What Is Tax Exempt Bond Financing and How Does It Work?

Tax-exempt bond financing allows certain organizations to borrow funds for projects that serve a public good. The interest income paid to bond investors is exempt from federal income taxes, so investors accept a lower interest rate than they would for taxable investments. This results in lower borrowing costs for the organization completing the project.

While state and local governments use this method for public infrastructure like schools and roads, it is also available to certain private entities. Nonprofit organizations can use this financing for projects that align with their public mission, giving them access to lower interest rates.

Qualifying for Tax-Exempt Bond Financing

To access tax-exempt bond financing, both the borrower and the project must meet specific criteria defined by the Internal Revenue Code (IRC). The eligibility of the borrowing entity is a key consideration. While state and local governments are frequent users, certain private organizations can also qualify.

A primary category of eligible borrowers is organizations with 501(c)(3) status. This includes nonprofit hospitals, private universities, and cultural institutions. To qualify, these organizations must receive a determination letter from the IRS confirming their tax-exempt status.

The nature of the project is equally important, as the requirement is that it serves a clear public benefit. For a 501(c)(3) organization, this means the project must directly relate to its charitable, educational, or scientific mission. Projects explicitly prohibited from using this type of financing include the acquisition of airplanes, the construction of gambling facilities, and certain health club facilities.

Types of Tax-Exempt Bonds

Tax-exempt bonds are categorized based on who benefits from the financing and the security backing them. The two main classifications are governmental bonds and private activity bonds (PABs).

Governmental bonds are issued by state or local governments to fund projects for general public use. These can be General Obligation (GO) bonds, which are backed by the full faith and credit, including the taxing power, of the issuing government entity. Alternatively, they can be Revenue Bonds, which are secured by the revenue generated from the specific project being financed, such as tolls from a bridge or fees from a public utility.

PABs are issued by a government entity on behalf of a private user for a project that serves a recognized public purpose. Because these bonds benefit a private entity, they are subject to stricter regulations. Common types of PABs include:

• Qualified 501(c)(3) bonds are used by nonprofit organizations for capital projects related to their mission, such as building hospitals, university dormitories, or expanding museums. The financed property must be owned by the organization.
• Exempt Facility Bonds finance specific types of privately-owned facilities, such as airports, docks, solid waste disposal facilities, and affordable rental housing developments.
• Qualified Small Issue Bonds, also known as industrial development bonds, are used to finance manufacturing facilities and equipment for for-profit businesses.

Each PAB category must follow specific federal tax rules. Some types require an allocation from a state’s annual volume cap, which limits the total amount of certain PABs that can be issued in a state each year.

The Issuance Process

Securing tax-exempt bond financing is a structured process that requires careful coordination among several professionals. This detailed undertaking moves from initial planning and team assembly through governmental approvals to the final sale of the bonds, differing significantly from a conventional loan.

The first step is to assemble a financing team, which includes:

• Bond counsel to provide a legal opinion on the bonds’ tax-exempt status.
• An underwriter or placement agent to structure and sell the bonds.
• A trustee, usually a bank, to represent bondholders’ interests.
• The borrower’s own legal counsel.

The borrower then submits an application to a conduit issuer, which is a government agency or authority that issues bonds on behalf of private entities. The application details the project and the borrower’s finances. For certain PABs, the project must also secure an allocation from the state’s volume cap. The process also requires public approval, often through a public hearing.

Once approved, the underwriter prepares a disclosure document, the Preliminary Official Statement, for potential investors. The borrower may also seek a credit rating from an agency like Moody’s or S&P Global Ratings to assess its ability to repay the debt. The underwriter then markets the bonds to its network of institutional and individual investors. The final stage is the closing, where legal documents are signed and bond proceeds are transferred to the borrower. Up to 2% of the bond proceeds from PABs can be used to cover issuance costs.

Post-Issuance Compliance Requirements

After the bond transaction closes, the borrower’s obligations continue for the entire life of the bonds. Maintaining the tax-exempt status requires strict adherence to ongoing compliance rules. Failure to comply can cause the IRS to declare the interest on the bonds taxable to bondholders, a severe consequence that can damage the borrower’s reputation and financial standing.

A primary requirement relates to the use of bond proceeds. At least 95% of the net proceeds of most PABs must be spent on the qualified capital project as described in the bond documents. Borrowers must keep detailed records to track every dollar spent.

Another area of compliance involves arbitrage and rebate rules. Arbitrage is the profit earned from investing tax-exempt bond proceeds in higher-yielding taxable securities. Federal law restricts arbitrage, and any excess earnings must be paid to the U.S. Treasury. These payments are submitted to the IRS using Form 8038-T, though some exceptions exist if bond proceeds are spent quickly.

Comprehensive record-keeping is a foundational element of compliance. The borrower must maintain records of all expenditures and investments for the entire term of the bonds. For 501(c)(3) organizations, this includes tracking the use of bond-financed facilities to ensure they are not used for private business activities beyond permissible limits. Nonprofits must also file Schedule K with their Form 990 if they have tax-exempt bonds with an outstanding principal over $100,000 issued after December 31, 2002.