It must: (i) represent new economic activity in the Commonwealth, (ii) indicate a net positive impact to the Commonwealth as certified by an independent outside consultant, and (iii) include pedestrian amenities and public space.²⁸ It must also incorporate at least two of the following "uses": (a) retail, (b) residential, (c) office, (d) restaurant, and/or (e) hospitality.²⁹ A "use" must comprise at least 20% of the total finished square footage or 20% of the total capital cost.³⁰ However, a project may qualify if all of the following three requirements are satisfied: (i) includes at least three uses, (ii) one of the uses meets the 20% requirement, and (iii) the other "uses" when combined together meet the 20% requirement. For purposes of this carve out, the area cannot include any retail space that exceeds 20,000 square feet of finished square footage and must meet three of the seven blight/deterioration conditions³¹

At this point, it is up to the developer to take the initiative to secure TIF incentives, and it all starts at the local level. Developers who consider making investments in the TIF Development Area begin by negotiating for local reimbursement with WEOP and Metro Louisville, and then approach the Commonwealth for state incentives. However, a project will not be able to seek state assistance until all local approvals have been received and the project demonstrates that the local revenues pledged to support a project are sufficient in amount to obtain state aid. Initially, it is up to the developer to provide the appropriate documentation to support the project costs, substantiate the capital investment, and convince both the WEOP Board and the public that the project's infrastructure investment would not be possible but for the incentives. Specifically, a developer must establish that the proposed project, with the TIF assistance, will: (i) increase the value of the taxes in the TIF Development Area, (ii) increase the tax base of Metro Louisville, (iii) increase employment in Metro Louisville, and (iv) enhance housing opportunities for Metro Louisville residents. All of this requires the developer to incur the time and expense of preparing a detailed project budget along with in-depth financial projections, while also engaging the services of an independent third party consultant to conduct a feasibility report to confirm the project's financial viability. If successful, the results of these efforts will be reflected in three key agreements, each of which will undergo considerable scrutiny and ultimately be drafted with the appropriate protections and assurances in order to protect the public.

1. The TIF Development Agreement.  The culmination of positive discussions at the local level concludes with the execution of the Tax Increment Financing Development Agreement between the developer and WEOP. This Agreement is the development plan used as a guide to coordinate development and evaluate the project to leverage the public investment. It specifically defines the respective roles and responsibilities of the developer and WEOP as to the TIF reimbursement. The Agreement will identify: (i) the particular project footprint within the TIF Development Area, (ii) the developer's minimum capital investment, (iii) the project design, (iv) the development schedule, (v) the construction of the improvements, and (vi) the range of increment financing available to the project within its footprint. This is an important first step for the developer. It is at this point that WEOP commits, by contact, to the specific TIF increments to the project with the WEOP Board having the ability to cap its award at anywhere less than 80% of TIF-eligible incremental tax revenues.

2. Local Participation Agreement.  As an inducement to the developer to commit to the project, Metro Louisville and WEOP will enter into the Local Participation Agreement. Based on the findings set forth in the TIF Development Agreement, WEOP will pursue the execution of the Local Participation Agreement with Metro Louisville.³² Under the law, Metro Louisville is authorized to enter into this Agreement with WEOP in acknowledgement of the public benefits to be gained within the TIF Development Area. It will be up to Metro Louisville to calculate the amount of the tax increment which will be equal to 80% of the tax increment released over a 20-year period. The Local Participation Agreement will be adopted by Metro Louisville by ordinance and will include, but not be limited to: (i) the identification of parties and their respective rights, duties, and responsibilities; (ii) specific identification of the incremental revenues pledged; and (iii) the anticipated benefit to be received by Metro Louisville.³³ Specifically, this Agreement will set forth the release to WEOP a portion of the "tax increments", usually in a dollar amount, to cover specific costs of the project. The pledge of these incremental revenues will take a superior priority to any other pledges of revenue.³⁴

3. Tax Incentive Agreement. As a mixed-use redevelopment in a blighted urban area TIF, projects located in the TIF Development Area are entitled to apply for state tax increment reimbursement. This can only occur once the local incentives are finalized. Metro Louisville, with the assistance of WEOP and the developer, will prepare and submit an extensive application to the Kentucky Cabinet for Economic Development & Finance Authority (the "KEDFA"). Much like the local process, this too is expensive and time consuming without any guarantee of success.³⁵

It is important to note that the Commonwealth does not simply rubber stamp the local jurisdictional findings. It is only after considerable evaluation and analysis of the applicant's materials and the independent consultant's feasibility report required by statute that KEDFA will make a determination based on the project's overall net positive economic impact to the Commonwealth and whether the project cannot occur if not for the granting of the incremental revenues.³⁶ If the conclusion is that the project reflects a positive impact to the Commonwealth, KEDFA will enter into a Tax Incentive Agreement. The contents of the grant contract must include, but not be limited to: (i) identifying the project's footprint, (ii) the maximum amount of the increment available, (iii) the specific state taxes pledged, (iv) the approved public infrastructure expenditures, and (v) the project's reporting requirements.³⁷ Any such agreement is made on the basis of automatic year-to-year renewals, with the option to discontinue it upon 60 days' notice before the end of any annual termination date.³⁸ Once finalized, the Agreement will be submitted to KEDFA for final approval.

There are several things worth noting about the Tax Incentive Agreement. While the Commonwealth has the statutory authority to pledge up to 80% of the incremental taxes generated to the project, in practice, the pledge often ends up between 40 and 60%.³⁹ Second, the Tax Incentive Agreement will contain a "percentage completion" provision requiring 100% of the project investment to be completed for the project to be eligible for 100% of the approved tax incentive pledged to it.⁴⁰ Third, the funding of anticipated eligible costs will be received in a "receipts-based" fashion that requires proof of the payment of the expenditure before funds are released and funds can only be released when the project actually begins to create the incremental tax revenues that will be financing the payments.⁴¹ Finally, only those costs incurred after preliminary approval qualify for the incentives.⁴² Costs incurred before preliminary approval is received from KEDFA will not be eligible for reimbursement.

IV. CONCLUSION.

Tax Increment Financing is often viewed as mutually advantageous for both the private developer and the public. As a popular government subsidy used to incentivize private developers, the end result is a public private partnership which stimulates economic development in blighted areas. While a developer's opportunity to leverage public dollars is appealing, the use of TIF has its own set of challenges, a number of which are out of the control of the developer. Therefore, a developer needs to take the time and expense to analyze the scope of the transaction and assess the risks and potential rewards of tax increment financing.

Footnotes

1. The paper highlights the general framework of tax increment financing in the Commonwealth of Kentucky and the particular analyses considered by Kentucky state and local governing bodies. However, the principles and concepts are often applicable in other jurisdictions.

2. KRS 65.7043(17). Tax revenues can include property, sales & use, and/or occupational taxes.

3. Incentive statutes which are "self-executing" take effect immediately upon satisfaction of the statutory provisions without the need of intervening court action, ancillary legislation, or other type of implementing action.

4. See "Tax Increment Finance State-By-State Report," CDFA Original Research, Released 2015.

5. Kentucky's Tax Increment Financing (TIF) legislation, codified in KRS 65.7041-65.7083, KRS 139.515 and KRS 154.30-010-154-30-090.

6. KRS 65.7043(1)

7. KRS 65.7043(2)(b)

8. KRS 65.7063(2)

9. See "Following board resignations, here are 7 questions answered about the West End TIF project," Ben Tobin, Louisville Courier Journal, October 18, 2021.

10. See "TIF Creep Means Growing Costs, Less Accountability," Pam Thomas, Kentucky Center for Economic Policy, June 12, 2017.

11. "Gov. Beshear Signs Bills that Help Build a Better Kentucky," Office of the Governor, Kentucky.gov, April 9, 2021.

12. The Development Area is established by a local government in accordance with KRS 65.7049 and KRS 65.7053, which allows a city or county to create a TIF area. Once the area is identified, it will be certified by the Commonwealth. All state TIF projects must first have a local TIF area approved.

13. KRS 154.30-060

14. KRS 65.503

15. KRS 65.502(1)

16. KRS 65.502(2)

17. KRS 65.501(7)

18. KRS 65.501(11)

19. Only the tax revenues generated within the footprint of the specific identified project are included in the increment. The footprint is defined as the actual perimeter of a discreet, identified project within a development area in which capital investments are made.

20. KRS 65.504(1)

21. KRS 154.30-060(5)

22. From a federal tax perspective, TIF proceeds received as a reimbursement of private developer's costs are considered income. As a general rule, TIF proceeds applied towards the permanent benefit of a private taxpayer will give rise to current or deferred income taxation. See also Michael R. McGivney CPA, MSA and Adam J. Hill, CPA, Tax Increment Financing: The Developer's Tax Issues," The Tax Advisor (August 1, 2015)

23. KRS 154.30-060(2)

24. Tax Increment Financing (TIF)," The World Bank, urban-regeneration.worldbank.org/node/17

25. KRS 154.30-060(4)(d). At this time the Louisville Metro Council has appropriated $10 million for the TIF Development Area.

26. KRS 154.30-080(1)(b)

27. KRS 154.30-010(26)

28. KRS 154.30-060(3)

29. KRS 154.30-060(3)(b)

30. KRS 154.30-060(3)(a)(1)

31. KRS 154.30-060(a)(a)(2)

32. KRS 65.504(2)

33. KRS 65.504(3)

34. KRS 65.504(4)

35. A non-refundable application fee of $1,000 is payable upon submission of the TIF application. Prior to final approval, the applicant will be responsible for an administrative fee equal to one-fourth of one percent (0.25%) of the final incentive amount authorized in the tax incentive agreement up to a maximum of $50,000. In addition, the applicant will be responsible for all independent outside consultant fees and legal fees, including expenses of counsel to KEDFA, necessary for the preparation of the consultant report and the tax incentive agreement.

36. KRS 154.30-030 (6)(a)(9)

37. KRS 154.30-070(1)

38. KRS 154.30-070(3)

39. See "FAQs: Tax Increment Financing (TIF) Program, Team Kentucky, Cabinet of Economic Development ,CED KY.gov., page 6.

40. KRS 154.30-080(1)(a)

41. KRS 154.30-080(2)

42. KRS 154.30-060(7)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.