Vol. 79, No. 5, May
Developer-Funded Tax Incremental
Promoting Development Without Breaking the Bank
Developer-funded tax incremental
financingeliminates a municipality's risk that the tax incremental
district will fail and offers developers a means of increasing project
costs paid by the municipality. Lawyers can help their developer and
municipal clients identify when financial and development conditions are
right to structure these.
by Jesse S. Ishikawa
ax incremental financing
(TIF) is the most powerful economic
development tool that Wisconsin municipalities have today. Since 1976,
municipalities have used this tool to fund industrial parks, attract
out-of-town businesses, promote downtown condominium projects, and even
to finance construction of "big box" retail stores. While the amount of
financing a municipality is willing to provide varies on a case-by-case
basis, it often ranges between 10 percent and 20 percent of a project's
total construction cost.
Traditionally, municipalities have used TIF to provide financial
assistance to developers at the beginning of a development project. The
municipality then recovers those costs in later years from the increased
property tax revenues generated by the project. Several municipalities
have used developer-funded tax incremental financing (developer-funded
TIF) to reduce the financial risks associated with TIF. With
developer-funded TIF, the developer lends money to the municipality, and
the municipality then uses the money to help pay for the project. The
municipality repays the loan to the developer from the increased
property tax revenues generated by the project.
This article informs lawyers how developer-funded TIF can be used by
both developer clients and municipal clients to promote economic
development with reduced risk to the municipality.
How Tax Incremental Financing Works
The TIF process begins when a municipality1 and a specially appointed joint review
board2 designate a parcel of land as a "tax
increment district." At least 50 percent of the land area within the
district must be blighted, in need of rehabilitation or conservation
work, suitable for industrial sites, or suitable for mixed-use
development. The municipality then expends funds, called "project
costs," to improve the district.3 Project
costs can include costs of streets and utilities, real property
assembly, capital improvements, clearing and grading of land, relocation
payments, and environmental remediation.4
Frequently, the project costs are provided in the form of a direct
financial grant to a developer.
If things go according to plan, the expenditure of project costs will
result in increased property values within the district, and hence,
increased property tax revenues. All of the resulting increase in
property tax revenues (the "tax increment") is paid to the municipality
to the exclusion of the other jurisdictions that rely on property taxes,
namely, the technical college district, the county, and the school
district. This arrangement continues until the earlier of 1) the
district's expiration date (which, depending on the type of district,
can be from 20 to 42 years after its creation), or 2) the date the
municipality has fully recovered its project costs from the tax
Jesse S. Ishikawa, Michigan 1980, practices
real estate law in the Madison office of Reinhart Boerner Van Deuren
s.c. He is a frequent author and speaker on real estate issues for State
Bar CLE Books and Seminars.
As a condition to creating the district, the joint review board must
find that the development expected within the district would not occur
without the use of TIF.6 This requirement is
commonly referred to as the "but for" test. The "but for" test is used
to ensure that TIF assists development projects that need help but does
not become a giveaway of tax dollars to private developers.7
How 'Lump Sum' TIF Works
In the typical tax increment district, the municipality expends
project costs to promote private development at the beginning of the
development process. The project costs might be earmarked to cover the
developer's land acquisition costs, relocation costs, or public
infrastructure costs. Because the municipality generally provides these
funds in the form of a "lump sum" payment to the developer, they are
referred to in this article as "lump sum" project costs.
The amount of lump sum project costs a municipality is willing to
spend is limited by 1) the municipality's underwriting, and 2) the
municipality's ability to borrow.
The municipality's underwriting. The municipality
needs to make sure that lump sum project costs will be recouped from the
tax increment generated by the project. This means that the amount of
project costs that a municipality can spend must be limited to the
present value of the total tax increment to be paid over the life of the
district. The municipality cannot, however, calculate this number
without lots of guesswork. The municipality must try to forecast the
future assessed value of property within the district, future borrowing
costs, future mill rates, and future increases or decreases in the flow
of tax increment resulting from changes in legislation.
To protect themselves from being caught short, municipalities often
take one or more of the following measures:
• Obtain security for repayment of the project costs.
The municipality may require a promissory note from the developer backed
by a mortgage, personal guarantee, letter of credit, or other security.
The promissory note will cover the gap between the actual tax increment
paid over the life of the district and the actual project costs
• Enter into an agreement with the developer to protect the
taxable value of the property. The municipality may require the
developer to enter into an agreement with the municipality under which
certain obligations are imposed on the developer to preserve the
property's taxable value. These obligations may include: prohibiting the
developer from transferring its property to tax-exempt entities;
prohibiting the developer from contesting tax assessments if the contest
could result in reducing the property's value below the level at which
the increment will repay the project costs; requiring the developer to
insure all improvements against casualty; and requiring the developer to
reconstruct improvements that are damaged or destroyed.
• Use conservative underwriting assumptions. Rather
than use the present value of the tax increment stream over the life of
the district to calculate the maximum amount of available project costs,
the municipality may calculate the present value over a much shorter
time, such as 10 to 12 years. The municipality also may limit the amount
of project costs to a percentage of the present value of the tax
• Take an equity position in the developer. The
municipality may enter into profit-sharing arrangements in which the
municipality is treated as an equity investor. These arrangements can be
structured to ensure that any profits in excess of a specified internal
rate of return to the developer belong to the municipality or to ensure
that any profits to the developer in excess of a negotiated amount
belong to the municipality.
The municipality's ability to borrow. The amount of
lump sum project costs that a municipality is willing to provide a
developer also is limited by the municipality's ability to borrow. Lump
sum project costs generally are financed with the proceeds of general
obligation bonds backed by the municipality's full faith and credit. The
Wisconsin Constitution imposes on a municipality's general obligation
debt a ceiling equal to 5 percent of the equalized value of taxable
property within the municipality.8 Even
without the constitutional debt ceiling, a municipality's ability to
borrow will be limited by its own concern about its credit rating. Just
as a disproportionately large amount of debt will depress an
individual's credit rating, a disproportionately large amount of debt
will depress a municipality's bond rating, which in turn will increase
the municipality's borrowing costs.
How Developer-Funded TIF Works
With developer-funded TIF, the municipality borrows the funds for
project costs not by issuing general obligation debt to be held by the
public but by issuing limited obligation debt to the developer. In other
words, the developer lends money to the municipality. The municipality
uses the money to pay the project costs to help the developer's project.
The loan is evidenced by a debt instrument, or developer bond, issued by
the municipality to the developer.
Under the developer bond, the municipality repays the developer out
of the tax increment that is generated by the district (or specific
lands within the district). The municipality's obligation is limited to
the amount of tax increment actually generated. Thus, if the project
doesn't generate the tax increment needed to pay off the obligation, the
party at risk is the developer, not the municipality.
The Wisconsin Supreme Court has held a pledge of tax increment to be
general obligation debt.9 If the
municipality is unwilling to have the developer bond treated as general
obligation debt, the bond must be structured as a "moral obligation"
bond. A moral obligation bond includes statements that 1) all payments
payable under the bond are subject to future appropriations by the
municipality, and 2) such payments are not backed by the municipality's
full faith and credit.
Advantages of developer-funded TIF to the
municipality. The following are advantages to the municipality
of using developer-funded TIF:
• The municipality uses none of its
constitutional debt capacity.
• The financial risk that the project will not
generate sufficient increment is transferred from the municipality to
Advantages of developer-funded TIF to the developer.
The advantages to the developer of using developer-funded TIF are less
obvious. Most developers would rather receive a lump sum cash payment
than a future stream of payments over a period of many years under a
bond that is not backed by the issuer's full faith and credit. (In
reality, because a municipality's failure to make future appropriations
would negatively affect the municipality's credit rating, a default
under a "subject to future appropriations" bond, even if legally
possible, is unlikely.)
So why would a developer prefer to receive a bond backed by a
municipality's moral pledge of future tax increment as opposed to an
up-front, lump sum payment? There are several reasons, all of which have
to do with getting the municipality to open its wallet a little
• Because developer bonds allow the
municipality to pay more project costs without burdening the
municipality's budget, they allow the municipality to increase the
amount of project costs that can be spent on the developer's
• A developer bond, by transferring all risk
of insufficient tax increment to the developer, frees the municipality
from its otherwise strict underwriting standards. Again, this transfer
of risk should increase the amount of project costs that can be spent on
the developer's project.
• The developer bond creates an asset that can
be pledged as collateral to a bank or other financial institution that
provides money to fund the developer's project.
Application of the "but for" test. Wisconsin
Statutes section 66.1105(4)(c)(1)a. requires the joint review board to
approve or deny creation of a district based on certain criteria, one of
which is "[w]hether the development expected in the tax incremental
district would occur without the use of tax incremental financing." As
noted, this criterion is referred to as the "but for" test. What effect
does the "but for" test have on developer-funded TIF?
Some might argue that if the developer has the money to purchase the
developer bond, then the development will certainly occur, with or
without TIF. Under this view, use of a developer bond will always flunk
the "but for" test. A closer look shows that this result is not
necessarily so. A development financed with a developer bond may not be
otherwise economically viable. Consider the following example:
1) Due to environmental contamination, the actual cost for acquiring
land and readying it for development is $20 per square foot.
2) The market rate for land in the development's neighborhood is $10
per square foot.
3) The developer seeks to borrow funds to fund the land purchase and
remediation at the $20 per square foot cost.
4) No bank will lend money for the purchase and remediation in excess
of $10 per square foot.
5) Therefore, the development will not occur unless the municipality
is willing to provide TIF assistance of $10 per square foot.
6) The municipality issues a developer bond to finance TIF assistance
of $10 per square foot.
7) The bank determines that the TIF generated from the development
will be sufficient to cover payment of the debt service on the
additional $10 per square foot. The bank now is willing to lend to the
developer the extra $10 per square foot, provided the developer
collaterally assigns the developer bond to the bank as additional
8) The bank would not have provided the extra $10 per square foot
without the TIF assistance.
9) The development would not have occurred without the TIF
Thus, use of developer-funded TIF in the above example meets the "but
Developer-funded TIF offers opportunities both to municipalities and
to developers. For municipalities, it offers a way to eliminate the risk
that the tax increment district will fail. For developers, it offers a
means of increasing the project costs provided to their