How Tax-Exempt Bonds Work
Under IRC §142(d), the 50 states are allowed to grant tax-exempt status to a limited amount of "private activity, volume cap" bonds. Each state determines how it allocates its allowance among projects such as multifamily housing, single-family dwellings, and industrial development.
When a project wins state approval to be financed with this type of bond, it also becomes eligible for 4% tax credits — which are almost a sure-thing because the application process for the 4% tax credits is entirely non-competitive.
Key Parties in the Transaction
Bond Issuer — A city, county, or housing authority empowered to issue tax-exempt bonds
Underwriter — Markets the bonds and smoothes the flow of money from purchasers to the Issuing Entity
Bond Counsel — Provides legal opinion that bonds will be tax-exempt; drafts all key documents
Credit Enhancer — Investment-grade financial institution guaranteeing bond purchasers receive interest payments on time
Trustee — Holds bond proceeds securely under the terms of the trust indenture
Basic Elements of the Transaction
The Issuer creates the bonds, the underwriter markets them, and purchasers buy them — effectively loaning you money at significantly lower interest rates than you'd get in any other market. However, the money paid for the bonds does not actually pass through to you. Instead, funds are paid to a Trustee who holds them under the terms of a trust indenture.
To actually receive your funding, you must take out a mortgage on the property, borrowing from an established lender affiliated with the deal's credit enhancer. These funds are set aside in a restricted account and made available to you in increments as work proceeds — typically drawn down once a month against contractor invoices.
All this time you will be paying monthly interest on the full amount of the mortgage loan. Should you fail to make your mortgage payments, the credit enhancer will exercise a legal claim to the property.
Arbitrage Must Be Limited
Because the proceeds of tax-exempt bonds are normally invested in securities that yield a higher rate of return than the bonds pay out, there is the issue of arbitrage. When the difference between these two rates is too large, the tax-exempt status of the bonds can be at risk.
That's why it's important to work with experts who are aware of the restrictions — and of the exceptions that allow tax-exempt bonds to retain their special status even when such restrictions are exceeded.
The 50% Test — Key Requirement for 4% Tax Credits
At least 50% of your project's aggregate basis (cost of land + all depreciable assets) must be financed by volume cap, tax-exempt bonds plus interest earned on the bonds. If your project meets this test, the entire "eligible basis" can be used for figuring the 4% tax credits.
Example: If only 40% of your project's aggregate basis gets financed with volume cap bonds, your project does not meet the 50% test — and only that portion of eligible basis that does meet the test can be used to claim 4% tax credits.
15 Steps to a Volume Cap Tax-Exempt Bond Deal
If you like the idea of developing projects with money borrowed at 100 or more basis points below market rates, here are the steps normally involved in putting together such a deal:
Find a property you think makes sense to develop, and pencil in numbers to see if this financing is feasible
Put together an experienced team: compatible underwriter, knowledgeable accountant, local developer's bond counsel, willing credit enhancer, experienced equity partner
Have the bond Issuing Entity pass its legally-required inducement resolution
Gain a commitment from a suitable credit enhancer
Submit your private activity bond application to the appropriate bond Issuing authority
Provide suitable public notification of the project (normally just two weeks)
Get through your Tax Equity and Fiscal Responsibility Act (TEFRA) hearing
Wait for your private activity tax-exempt bond application to be approved and your bond allocation to be awarded
Submit your application for 4% tax credits
Have your local bond counsel draft the necessary documents
Work with your bond Issuer to have the bond resolution passed
Wait for your underwriter to price the bonds and sign contracts for marketing them
Negotiate and sign your bond purchase agreement
Get through your bond closing
Issue your final official statement
That wasn't so bad, was it?
Brief Glossary
Indenture
The agreement between a bond Issuer and a Trustee that sets forth the terms, conditions, and procedures under which the bonds will be repaid.
Inducement Resolution
A formal resolution approved by the bond Issuing Entity that publicly states its intention to issue new bonds.
Official Statement
Basically a marketing prospectus that underwriters distribute as part of their effort to market newly issued bonds.
Rating Agency
Well-established companies that issue public statements about bonds and other investment vehicles, generally accepted as reliable indicators of risk.
Regulatory Agreement
A contract specifying project details including income restrictions and reduced rental rates available to qualifying tenants.
TEFRA Hearing
The formal procedure by which elected officials may give their approval of a new tax-exempt bond issue.
Underwriter
An investment bank that agrees to market newly issued bonds to potential purchasers.