Quarterly: Summer 2000

CBQ >> Summer 2000 Issue

Tax Increment Financing - A Primer

by Michael Goodwin, Arnold & Porter

Tax increment financing - or "TIF" - has been widely hailed as a powerful tool for subsidizing real estate projects that advance important public interests. It exists in over 40 states, and the District of Columbia and several neighboring jurisdictions are now experimenting with fledgling TIF programs. It is becoming an important stock-in-trade for developers and the professionals that counsel them.

The Concept

The premise of TIF is that real estate development generates new real estate and sales taxes above and beyond the taxes generated by land in its undeveloped state. In a TIF-funded project, the local government permits the developer to use a portion of these new taxes to support financing for the project. Since the financing is repaid solely from the dedicated taxes, TIF effectively functions like a grant from the standpoint of the developer.

Because TIF involves the expenditure of the public fisc for private projects, it is limited to projects that advance public development objectives. Nearly all jurisdictions require that TIF applicants satisfy a "but for" test: but for the availability of TIF, the public priorities will not be achieved.

TIF in the District

In 1998, the City Council enacted a comprehensive program for TIF in the District. The eligibility criteria are many and complex, but in general there are four threshold tests that a project must satisfy:

The project must be located in a priority development area. These areas are designated in the TIF law, and include federally-designated Enterprise Zones (some 65 of the City's 193 census tracts), most of the old downtown, large portions of the area east of the Anacostia River, and development opportunity areas identified under the City's Comprehensive Plan.

The project must advance public development goals that the private sector has left unfulfilled. For years, the District's old downtown has lacked a critical mass of retail; the Gallery Place retail/entertainment project will address this need and is the first TIF project approved by the City. Other areas of the City have their own unique needs, such as neighborhood retail east of the river, and headquarters hotels near the new Convention Center.

The TIF subsidy is necessary to enable the project to proceed. Since TIF is "but for" financing, it will be used only as and to the extent necessary to enable a project to move forward. The amount of the TIF subsidy will be determined by the "financing gap" that cannot be closed by attracting conventional private equity and debt.

The project satisfies rigorous underwriting. The District limits TIF to projects that will generate sufficient taxes to provide a comfortable (e.g., 1.5:1) coverage ratio over repayment of the TIF. But there are structural issues in the District's tax base that make this a challenge. A substantial portion of the real property tax base is already pledged to secure the City's GO bonds, which means that TIF is generally not feasible for projects (e.g., residential) that generate exclusively real property taxes. While sales taxes rates are high, only the largest of retail projects will produce the stable tax revenue stream from credit tenants that is generally required for TIF. Because of these limitations, much of the early interest in TIF has come in the hotel sector.

Is the Program Working?

It's premature to pass judgment on the District's TIF program. A variety of legal and procedural issues initially slowed the implementation of TIF, but have now been resolved. Policy issues also retarded the program, since its implementation coincided with the transition to a new mayoral administration. Nevertheless, two TIF deals have been formally approved and are awaiting closing: a $44 million TIF for the Gallery Place retail/entertainment project, and a $24 million TIF for the Mandarin Oriental Hotel at the Portals.

The TIF process is a daunting one. A project is subjected to rigorous scrutiny by the Mayor, CFO, City Council and Control Board in a very public process. It is the unusual real estate deal that can withstand this bright light. But for the right project, the benefits of TIF - for both the public sector and the private developer - are enormous.

About the Author

Michael Goodwin is a partner in the real estate practice group of Arnold & Porter, specializing in real estate development and finance. He focuses on the representation of developers in the Washington metropolitan region, and has handled all aspects of the acquisition, development, financing and leasing of large-scale office, retail, hospitality and residential projects.

Mr. Goodwin has been heavily involved in the creation and implementation of the financial incentives and public/private partnerships that are changing the face of Washington. He was involved in formulating and drafting the tax increment financing legislation passed by the City Council in 1998. He is currently representing the coalition that has formulated the public/private financing for the new Metro station on New York Avenue.

Mr. Goodwin received his JD with honors from Harvard Law School in 1984, and his AB from The University of Chicago in 1981.