New Market Tax Credits (NMTCs) offer investors compelling benefits—39% tax credits over seven years while supporting economic development in underserved communities. However, NMTC transactions carry risks that prudent investors must understand and evaluate before committing capital. These risks span regulatory compliance, business performance, legal complexities, and structural vulnerabilities that can diminish returns or trigger credit recapture.
The NMTC Investment Structure
Investors make Qualified Equity Investments (QEIs) in Community Development Entities (CDEs) that deploy 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% annually in years one through three, then 6% 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.
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% return into a catastrophic loss that could exceed the original investment.
Multiple scenarios trigger recapture, including loss of CDE certification status, failure to maintain the 85% substantially all requirement, or if the underlying business loses QALICB status by relocating outside qualifying census tracts or changing to prohibited business activities. Business failure represents a particularly concerning trigger. If the QALICB goes bankrupt during the compliance period, the CDE may be unable to maintain sufficient QLICI investments. 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.
Limited Liquidity and Restricted Exit Options
NMTC investments inherently lack liquidity. Investors must maintain their QEIs throughout the seven-year compliance period; early redemptions trigger recapture. During the compliance period, investors facing financial difficulties or changed circumstances cannot exit NMTC positions without triggering recapture. The credits provide tax benefits, but the capital remains locked, unavailable for other opportunities.
While investors might theoretically sell their positions, the restricted nature of NMTC investments and recapture risks make finding buyers extremely difficult. No active secondary market exists for NMTC positions. The typical transaction structure includes put and call options that enable unwinding after seven years, but these exit valuations often heavily favor CDE, leaving investors with minimal residual value.
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, as well as additional challenges associated with their locations.
Market risks affect businesses in low-income communities intensely, 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 companies receiving NMTC financing often represent entrepreneurial ventures or small enterprises with limited track records. Location-specific risks stem from operating in low-income communities that may lack robust infrastructure, a skilled workforce, and customer density.
Regulatory and Compliance Complexity
NMTC regulations are highly complex, creating risks of technical noncompliance even when transactions are structured in good faith. Sections 45D of the Internal Revenue Code, 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. 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 QALICB status, census tract eligibility, and proper cost allocation. Even technical violations can trigger recapture regardless of the investor’s good faith.
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. Investors with insufficient tax liability during the credit-claiming period fail to realize the full economic benefit.
Changes in investors’ circumstances affecting tax liability—such as business losses, income reductions, retirement, or corporate restructuring—can reduce credit utilization. Changes in tax law represent another significant risk. Future tax legislation could affect the value of unclaimed credits. Reductions in corporate or individual tax rates reduce the absolute value of credits.
Structural and Legal Risks
NMTC transactions involve complex legal structures incorporating multiple entities and agreements. Partnership structures that allocate tax benefits create risks if arrangements are challenged as lacking economic substance or a business purpose beyond tax benefits. Guarantee obligations that investors undertake create contingent liabilities that could be called if underlying businesses face difficulties. Disputes among transaction parties can trigger costly litigation and reduce returns.
Environmental and Force Majeure Risks
Projects financed with NMTC capital face environmental risks, including contamination discovered on project sites, hazardous materials requiring remediation, and unforeseen ecological compliance 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.
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 help reduce risk.
Engaging qualified legal and tax advisors with NMTC expertise, obtaining opinions supporting transaction structure and compliance, and maintaining comprehensive documentation provides additional protections.
Informed Investment Decision-Making
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 a clear understanding of potential downsides, a realistic assessment of risk tolerance, and appropriate mitigation strategies.
The most successful NMTC investors balance the attraction of tax benefits and community impact with a sober evaluation of circumstances in which investments could underperform or trigger adverse outcomes. For expert guidance on NMTC investment risk assessment and mitigation, explore our NMTC advisory services, review our track record in our project portfolio, or request a free project analysis to evaluate investment opportunities and associated risks.