Volume 5, No. 2, Summer 2000

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Valuation: The Analytical Foundation of Tax Increment Financing

By Robert H. Brown, Vice President; Darrell V. Koehlinger, Appraiser; & Robert J. Strachota, President

One of the more important and least understood tools for real estate development today is tax increment financing (TIF). TIF is a development tool available to municipalities and development authorities in Minnesota as authorized by the Minnesota Tax Increment Financing Act which governs its uses. It was first passed by the state legislature in 1979 and has been modified repeatedly since its adoption. Currently, there are seven different types of TIF districts, each with its own qualifying criteria and expenditure parameters: redevelopment, renewal and renovation, soils condition, housing, economic development, mined underground space and hazardous substance subdistricts. Typically, local governments stimulate development in "blighted" or "under-utilized" areas by providing incentives to developers through the creation of TIF districts.

The establishment of a TIF district requires an analysis and forecast of the incremental taxes anticipated by a new development compared to the taxes currently generated by the existing use. This expected incremental cash flow is assigned to the designated developer and/or the municipality according to the terms of the agreement. Reliable value estimates are an important component of these development agreements when tax increment financing is required. Every development agreement involving this form of special financing is unique. Each one requires realistic valuation estimates throughout the negotiation process in order to accurately determine the expected incremental cash flow. A clear view of how TIF operates and a well grounded understanding of current and future market values are indispensable.

The Tax Increment Financing Process
Before TIF can be used to finance a project, the established notice, review and approval process must be followed. TIF plans must first be filed with the State Department of Revenue. The State Auditor conducts an annual audit and disclosure for all TIF districts in Minnesota. There is no legal limit to the number of TIF districts which may be created. However, most municipalities prefer that the total does not exceed 15% to 20% of their taxable base.

Once a TIF district is established, the tax capacity of properties located within the district is "frozen". The tax capacity is the actual taxable value of the properties as determined by multiplying its market value (estimated by the assessor) times its assigned class rate, or percentage (determined by the Legislature). Tax capacity times the local tax extension rate equals taxes generated. Property taxes generated from the "frozen" tax capacity continue to be paid to the various taxing jurisdictions such as the local school district, county, and city, among others. Freezing declining property values in underutilized areas effectively buffers the local school district and other taxing jurisdictions from the continued erosion of the local tax base. When the TIF district expires, the municipalities benefit from property anticipated to have a tax capacity higher than that prior to the new development or redevelopment. The tax increase generated by ad valorem taxes from this new development is diverted into a special account which is used to finance or subsidize the development.

A qualifying project is anticipated to create new property taxes resulting from an increase in tax capacity above the "frozen" level. For a district's duration (which varies depending on the type of district but generally ranges from 9 to 25 years), this incremental cash flow is available to the municipality or development authority to finance qualified project costs which might include property acquisition, demolition, relocation, certain site improvements, public and on-site utilities, public street improvements, soil corrections, and certain administration and financing costs depending on the development agreement.

Except for qualified housing districts, projects financed with TIF must serve a public purpose and pass the "but for" test, i.e., private developers would not undertake a project within the reasonably foreseeable future but for the existence of special financing such as TIF. Because cities were found to be applying the "but for" test arbitrarily, in 1995, the Legislature required municipalities to find "that the increased market value of the site that could reasonably be expected to occur without the use of tax increment financing would be less than the increase in the market value estimated to result from the proposed development after subtracting the present value of the projected tax increments for the maximum duration of the district permitted by the plan". This means the municipality must find that the market value of a TIF assisted project would exceed the market value of a reasonable project not using TIF by at least the present value of the expected TIF benefits.

Types of Tax Increment Financing
TIF agreements are not standard contracts; they are legal agreements which are unique to the specific development and can often be quite complex in nature. However, three common financing methods are summarized below:

Pay-as-you-go: The developer pays for TIF eligible costs, and the development authority promises to reimburse the developer as the tax increment is generated. The developer pays property taxes and is reimbursed from these payments. The financing risk is shifted to the developer with this method.

Bonds: Bonds are issued "up front" to pay for public redevelopment costs and are repaid with new taxes (the tax increment) generated by the development.

Internal financing: The development authority pays costs directly and may be reimbursed through tax increments or other revenue sources.

Since passage of the Tax Reform Act of 1986, the pay-as-you-go method is the most common method of financing eligible project costs, with terms of repayment described in a development agreement between the developer and the municipality or authority.

Importance of Valuation In Tax Increment Financing
Valuation tools and skills are needed throughout the TIF process. As mentioned, one must be familiar with property market values to demonstrate that the "but for" test is satisfied. An accurate forecast of the cost of acquiring land or improved properties, through private negotiations or eminent domain, is often needed prior to beginning a development or redevelopment project and requires reliable value estimates. Estimating realistic future values of a development or redevelopment project is critical for predicting the increments a development project is likely to generate. Because base tax values are fixed, the level of tax increment is wholly dependent on future values. While no one can be certain of future rent or vacancy levels, sale prices or property values, valuation experts can assist in the process of determining reasonable estimates of future value based on knowledge of past and current activity as well as real estate trends. Because municipalities sometimes ask for minimum assessment agreements, a knowledge of value trends is also helpful in assessing their risk in a development project.

The objective in securing a third party opinion for TIF analyses is to protect and assure the municipality and private developer so that they mutually undertake a financially feasible project. A competent third party consultant can often provide objective advice and counsel to both municipality and (re)developer in properly structuring a development agreement which involves TIF. A valid third party opinion often serves the same necessary role as a valid property appraisal does in the securing of a loan.

Summary
From testing project feasibility to estimating likely increments generated from a TIF assisted project, valuation is the analytical foundation on which development agreements involving TIF are negotiated. Dependable valuation not only facilitates the process, but helps to minimize the associated risks of developers and municipalities involved in TIF projects. Knowledge of the characteristics of current tax increment financing laws and basic market valuation knowledge are indispensable.