Advance refunding of tax-exempt bonds effectively ended on December 31, 2017. Under the Tax Cuts and Jobs Act, interest on any bond issued to advance refund another bond no longer qualifies for the federal income tax exemption, whatever the public purpose. State and local governments can still advance refund their outstanding debt, but the new bonds have to be taxable, which sharply reduces the savings the technique used to deliver. Refundings that redeem the old bonds within 90 days of the new issuance are treated as current refundings and can still be done on a tax-exempt basis.
The 2018 Rule Change
The federal tax code draws a hard line based on timing. If the new bonds are issued more than 90 days before the old bonds can be redeemed, the transaction is an advance refunding.1Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered To Be Tax Exempt If the old bonds are redeemed within that 90-day window, it qualifies as a current refunding and the replacement bonds generally keep their tax-exempt status.2Internal Revenue Service. Advance Refunding Bond Limitations Under Internal Revenue Code Section 149(d)
Public Law 115-97 amended Section 149(d) of the Internal Revenue Code to state flatly that nothing in Section 103 or any other law provides a federal income tax exemption for interest on bonds issued to advance refund another bond.3Congress.gov. Public Law 115-971Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered To Be Tax Exempt The change applies to advance refunding bonds issued after December 31, 2017. Before then, Section 103 excluded interest on state and local bonds from gross income, and the old version of Section 149(d) let advance refunding bonds qualify for that exclusion if they met specific conditions.4Office of the Law Revision Counsel. 26 US Code 103 – Interest on State and Local Bonds Those conditions were replaced with a blanket prohibition.
The stakes are real because many municipal bonds carry call protection of 10 years or longer. A city that issued bonds in 2020 with a 2030 call date cannot redeem them early. If rates drop in 2026, the city has to wait four more years to do a current refunding. Before 2018, the city could have issued new tax-exempt bonds immediately, escrowed the proceeds, and used those funds to pay off the old bonds at the 2030 call. That structure still works mechanically. The tax exemption for it does not.
How Advance Refunding Still Works, on a Taxable Basis
Municipalities can issue advance refunding bonds today; they just cannot offer tax-exempt interest on them. The mechanics are unchanged from the pre-2018 process. New bonds are sold, proceeds go into an escrow fund managed by a trustee, and the escrow holds government securities timed to generate enough cash to cover interest payments on the old bonds and redeem them at the call date. Once the escrow is fully funded and irrevocably pledged, the old bonds are legally defeased. Original bondholders look to the escrow for payment, and the old debt effectively drops off the issuer’s balance sheet. A verification agent independently confirms that the escrow’s cash flows will meet every scheduled payment on the refunded bonds through redemption.
What changed is who pays tax on the interest. Investors owe federal income tax on the coupons, so the issuer has to offer a higher rate to attract buyers. For 2026, federal income tax rates run from 10% to 37% depending on the investor’s bracket.5Internal Revenue Service. Federal Income Tax Rates and Brackets The higher coupon eats into the savings that made advance refunding attractive in the first place.
Negative arbitrage makes the math worse. The taxable coupon the issuer pays on the new bonds is typically higher than the yield earned on the escrow investments during the years before the old bonds can be called. That gap can amount to several percentage points over a multi-year escrow period. In practice, taxable advance refundings capture only a fraction of the potential savings a tax-exempt advance refunding would have delivered. Issuers who can wait for the call date and execute a tax-exempt current refunding usually come out ahead.
Taxable advance refundings still make sense in specific cases. If the rate differential between old and new debt is wide enough to absorb the higher taxable coupon and the negative arbitrage, the issuer can lock in real savings now rather than gambling that rates stay low until the call date arrives.
Alternatives Municipal Issuers Use Instead
Since 2018, municipal finance professionals have developed several workarounds. None fully replicates what tax-exempt advance refunding offered, and each carries its own tradeoffs.
Forward Delivery Bonds
A forward delivery bond locks in today’s interest rate for bonds that will not actually be issued until a future date, typically timed to fall inside the 90-day current refunding window. The issuer signs a purchase agreement with an underwriter now, and the bonds settle months later, sometimes up to 24 months out. Because delivery lands inside the current refunding window, the bonds can qualify for tax-exempt status.
Investors demand a yield premium for committing their money in advance and accepting illiquidity during the forward period. Execution risk is real too. If market conditions deteriorate, the issuer’s credit gets downgraded, or a change in law prevents delivery of the tax opinion, the deal can fall apart. Forward delivery agreements typically include termination events covering these scenarios, but unwinding a failed forward creates its own complications.
Cinderella Bonds
A Cinderella bond starts life as a taxable instrument and converts to tax-exempt status when a specified event occurs. In the refunding context, conversion happens when the old bonds enter their 90-day current refunding window, at which point bond counsel delivers an opinion that the interest qualifies for the Section 103 exclusion. Until conversion, the issuer pays a taxable rate, so the structure works best for shorter waiting periods where the taxable interest cost stays manageable.
The risk is that tax law changes during the waiting period could prevent the conversion from ever happening, leaving the issuer with taxable bonds for the full term. These structures have most often been used in private placements with banks rather than public offerings.
Tender Offers
Instead of issuing new bonds to defease the old ones through an escrow, an issuer can go directly to existing bondholders and offer to buy back their bonds. The issuer finances the purchase with new tax-exempt current refunding bonds or other available funds. Tender pricing typically uses one of three approaches: a fixed price for each bond, a fixed spread to a benchmark index, or a modified Dutch auction where investors submit competing offers. The offer period usually runs about 10 business days.
Tender offers only work if enough bondholders agree to sell, and the issuer generally includes the right to reject all offers if the economics fall short. The approach sidesteps the advance refunding rules entirely because the issuer is purchasing bonds on the open market rather than refunding them through an escrow structure.
Prospects for Restoring the Tax Exemption
There has been persistent bipartisan interest in Congress in bringing back the tax exemption for advance refundings. In the 119th Congress, the Investing in Our Communities Act (H.R. 1255) was introduced in February 2025, and the LOCAL Infrastructure Act of 2025 (S. 1481) was introduced in the Senate in April 2025. Similar bills were introduced in earlier sessions without becoming law.
Municipal finance groups have argued that losing tax-exempt advance refunding costs state and local governments billions in foregone savings, forcing them to pay higher taxable rates, wait years for a current refunding window, or use more complex alternative structures. Whether restoration passes depends on the broader fiscal environment and competing priorities in tax legislation. Issuers watching this space should track whether advance refunding language gets attached to larger tax packages, which has historically been the most viable path for standalone municipal bond provisions.