What is tax increment financing (TIF)? How does a TIF work? What benefits are there to the developer or to the political subdivisions involved? Why would a bank get involved? These are typical questions that are posed when a TIF is first mentioned or suggested with regards to a project that has economic development aspects. A TIF can be a polarizing issue and a confrontational matter between the public body implementing the TIF exemption and the property owner/developer, or between the implementing public body and the affected school district. This article will focus on shedding some light on TIFs.
What is a TIF?
A TIF is an infrastructure financing tool authorized by several different sections of the Ohio Revised Code. It is usually viewed as an economic development tool because it provides a mechanism for the funding of infrastructure improvements that “directly benefit” the commercial development that results in the economic development (i.e., creation of jobs, long-term increase in property values, etc.) and also helps level the playing field between communities competing to attract commercial development. Although a TIF can be implemented by a municipal corporation (within the boundaries of the municipality) or by a county or township (within the unincorporated portion of the county), this article focuses on municipal TIFs.
A TIF is somewhat similar to Enterprise Zone (EZ) and Community Reinvestment Area (CRA) programs because it provides an exemption from property taxes of the increased property value from a commercial development project. What makes a TIF different is that the property owner is required to make “service payments in lieu of taxes” (commonly referred to as PILOTs) with respect to the exempted real property taxes. Those PILOTs are used to pay for costs of the infrastructure improvements (or to pay debt service charges on bonds or notes issued to finance the infrastructure improvements). Thus, the property owner does not receive a direct financial benefit (as is the case with EZ and CRA programs where certain percentages of property taxes are abated) but instead gets a more indirect benefit because the PILOTs are used to fund infrastructure improvements, the costs of which the property owner might otherwise have to pay.
The reason a TIF is advantageous for the Developer is that the increased property taxes that would otherwise be distributed to county, township, school and any special taxing districts, is instead used to pay costs of infrastructure improvements needed for the site.
What are the terms of a TIF?
A TIF is implemented by an ordinance of council which declares the increased real property values resulting from a development to be exempt from real property taxation. The maximum term of a TIF exemption is 30 years, and the maximum percentage exemption is 100 percent; however, without the consent of the affected school district(s), the exemption cannot exceed 10 years or be greater than 75 percent.
The TIF exemption commences with the tax year in which an improvement first appears on the tax duplicate that begins after the effective date of the TIF ordinance. The property owner is required to pay the PILOTs in an amount equal to the real property taxes exempted. The PILOTs paid by the property owner are used to pay costs of infrastructure improvements that directly benefit the property owner.
The property taxes of the existing land value, before the TIF, continue to be collected and distributed to the taxing entities just as before.
Project Subject to TIF Exemption
The law defines the types of commercial improvements that may be included in the TIF exemption as “construction, expansion, and alteration of buildings or structures, demolition, remediation, and site development, and any building or structure that results from those activities.”
A TIF of residential property is permitted only in limited circumstances. First, a residential TIF is permitted in situations where the project is located in a “blighted area of an impacted city,” as defined in RC Chpt. 1728. Second, a municipality is permitted to utilize a residential TIF when it creates an “incentive district.” An incentive district is an area not more than 300 acres in size enclosed by a continuous boundary with certain distress characteristics described by law.
Within an incentive district, not only can the increased value of residential development be included in the TIF, but also the PILOTs can be used to provide for “housing renovations” (including financing or supporting loans, deferred loans, and grants for housing renovations); provided the district also includes commercial or industrial property.
Recent legislation has limited the effectiveness of residential TIF. Tax levies approved or increased on or after January 1, 2006 and specific levies supporting many special taxing districts have been carved out of the potential amount of the PILOTs.
School District Notice and Consent
A municipality must give notice to the affected city, local or exempted village school district, as well as the joint vocational school district, of its intent to grant the TIF exemption for the project prior to the adoption of the TIF ordinance. The notice must be delivered to such school districts not less than 14 days prior to adoption of the TIF ordinance. If the exemption is to exceed the 10 year/75 percent threshold, the notice to such school districts must be delivered at least 45 business days prior to adoption of the TIF ordinance, and such school district’s board of education must consent to the TIF exemption. This requirement for school district consent can be avoided if the municipality uses TIF moneys to “make whole” the school district before it pays for infrastructure costs. This “non-school TIF” is difficult to accomplish in most cases because such a large portion of the real estate taxes go to the school district.
Income Tax Sharing
Also, if the project will generate annual payroll for “new employees” of $1,000,000 or more, the municipality is required to attempt to negotiate an income tax sharing arrangement with the affected school district (other than a joint vocational school district). If an agreement is not negotiated within six months after council formally approves the TIF exemption, the municipality is required to split income tax revenue generated from new employees with the school district on a 50/50 basis, subject to an “infrastructure set-off” amount up to 35 percent of the taxes levied and collected on the income of new employees at the site.
School Compensation Agreements
Increasingly, communities are finding creative ways to utilize the unique aspects of Ohio school funding when it comes to seeking school board approval for the creation of a TIF. Ohio school districts receive their funding from two primary sources - local property taxes and state funding. For most school districts, as local property values increase, state funding is reduced. The biggest factor in creating this situation is known as the “23-mill charge-off,” which reduces a school district’s state aid amount by 23 mills times the adjusted assessed valuation for that district. This is based on an assumption that every school district has at least 23 mills of local revenue from property tax levies. Some municipalities have taken advantage of this anomaly by establishing a TIF with a 100 percent exemption and then making a compensation payment to the affected school district for all or a portion of the property taxes that the school district would have received if the property had not received the TIF exemption. In certain circumstances this will put the school district in a more favorable financial situation, on a net basis, than it would have been in had the development been undertaken without any exemption. Using this model, the municipality and the school district can find themselves in one of those rare win-win situations.
What are some of the important financing issues related to the use of TIFs?
As previously noted, a TIF is typically used to make debt service payments on bonds issued to finance the infrastructure improvements (TIF Bonds). Two issues are worth noting in this context: (1) credit/security issues relating to the TIF Bonds; and (2) tax exemption of interest on the TIF Bonds. If the municipality is willing to issue TIF Bonds for the project, it very likely will require that the Developer provide the municipality with assurances that the PILOTs will cover the principal and interest requirements of the TIF Bonds.
Marketability of TIF Bonds
Until a development is completed, there is no assurance that the TIF revenue stream will be created. While the municipality might want to finance the infrastructure improvements pledging only the revenue from the TIF (and not a pledge of its general obligation taxing power), in most cases TIF Bonds would not be marketable without some additional security that investors can rely on as the source of payment of principal and interest on the TIF Bonds. The TIF Bonds may not be marketable because, at the time the TIF Bonds are issued, the development that will create the PILOTs has not been completed (and sometimes not even started). In some cases, the municipality may be willing to use its general obligation taxing power to provide the security for the TIF Bonds. However, this may not be practical because debt capacity issues or debt policies of the municipality.
Even if the municipality were willing to issue general obligation bonds to finance the infrastructure improvements, most municipalities would require that the Developer provide some security to protect against the development risk associated with the project. That might include a minimum service payment agreement or a letter of credit provided by a bank. Under a minimum service payment agreement, the Developer agrees that minimum payments, equal to principal of and interest on the TIF Bonds, will be paid by the Developer to the municipality, regardless of the PILOT that would otherwise be payable based on the assessed value of the project. Recently, the IRS promulgated new proposed regulations that make minimum service payments harder to use.
In the case of a letter of credit, the Developer is required to maintain the letter of credit through construction and into project stabilization, with an established PILOT-to-debt service ratio greater than the annual debt service requirements of the TIF Bonds.
Keys for Consideration and Conclusion
TIFs can be complicated to initiate and somewhat difficult to administer. When considering the use of tax increment financing, the parties involved should consider the following issues:
1. How important is the project to the community?
2. What are the infrastructure needs of the project, and who should provide that infrastructure?
3. What is the school district’s attitude about TIFs in general and about the project?
4. What is the reputation and credit of the developer and its affiliates?
5. How reliable are the projections that are being used to build the TIF revenue model?
6. How is the risk associated with the development of the project to be minimized?
7. Is the municipality able to access the credit markets on its own?
With careful analysis and planning, tax increment financing can be an effective financing tool for public infrastructure improvements.