What Are Tax Credit Bonds and How Do They Work?
Explore tax credit bonds, a unique financing tool where investors receive a federal tax credit, and understand the tax implications for current holders.
Tax credit bonds are a financial instrument through which investors lend money to state or local governments for public projects. Instead of receiving periodic interest payments like traditional bonds, the holder of a tax credit bond receives a federal tax credit. This credit directly reduces the bondholder’s federal income tax liability, offering a dollar-for-dollar offset against taxes owed.
These bonds are now primarily historical instruments. The authority for governments to issue new tax credit bonds under most federal programs was eliminated after December 31, 2017, by the Tax Cuts and Jobs Act of 2017 (TCJA). While new bonds are no longer issued, many are still outstanding, meaning the rules governing them remain relevant for investors who hold them until maturity.
The Tax Credit Mechanism Explained
The structure of a tax credit bond differs from a traditional tax-exempt municipal bond, where the benefit is tax-free interest income. With a tax credit bond, the investor’s return is delivered as a tax credit from the U.S. Treasury. The government issuer gets its project funded, while the federal government provides the subsidy directly to the investor.
The value of the benefit was determined by a “credit rate” set by the Treasury Department. This rate was calculated to approximate the interest the issuer would have paid on a comparable taxable bond. For example, if the Treasury set a 4% credit rate for a bond, the holder of a $10,000 bond would be entitled to a $400 tax credit for that year.
Tax Treatment for Bondholders
The value of the tax credit received is considered taxable income at the federal level. Even though the credit reduces a bondholder’s tax liability, the amount of the credit must be included in the holder’s gross income for the year.
To claim the credit, a bondholder files Form 8912, Credit to Holders of Tax Credit Bonds, with their federal income tax return. The credit is allowed on four dates throughout the year: March 15, June 15, September 15, and December 15. A taxpayer holding a bond on one of these “credit allowance dates” can claim a portion of the annual credit.
The bond’s issuer provides the necessary information on Form 1097-BTC, Bond Tax Credit. This document includes the bond’s name, CUSIP number, and the total credit amount for the year. This information is used to complete Form 8912, and the total credit is then transferred to Schedule 3 (Form 1040) to be applied against the taxpayer’s total tax.
If a bond is sold before maturity, the right to claim future tax credits transfers to the new owner. The seller can claim the credit only for the allowance dates on which they were the official bondholder. The buyer then claims the credit for subsequent dates.
Major Tax Credit Bond Programs
The federal government authorized several tax credit bond programs, each targeting a specific public policy goal. While the authority to issue new bonds under these programs has expired, they represent past infrastructure and energy initiatives. Major programs included:
- Qualified Zone Academy Bonds (QZABs), which helped public schools in economically distressed areas finance renovations, equipment, and curriculum development.
- Clean Renewable Energy Bonds (CREBs) and Qualified Energy Conservation Bonds (QECBs), which financed projects involving renewable power and energy-saving technologies.
- Build America Bonds (BABs), which were taxable municipal bonds created by the American Recovery and Reinvestment Act of 2009. Issuers could either let the bondholder claim a tax credit equal to 35% of the interest paid or elect to receive that 35% as a direct cash subsidy from the U.S. Treasury.
- Qualified School Construction Bonds (QSCBs) for building and repairing public schools.
- Recovery Zone Economic Development Bonds (RZEDBs) to spur business growth in areas with significant job losses.