New Market Tax Credits (NMTCs) offer investors compelling benefits—39 percent tax credits over seven years while supporting economic development in underserved communities. However, like all investment opportunities, NMTC transactions carry risks that prudent investors must understand and evaluate before committing capital. These risks span regulatory compliance, business performance, legal complexities, market conditions, and structural vulnerabilities that can diminish returns or trigger adverse outcomes including credit recapture. Comprehensive risk assessment enables informed investment decisions that balance attractive benefits against realistic evaluation of potential downsides.
The NMTC Investment Structure and Inherent Vulnerabilities
Before examining specific risks, understanding the basic NMTC transaction structure illuminates where vulnerabilities emerge. Investors make Qualified Equity Investments (QEIs) in Community Development Entities (CDEs) that have received allocation authority from the Community Development Financial Institutions (CDFI) Fund. These CDEs deploy substantially all investment proceeds into Qualified Low-Income Community Investments (QLICIs), typically loans to Qualified Active Low-Income Community Businesses (QALICBs).
The investor claims tax credits over seven years—5 percent annually in years one through three, then 6 percent annually in years four through seven. The investment must remain in place throughout this compliance period, with early exit triggering recapture of previously claimed credits plus interest. Understanding this structure reveals multiple points where risks can materialize.
What Are the Potential Risks Associated With Investing in New Market Tax Credits?
NMTC investments expose investors to diverse risk categories, each requiring careful evaluation and appropriate mitigation strategies.
Recapture Risk: The Primary Compliance Threat
Recapture risk represents the most significant threat to NMTC investors. If the CDE fails to maintain compliance with NMTC requirements during the seven-year compliance period, the Internal Revenue Service (IRS) can recapture all previously claimed credits plus interest. This outcome transforms what appeared to be a 39 percent return into a catastrophic loss potentially exceeding the original investment amount.
Multiple scenarios trigger recapture. If the CDE fails to maintain its certification status through loss of qualifying board composition, mission drift away from serving low-income communities, or failure to maintain accountability mechanisms, recapture occurs. If the CDE doesn’t maintain the substantial all requirement—keeping at least 85 percent of QEI proceeds invested in QLICIs—recapture follows. If the underlying business loses QALICB status by relocating outside qualifying census tracts, changing to prohibited business activities, or failing active business tests, credits face recapture.
Business failure represents a particularly concerning recapture trigger. If the QALICB receiving CDE financing goes bankrupt, ceases operations, or otherwise fails during the compliance period, the CDE may be unable to maintain sufficient QLICI investments to satisfy the substantial all requirement. Even if the CDE attempts to redeploy capital into substitute businesses, the time required to identify, underwrite, and close replacement transactions may cause compliance gaps triggering recapture.
The recapture calculation compounds losses through interest charges on the recaptured amounts, creating liability exceeding the face value of credits claimed. An investor who claimed $3.9 million in credits on a $10 million investment might face recapture liability of $4.5 million or more including interest, turning a profitable investment into a devastating loss.
Limited Liquidity and Restricted Exit Options
NMTC investments inherently lack liquidity. Investors must maintain their QEIs throughout the seven-year compliance period, with early redemption triggering recapture. This illiquidity creates multiple challenges and risks.
During the compliance period, investors facing financial difficulties, portfolio rebalancing needs, or changed circumstances cannot exit NMTC positions without triggering recapture. The credits might provide tax benefits, but the capital remains locked, unavailable for other opportunities or emergencies. For investors whose financial situations deteriorate, this illiquidity can exacerbate difficulties.
While investors might theoretically sell their positions to other investors, the restricted nature of NMTC investments and recapture risks make finding buyers extremely difficult. No active secondary market exists for NMTC positions, and any potential buyer faces the same risks and restrictions as the original investor. Transaction costs and complexity further discourage secondary transfers even when willing buyers exist.
The typical transaction structure includes put and call options that enable unwinding after seven years at predetermined values. However, these exit valuations often heavily favor the CDE or project sponsor, leaving investors with minimal residual value beyond the already-claimed tax credits. While investors primarily invest for the credits rather than equity appreciation, the near-zero exit value means that any unexpected circumstances extending the investment period or complicating exit create pure cost without offsetting benefits.
Business Performance and Operational Risks
NMTC investments ultimately depend on the performance of underlying businesses operating in economically distressed communities. These businesses face all standard operational risks plus additional challenges associated with their locations and circumstances.
Market risks affect businesses in low-income communities as intensely as those elsewhere, but often with fewer buffers. Economic downturns, competitive pressures, technological disruptions, and changing consumer preferences threaten business viability. Businesses in distressed communities may serve customer bases with limited discretionary income, making them particularly vulnerable to economic cycles.
Management execution risks loom large for businesses that might lack experienced leadership or sophisticated operational capabilities. The businesses receiving NMTC financing often represent entrepreneurial ventures, small enterprises, or organizations with limited track records in their industries or markets. Management teams might struggle with rapid growth, market challenges, or operational complexity introduced by expansion projects.
Industry-specific risks vary dramatically across NMTC-financed businesses spanning healthcare, manufacturing, retail, real estate, and services. A community health center faces regulatory compliance risks, reimbursement rate changes, and workforce recruitment challenges. A manufacturer confronts supply chain vulnerabilities, quality control issues, and market demand fluctuations. Retail operations struggle with foot traffic, competition from e-commerce, and inventory management.
Location-specific risks stem from operating in low-income communities that may lack robust infrastructure, skilled workforce availability, supply chain access, and customer density that businesses in more affluent areas take for granted. Crime, blight, inadequate public services, and negative perceptions about distressed communities create headwinds affecting business performance.
Regulatory and Compliance Complexity
NMTC regulations present substantial complexity creating risks through technical noncompliance even when transactions are structured in good faith. The Internal Revenue Code Section 45D establishing NMTCs, Treasury regulations, IRS guidance, and CDFI Fund allocation agreements create layers of requirements that must be satisfied continuously throughout the compliance period.
Changes in regulations or IRS interpretations can affect existing investments. While major retroactive changes are uncommon, IRS guidance clarifying ambiguous provisions or addressing novel structures can create uncertainty about whether existing transactions comply fully. Investors generally cannot restructure transactions to accommodate new guidance without triggering recapture, creating vulnerability to evolving regulatory interpretations.
Audit risk exposes investors to IRS examination of NMTC positions potentially years after credits are claimed. The IRS has shown increased interest in NMTC compliance, conducting audits that scrutinize every aspect of transactions including QALICB status, census tract eligibility, active business requirements, and proper allocation of costs between NMTC-eligible and ineligible uses. Even technical violations discovered during audits can trigger recapture regardless of investor good faith or substantial compliance with program objectives.
Documentation requirements throughout the compliance period create administrative burdens and risks. CDEs must maintain extensive records demonstrating ongoing compliance, conduct annual audits, submit reports to the CDFI Fund, and track numerous metrics. Failure to maintain adequate documentation or submit required reports can jeopardize compliance even when underlying business operations proceed successfully.
Credit Capacity and Tax Planning Risks
Investors must have sufficient tax liability to utilize NMTC credits. The credits are nonrefundable, meaning they can reduce tax liability to zero but cannot generate refunds for any excess credit amount. While unused credits carry forward for some period, investors with insufficient tax liability over the credit claiming period fail to realize the full economic benefit of their investments.
Changes in investor circumstances affecting tax liability—business losses, income reductions, retirement, or corporate restructuring—can diminish credit utilization. An investor who anticipated robust taxable income throughout the seven-year period but experiences business downturns may find credits generating less value than projected.
Changes in tax law represent another significant risk. While credits already earned under current law generally enjoy some protection, future tax legislation could affect the value of unclaimed credits. Reductions in corporate or individual tax rates reduce the absolute value of credits, since a 5 percent or 6 percent credit provides less benefit when applied against lower baseline tax rates.
Alternative Minimum Tax (AMT) considerations can affect individual investors, as NMTC credits must be calculated separately for AMT purposes. Investors subject to AMT may realize less benefit from credits than those paying regular tax, complicating tax planning and potentially reducing investment returns.
Structural and Legal Risks
NMTC transactions involve complex legal structures incorporating multiple entities, agreements, and contingent arrangements that create various risks.
Partnership structures allocating tax benefits create risks if arrangements are challenged as lacking economic substance or business purpose beyond tax benefits. While properly structured NMTC transactions clearly satisfy economic substance doctrine requirements, aggressive structures attempting to maximize benefits beyond program parameters might face IRS challenge.
Guarantee obligations that investors undertake to support transactions create contingent liabilities that could be called if underlying businesses face difficulties. While investors typically structure guarantees with dollar limits or other constraints, they nonetheless represent potential obligations beyond the initial investment amount.
Disputes among transaction parties—investors, CDEs, project sponsors, and lenders—can arise from changing circumstances, different interpretations of agreements, or conflicting interests regarding transaction management and exit timing. These disputes can trigger costly litigation, complicate compliance, and reduce returns.
Legal changes affecting parties’ rights and obligations—bankruptcy law, debtor-creditor rights, partnership law—might alter transaction dynamics in ways that disadvantage investors despite careful initial structuring.
Environmental and Force Majeure Risks
Projects financed with NMTC capital face environmental risks through contamination discovered on project sites, hazardous materials requiring remediation, or unforeseen environmental compliance costs. While due diligence attempts to identify such issues, unexpected environmental problems can derail projects or substantially increase costs.
Natural disasters, pandemics, civil unrest, or other force majeure events can disrupt businesses receiving NMTC financing. The COVID-19 pandemic demonstrated how external shocks can threaten even well-conceived projects, with businesses forced to close, demand evaporating, and supply chains disrupted. While most businesses eventually recovered, some sustained permanent damage affecting their ability to satisfy NMTC debt obligations.
Concentration and Portfolio Risks
Investors deploying capital into individual NMTC transactions bear concentration risk, with transaction outcomes depending entirely on single projects or businesses. Unlike diversified funds spreading risk across multiple investments, a single-transaction investor faces binary outcomes with limited ability to absorb losses.
Even investors participating in funds deploying capital across multiple NMTC transactions face concentration relative to geographic areas, industries, or CDE relationships. A fund focused on a single metropolitan area faces regional economic risks, while an industry-focused fund concentrates sector-specific vulnerabilities.
Reputation and Mission Alignment Risks
Investors attracted to NMTCs partly for community development impact face reputation risks if projects fail to deliver promised benefits or cause community harm. A business that fails and leaves community residents unemployed, a facility that remains vacant after substantial investment, or projects that displace residents through gentrification effects can generate negative publicity affecting investor reputations.
Mission drift where projects evolve away from community benefit toward purely profit-driven outcomes can disappoint investors who valued social impact alongside financial returns.
Risk Mitigation Strategies
While NMTC risks are substantial, sophisticated investors employ various strategies to mitigate exposures. Thorough due diligence on underlying businesses, experienced CDEs with proven track records, conservative financial underwriting, diversification across multiple transactions, and active compliance monitoring throughout the investment period all reduce risk levels.
Engaging qualified legal and tax advisors with NMTC expertise, obtaining opinions supporting transaction structure and compliance, and maintaining comprehensive documentation provide additional protections.
Conclusion
NMTC investments offer compelling benefits but carry meaningful risks spanning regulatory compliance, business performance, liquidity constraints, tax planning variables, and structural complexities. Investors must approach these opportunities with clear understanding of potential downsides, realistic assessment of risk tolerance, and appropriate mitigation strategies. The most successful NMTC investors balance attraction to tax benefits and community impact against sober evaluation of circumstances where investments could underperform or trigger adverse outcomes. For investors willing to accept seven-year commitments, compliance obligations, and underlying business risks, NMTCs provide opportunities to earn attractive tax benefits while supporting economic development in America’s most distressed communities.