Don't Let Your "TIF" Cause a "Tiff"
July/August 2003

By: Price D. Finley

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No, the title of this article is not meant to be a spelling test. “TIF” is an acronym for “tax increment financing,” the topic of this article. Merriam-Webster defines a “tiff” as a “petty quarrel.” Ironically, many economic development practitioners mistakenly refer to tax increment financing as a “TIFF” (perhaps their automatic spell checkers are to blame). This is ironic because, without careful preparation, a “TIF” can evolve into something more than just a petty quarrel, either between the municipality implementing the TIF exemption and the property owner/developer, or between the municipality and the affected school district.

What is a TIF?

Tax increment financing (TIF) is an infrastructure financing tool authorized by several different sections of the Ohio Revised Code. It is generally 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.). 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 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) 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. In comparison to an EZ exemption, which can apply to both real and personal property taxes, a TIF exemption applies only to real property taxes.

For example, if a property owner or other party undertaking a commercial development (a Developer) needed to invest $10 million on a new building but the site of the development did not have adequate roads and needed water and sewer service, tax increment financing could provide the funding mechanism for such infrastructure improvements. The reason a TIF is advantageous for the Developer is that, if the real property effective tax rate for commercial property were 65 mills (including millage that, without a TIF exemption, would go to the county, township, municipality, school district, and any special taxing districts), using a TIF, the increased property taxes that would otherwise be distributed to those subdivisions is instead used to pay costs of those infrastructure improvements. In this example, because real property is taxed at its “assessed” value (35 % of its true value), the new building would produce $227,500 of PILOTs annually ($3,500,000 x .065 = $227,500 – 1 mill produces $1 for each $1,000 of value). This additional revenue could be used to pay for costs of the road, water and sewer improvements that enable that site to service the project.

TIFs are considered economic development tools (just like EZs and CRAs) because they help one community “level the playing field” with respect to other communities against which they may be competing to attract commercial development and, in turn, employers. In the example above, if the Developer were looking at potential sites in two different communities, one that had all of the necessary infrastructure in place and the other that needed to build it, a TIF enables the second community to provide that infrastructure and does not require the Developer to provide those infrastructure improvements, which would have added millions of dollars of cost to the second site. Now the two sites can compete on the basis of other factors like workforce, community support, quality of life, etc.

What are the terms of a TIF?

A TIF is implemented by an ordinance of council. The ordinance determines that the development or redevelopment of a site serves a public purpose and declares the increased real property values resulting from such development to be exempt from real property taxation. Under Ohio law, the maximum term of a TIF exemption is 30 years, and the maximum percentage exemption is 100 %; however, as discussed in more detail below, without the consent of the affected city, local, or exempted village school district, the exemption cannot exceed 10 years or be greater than 75 %.

The TIF exemption commences with the tax year in which an improvement first appears on the tax list and duplicate of real and public utility property that begins after the effective date of the TIF ordinance. Under the terms of the TIF, the property owner is required to pay the PILOTs in an amount equal to the real property taxes that would have been payable if the property had not received the TIF exemption. The PILOTs paid by the property owner are deposited into a special tax increment equivalent fund and used to pay costs of infrastructure improvements that directly benefit the property owner.

It is important to note that a TIF exemption does not affect existing real property taxes. If a parcel that is the subject of a TIF has historically been valued at $500,000, the property taxes from that land value are not exempted by the TIF. They continue to be collected and distributed to the county, township, municipality, school district, and any special taxing districts just as they were prior to the TIF exemption. The TIF exemption only relates to the increased value in the land (which may result from rezoning of the parcel or other factors resulting from the parcel’s development) and the increased value from the new buildings. Thus, in our example the Developer would pay $11,375 in real property taxes on the land value (35 % of $500,000 x 65 mills), which would be distributed to the county, township, municipality, school district, and any special taxing districts, and $227,500 in PILOTs relating to the increased building value. If the value of the land increased by $100,000 after the implementation of the TIF, the amount of the PILOT would be increased by $2,275 (35 % of $100,000 x 65 mills).

What are some of the key issues affecting how a TIF is implemented?

Project Subject to TIF Exemption

The Ohio Revised Code provides a broad definition of the types of commercial improvements that may be included in the TIF exemption (and, therefore, used to generate PILOTs) by defining the “project” (the infrastructure improvements eligible for a TIF exemption) to include “construction, expansion, and alteration of buildings or structures, demolition, remediation, and site development, and any building or structure that results from those activities."1

Residential TIF

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 and having one or more of the following “distress characteristics,” as set forth in RC 5709.40:

1. At least 51 % of the residents of the district have incomes of less than 80 % of the median income of residents of the political subdivision in which the district is located2.

2. The average rate of unemployment in the district during the most recent 12-month period for which data are available is equal to at least 150 % of the average rate of unemployment for this state for the same period.

3. At least 20 % of the people residing in the district live at or below the poverty level3.

4. The district is a “blighted area.”

5. The district is in a situational distress area as designated by the director of development under RC 122.23 (F)4.

6. As certified by the engineer for the municipality, the public infrastructure serving the district is inadequate to meet the development needs of the district as evidenced by a written economic development plan or urban renewal plan for the district that has been adopted by the council of the municipality.

7. The district is comprised entirely of unimproved land that is located in a distressed area as defined in section RC 122.235.

Of the seven distress characteristics described above, the sixth characteristic, inadequacy of existing infrastructure, would seem to be satisfied in almost any tax increment financing project, since the TIF is to be used to provide for infrastructure costs. The most challenging part of satisfying the requirements for that characteristic may be the need for a “written economic development plan or urban renewal plan for the district.”

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 property6. The legislation creating the incentive district must designate parcels within the district that are eligible for housing renovation and must state separately the amounts or percentages of the expected aggregate PILOTs that are designated for each infrastructure improvement and for the general purpose of housing renovation. A municipality can create multiple incentive districts within its boundaries7.

Public Infrastructure Improvements

The Revised Code also broadly defines “public infrastructure improvement"8 (the improvements that can be paid from the PILOTs), to include:

• public roads and highways;

• water and sewer lines;

• environmental remediation;

• land acquisition, including acquisition in aid of industry, commerce, distribution, or research;

• demolition, including demolition on private property when determined to be necessary for economic development purposes;

• stormwater and flood remediation projects, including such projects on private property when determined to be necessary for public health, safety, and welfare;

• the provision of gas, electric, and communications service facilities; and

• the enhancement of public waterways through improvements that allow for greater public access.

Thus, the development activities that can be used to generate the PILOTs are very inclusive, as is the list of eligible infrastructure costs.

What is the role of the school district with respect to the implementation of a TIF?

School District Notice and Consent

Prior to the date that council adopts the TIF ordinance, the 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. The notice must be delivered to such school districts not less than 14 days prior to the date that council intends to adopt the TIF ordinance. If the municipality intends to exceed the 10 year/75 % threshold, the municipality must give notice to the affected city, local, or exempted village school district (but not the joint vocational school district) at least 45 business days prior to adopting the TIF ordinance, and such school district’s board of education must, by resolution of its board, consent to the TIF exemption9. This requirement for school district consent can be avoided if the municipality uses TIF moneys to “make whole” the city, local, or exempted village school district (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) before it pays for infrastructure costs10. The school district, in approving the TIF exemption, may waive the 14-day and 45-business day notice requirements11.

Income Tax Sharing

Regardless of whether the affected city, local, or exempted village is required to approve the TIF exemption, if the project will generate annual payroll for “new employees”12 of $1,000,000 or more, the municipality is required to attempt to negotiate an income tax sharing arrangement with the affected school district (but not the joint vocational school district)13. If an agreement is not negotiated within 6 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 the “infrastructure set-off.”

Under the infrastructure set-off, for any year in which the income tax sharing requirement is in effect, the municipality is permitted to deduct from its compensation payment to the school district the infrastructure costs (which includes debt service charges on infrastructure bonds) incurred in that calendar year; provided that such infrastructure costs cannot exceed 35 % (or a higher amount if approved by the school district) of the taxes levied and collected on the income of new employees at the site14. Income tax sharing is not required if the municipality employs a non-school TIF, as described above15.

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 district16. 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 % 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 relating 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

In our example above, the commercial development, once built, will generate $229,775 annually in PILOTs ($2,275 from the increase in the value of the land and $227,500 from the new building value). At 6 % interest financed over 25 years with level debt service payments (same amount of total principal and interest paid each year, like a home mortgage), $229,775 of PILOTs would cover principal and interest on approximately $2.9 million of TIF Bonds. However, until the development is completed, there is no assurance that the TIF revenue stream will be created.

Revenue Bonds vs. General Obligation Bonds

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 is implemented and the TIF Bonds are issued, the development that will create the PILOTs has not been completed (and sometimes not even started).

Although, in some cases, the municipality may be willing to use its general obligation taxing power to provide the security for the TIF Bonds, this may not be practical. The municipality may not have sufficient capacity to issue general obligation bonds for the project17. Although a TIF Bond would generally be exempt from the direct debt (or statutory) limit because it would be considered self-supporting, such debt would not be exempt for the indirect debt (or 10-mill) limit. Thus a municipality that might be otherwise willing to issue general obligation debt for the infrastructure improvements might not be able to do so because of the 10-mill limitation.

Developer Security

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 and 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. That way, the municipality would not be required to assume the development risk associated with the project18.

Many times the municipality implementing the TIF also requires the Developer to provide a letter of credit19, for the benefit of the municipality in order to guarantee that the Developer will be able to complete the project and that the PILOTs will be sufficient to pay debt service on the TIF Bonds. In most cases, 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 Bonds20.

Developer Construction Agreement

The TIF project could also be structured as an arrangement between the municipality and the Developer whereby the Developer undertakes to make the infrastructure improvements and is reimbursed with TIF revenues. Under this arrangement, the Developer has a contract with the municipality to construct the infrastructure improvements and, upon completion, dedicate them to the municipality. The municipality agrees in turn to pay over the PILOTs, when collected, to the Developer. Thus, the municipality does not issue TIF Bonds or assume development risk, and the Developer only gets repaid for infrastructure costs if the project is successful21.

Special Assessments

Additional financing structural options include the use of a special assessment as a means of providing security for the debt until the TIF produces PILOTs sufficient to cover debt service charges on the TIF Bonds. A special assessment is a “special and local charge levied upon property especially benefited by a public improvement for the purpose of paying all or a portion of the cost of such improvement.” 22

Special assessments have been used in Ohio since at least 1854 and have been used to provide a broad range of infrastructure improvements for property owners. A special assessment is an additional charge, over and above the amount of the real property tax levy, that is used to pay for the costs of infrastructure improvements that specially benefit the property. Thus, a special assessment will not be affected by the valuation of the real property subject to the assessment or improvements to that property. Special assessments are specifically authorized by statute23. Under a combined TIF-special assessment financing structure, which has been utilized by several Ohio communities under various forms, the TIF is intended to be sufficient to pay debt service on the TIF Bonds.

However, if the TIF does not, for one reason or another, generate sufficient PILOTs, the special assessment will be collected to pay debt service on the TIF Bonds. This structure may be advantageous for the Developer because the Developer is not required to supply a letter of credit or other security for the PILOTs and does not have to depend on the TIF revenues to assure repayment of infrastructure costs (i.e., the Developer could sell the property without worrying about being able to recover the infrastructure costs from the TIF). This approach may also be advantageous if the municipality would have otherwise been required to issue general obligation bonds to finance the project.

Tax-Exempt Financing

Depending on the structure of the financing, in most cases the TIF Bonds would be tax-exempt (i.e., interest on the debt would be excluded from gross income for federal tax purposes) and, therefore, would bear interest at a lower rate than conventional debt, which would be at a taxable interest rate. Issues that impact tax-exempt versus taxable financing include: (a) ownership and control of the infrastructure (public ownership necessary for tax-exempt debt); (b) lack of preferential rights to use the infrastructure improvements (i.e., project is generally open to the public); and (c) whether it is reasonable to expect on the date that the Developer agrees to provide a guarantee for the payment of debt service on the TIF Bonds (i.e., letter of credit or minimum service payment agreement) that payments will actually be made with respect to such guarantee24. Tax-exempt financing would be available for any of the financing structures previously discussed, but the municipality would need to carefully structure the transaction to avoid characteristics of taxable debt.

What are keys for a municipality considering a TIF project?

If nothing else, the discussion in this article demonstrates that a TIF is complicated and difficult to initiate and administer. When considering the use of tax increment financing, a municipality 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?

Conclusion

With careful analysis and planning, tax increment financing can be an effective financing tool for municipal infrastructure improvements. Without that analysis and planning, a municipality may find itself in the middle of a TIFF among the Developer and the school district.

Footnotes

1. RC 5709.40(A)(6)

2. As determined in the same manner specified under section 119(b) of the “Housing and Community Development Act of 1974,” 88 Stat. 633, 42 U.S.C. 5318, as amended.

3. As defined in the Federal Housing and Community Development Act of 1974, 42 U.S.C. 5301, as amended, and regulations adopted pursuant to that act.

4. “Situational Distress Area” means a county that has a population of less than 125,000 persons, or a municipal corporation in such a county, that has experienced or is experiencing a closing or downsizing of a major employer that will adversely affect the county’s or municipal corporation’s economy. In order to be designated as a situational distress area for a period not to exceed thirty-six months, the county or municipal corporation may petition the director of development. The petition shall include documentation that demonstrates all of the following:

   1. The number of jobs lost by the closing or downsizing;

   2. The impact that the job loss has on the county’s or municipal corporation’s unemployment rate as measured by the Ohio director of job and family services;

   3. The annual payroll associated with the job loss;

   4. The amount of state and local taxes associated with the job loss;

   5. The impact that the closing or downsizing has on the suppliers located in the rural county or municipal corporation.

5. “Distressed area” means a county with a population of less than one hundred twenty-five thousand that meets at least two of the following criteria of economic distress:

   1. Its average rate of unemployment, during the most recent five-year period for which data are available, is equal to at least one hundred twenty-five per cent of the average rate of unemployment for the United States for the same period.

   2. It has a per capita income equal to or below eighty per cent of the median county per capita income of the United States as determined by the most recently available figures from the United States census bureau.

   3. In intercensal years, the county has a ratio of transfer payment income to total county income equal to or greater than twenty-five per cent.

6. RC 5709.40(C)

7. RC 5709.40(C)

8. RC 5709.40(A)(7)

9. RC 5709.40(D)(2)

10. RC 5709.40(D)(1)

11. RC 5709.40(D)(3) and (4)

12. RC 5709.82(A)(1) defines a new employee as a person employed in the construction of the exempted property and other persons who are first employed at the site of the exempted property and for two years prior have not been subject, prior to being employed at that site, to the municipality’s income tax on income derived from employment for the person’s current employer. (Note: “new employee” does not include any person who replaces a person who is not a new employee.)

13. 2000 Ohio Atty.Gen. Ops. No. 2000-030

14. RC 5709.82(D)

15. RC 5709.82(C)(2)

16. RC 3317.022(A)(1)

17. Ohio municipalities’ ability to borrow money without a vote of the electors for indebtedness that is a “general obligation” of the municipality (i.e., the debt is secured by a pledge of the municipality’s full faith and credit and taxing power) is limited by the indirect debt or “10-mill” limitation and by the direct debt or “statutory” limitation. The 10-mill limitation applies to the aggregate of taxes which may be levied for payment of principal and interest (debt service) on unvoted general obligations issued by all overlapping subdivisions taxing the same property. For example, assume a county requires 5 mills annually for debt service on unvoted general obligations, and a city located in the county requires 4 mills annually for debt service on unvoted general obligations. Such subdivisions could not issue any combination of unvoted general obligations which would require an annual tax for debt service in excess of 1 mill, since outstanding obligations together require 9 mills and the additional millage would exceed the limitation. See State ex rel. Portsmouth v. Kountz, 129 Ohio St. 272, 194 N.E. 869 (1935). The direct debt limitation is imposed by RC 133.05, which provides that the net indebtedness incurred by a municipality without a vote of its electors shall not exceed 5-½ % of its assessed valuation, RC 133.04 and RC 133.05 provide certain exemptions from the direct debt limitation, including debt paid from PILOTs. Therefore, general obligation TIF Bonds would be subject to the 10-mill limitation but exempt from the direct debt limit.

18. A service payment agreement may also contain: (a) a covenant from the Developer to complete the project within a certain timeperiod; (b) a representation from the Developer with respect to the value of the development at build-out; (c) a covenant from the property owners to maintain insurance on the development and, in the event of damage or destruction of the development and a failure to re-build, to use the insurance proceeds to redeem TIF Bonds; and (d) a covenant to cooperate with the municipality in the filing of any necessary reports and applications.

19. A letter of credit is an obligation of a bank to pay out certain amounts with respect to an obligation of a third party (in this case, the Developer). The letter of credit will state on its face the conditions under which it is drawable, which in the case of a TIF relates to a determination that an insufficient amount of PILOTs has been deposited into the account for payment of the TIF Bonds. The municipality may require that the bank providing the letter of credit maintain a rating at a certain minimum level, in order to ensure the security and liquidity of the letter of credit.

20. Debt service coverage is calculated by comparing the annual principal and interest payments due on the TIF Bonds (typically by looking at the year in which those payments are highest) to the amount of PILOTs received in the year of the test.

21. Even if the Developer undertakes to make the improvements on behalf of the municipality, because of the contractual relationship between the municipality and the Developer, the construction work on the infrastructure improvements will almost certainly be subject to prevailing wage laws (RC Chpt. 4115) and may also be subject to competitive bidding.

22. Ohio Municipal Code, 11th Edition, Farrell-Ellis, Copyright 1962, Text Section 5.5.1

23. RC Chpt. 727 contains the primary authorization and procedural requirements for special assessments.

24. See § 1.141-5(d)(ii) of the Treasury Regulations to the Internal Revenue Code of 1986, as amended. From a practical standpoint, a determination and certification by the fiscal officer for the municipality that it is not reasonable to expect that payments will be made with respect to such guarantee is usually supported by financial projections provided by the Developer and reviewed by the municipality.

Reprinted from Finley’s Ohio Municipal Service, with the permission of the publisher and copyright owner, West Group.