Bond proceeds are the funds an issuer collects from investors when it sells bonds, and for tax-exempt municipal bonds, federal law under Internal Revenue Code Section 148 controls how those funds can be spent, how any idle balances may be invested, and how long the issuer must document every dollar. Breaking the rules can retroactively strip the bonds of their tax-exempt status, which sticks bondholders with an unexpected tax bill and leaves the issuer exposed. The mechanics matter whether you are the issuer, the bond counsel reviewing a transaction, or an investor sizing up credit risk.
What Counts as Bond Proceeds
The total an issuer collects breaks into several pieces, and the accounting at closing shapes everything afterward.
Gross proceeds are the full amount investors pay. Bonds sold at a premium bring in more than par; bonds sold at a discount bring in less. Accrued interest is separated out when bonds change hands between scheduled interest payment dates, because that money belongs to bondholders rather than the project fund.
Costs of issuance come off the top: underwriting fees, legal costs, financial advisor charges, and rating agency fees. For municipal bonds these typically run around 1% to 2% of principal, with underwriting and legal work consuming the largest shares. What remains is net proceeds, the money actually available for the issuer’s purpose.
Capitalized interest is a third common slice. Issuers often set aside proceeds to cover interest payments during a construction period, before the financed project generates revenue. Federal rules allow this on new-money transactions from the issue date through the later of three years from that date or one year after the project is placed in service. For qualified private activity bonds the window is narrower, covering only interest accruing before the project is placed in service.
What Bond Proceeds Can Be Spent On
Net proceeds have to flow into uses spelled out in the offering documents. Every dollar must trace to a permitted purpose.
Capital Projects and Refunding
The most common use is funding long-term capital assets: roads, water treatment plants, school buildings, hospital wings, heavy equipment. A portion may also fund a debt service reserve, a cushion that keeps bondholders paid if revenue dips.
Refunding older debt is another standard application. The issuer retires existing higher-rate bonds by issuing new ones at a lower rate. The Tax Cuts and Jobs Act of 2017 eliminated tax-exempt advance refundings (those issued more than 90 days before the refunded bonds are redeemed), so current refundings now have to occur close to the call date of the old bonds.
Reimbursing Earlier Project Spending
Issuers sometimes pay for project costs before the bonds actually sell. Federal rules allow proceeds to reimburse those earlier expenditures, but only if the issuer adopted an official declaration of intent no later than 60 days after making the original payment. The declaration has to describe the project and state the maximum amount of bonds expected. Reimbursement itself must then occur within 18 months of the later of the payment date or the date the project is placed in service, and in no case more than three years after the original expenditure.1eCFR. 26 CFR 1.150-2 – Proceeds of Bonds Used for Reimbursement
Two exceptions soften the rule. A de minimis carve-out exempts amounts up to the lesser of $100,000 or 5% of the issue’s proceeds. Preliminary expenditures such as architectural fees, engineering studies, and soil testing are also exempt up to 20% of the issue price, though land acquisition and site preparation costs do not qualify.1eCFR. 26 CFR 1.150-2 – Proceeds of Bonds Used for Reimbursement
The Working Capital Limit
Tax-exempt proceeds generally cannot fund ordinary operating expenses. For any working capital use (anything that is not a capital expenditure), a proceeds-spent-last rule applies: proceeds may only cover working capital costs that exceed all other available amounts the issuer has on hand for the purpose.2Internal Revenue Service. Tax-Exempt Bond Financing Lesson 6 – Arbitrage Restrictions
The meaningful exception covers extraordinary, nonrecurring items that are not normally payable from current revenue, such as catastrophic casualty losses or massive legal judgments exceeding insurance coverage. Even then, if the issuer maintains a reserve for extraordinary items, that reserve must be drained before bond proceeds can be tapped.2Internal Revenue Service. Tax-Exempt Bond Financing Lesson 6 – Arbitrage Restrictions
The Private Business Use Trap
For governmental bonds to keep their tax-exempt status, the issuer has to limit how much of the bond-financed property is used by private businesses. Two tests apply at the same time. If more than 10% of proceeds are used in any private trade or business, or if more than 10% of debt service is secured by or derived from payments related to private business property, the bonds are reclassified as private activity bonds. The threshold drops to 5% for private use that is unrelated or disproportionate to the governmental purpose of the issue. A separate dollar cap applies: if the private business use portion exceeds $15 million, the bonds can be reclassified regardless of the percentage test.
This is where issuers often stumble years after closing. A city builds a convention center with bond proceeds, then leases part of it to a private restaurant operator. That lease creates private business use. If cumulative private use exceeds the thresholds, the entire issue’s tax-exempt status is at risk.
Hiring a private company to manage a bond-financed facility does not automatically trigger private business use, provided the management contract fits the safe harbor conditions in Revenue Procedure 2017-13. Those conditions limit compensation structures, contract length, and overlap between the service provider and the governmental owner.3Internal Revenue Service. Private Business Use – Management Contracts
Investing Proceeds Before They Are Spent
Large projects do not consume funding on day one. Proceeds often sit for months or years before being drawn down, and idle balances have to be invested carefully. Permitted investments typically include U.S. Treasury securities, high-grade money market funds, and other instruments spelled out in the bond indenture. The priorities are preserving principal and keeping funds liquid enough to meet the project payment schedule.
Here is where federal oversight gets sharpest. The core problem Congress wanted to prevent: an issuer borrows at a low tax-exempt rate, parks the money in higher-yielding taxable investments, and pockets the spread. Internal Revenue Code Section 148 defines an arbitrage bond as any bond whose proceeds are reasonably expected to be invested at a yield materially higher than the bond’s own yield. Arbitrage bonds lose their tax exemption.4Office of the Law Revision Counsel. 26 USC 148 – Arbitrage
Temporary Periods
Yield restriction rules generally cap investment yield at the bond yield. But construction schedules make it impractical to restrict yield from day one, so the regulations provide temporary periods during which higher-yielding investments do not trigger arbitrage bond status. Net sale proceeds and investment proceeds reasonably expected to be spent on capital projects qualify for a three-year temporary period beginning on the issue date.5eCFR. 26 CFR 1.148-2 – General Arbitrage Yield Restriction Rules Once the temporary period ends, unspent proceeds must be yield-restricted or the excess earnings must be rebated to the Treasury.
Arbitrage Rebate and Spending Exceptions
When an issuer does earn investment income above the bond yield, the excess has to be paid to the Treasury in installments at least every five years. If an issuer misses a required rebate payment and the failure is not due to willful neglect, it can preserve the bonds’ tax-exempt status by paying the overdue amount plus a correction payment equal to 50% of the unpaid rebate plus interest at the underpayment rate. Fail to make even the corrective payment, and the bonds are treated as never having been tax-exempt.4Office of the Law Revision Counsel. 26 USC 148 – Arbitrage
Several spending exceptions can eliminate the rebate obligation entirely if the issuer deploys proceeds fast enough:6eCFR. 26 CFR 1.148-7 – Spending Exceptions to the Rebate Requirement
- Six-month exception: all gross proceeds are spent on the governmental purpose within six months of the issue date.
- 18-month exception: at least 15% is spent within six months, 60% within 12 months, and 100% within 18 months.
- Two-year construction exception: for construction issues, at least 10% of available construction proceeds are spent within six months, 45% within one year, 75% within 18 months, and 100% within two years.
A small issuer exception also exists. Governmental entities with general taxing powers that issue no more than $5 million in governmental bonds per year ($15 million for public school construction) are exempt from the rebate requirement altogether, provided at least 95% of proceeds fund local governmental activities.
Guaranteed investment contracts, where the issuer locks in a fixed return for a set period, carry their own competitive-bidding requirements designed to ensure the issuer paid fair market value, including solicitation of at least three qualifying bids and restrictions on who can bid.7Internal Revenue Service. Determining if a Guaranteed Investment Contract Was Purchased at Fair Market Value When proceeds are commingled with the issuer’s other funds in a single investment account, the IRS requires consistent ratable allocation of earnings among the different sources at least as often as the close of each fiscal period, which can be no longer than three months.8eCFR. 26 CFR 1.148-6 – General Allocation and Accounting Rules
Recordkeeping and Monitoring After Closing
Selling the bonds is just the beginning. The compliance burden runs for the entire life of the debt and beyond, and this is where inattention costs the most.
Issuers of tax-exempt governmental bonds file IRS Form 8038-G at closing, reporting the type of bonds, their terms, and the planned uses of proceeds.9Internal Revenue Service. Instructions for Form 8038-G – Information Return for Tax-Exempt Governmental Bonds Beyond the initial filing, the issuer needs a spend-down schedule tracking every dollar from receipt to final expenditure, along with records supporting rebate calculations, investment transactions, and allocations of proceeds among different uses.
The IRS expects issuers to retain all material records for the life of the bonds plus three years after final redemption. For a 30-year bond that means more than three decades of documentation, covering everything from closing transcripts to investment records to evidence of how bond-financed property has been used over time.10Internal Revenue Service. Tax Exempt Bond FAQs Regarding Record Retention Requirements
A bond-financed facility that starts out serving a purely governmental purpose can drift into private use. A public hospital leases a wing to a private practice group. A city sells a bond-financed building to a developer. Each is a deliberate action that can retroactively disqualify the bonds if private use thresholds are exceeded.
When a change in use occurs involving private activity bonds, the issuer generally has to take remedial action. The primary remedy is redeeming all affected bonds on the earliest available call date. If the bonds cannot be redeemed within 90 days, the issuer must establish a defeasance escrow within that same 90-day period and notify the IRS within 90 days after establishing it. If the gap between the issue date and the first call date exceeds 10½ years, a defeasance escrow alone will not satisfy the remedial requirements.11eCFR. 26 CFR 1.142-2 – Remedial Actions Alternatively, if the property is put to a different qualifying use, or if disposition proceeds are spent on a new qualifying purpose within 90 days of the deliberate action, the change-in-use penalties can be avoided.12eCFR. 26 CFR 1.150-4 – Change in Use of Facilities Financed With Tax-Exempt Private Activity Bonds
Fixing a Violation Before It Gets Worse
When an issuer discovers it has violated the rules through accidental private use, a missed rebate payment, or improper investment, the worst move is doing nothing. The IRS offers a formal path to resolve violations before they escalate.
The Tax Exempt Bonds Voluntary Closing Agreement Program (TEB VCAP) lets issuers approach the IRS to negotiate a closing agreement that conclusively resolves the violation. The issuer submits a request describing the problem and proposing a resolution, and the IRS works with it to reach terms. A VCAP agreement does not resolve questions about future events; it only addresses the specific violation at hand.13Internal Revenue Service. TEB Voluntary Closing Agreement Program
The practical value is significant. An issuer that self-reports and negotiates typically pays a settlement amount far smaller than the tax revenue the IRS would collect by declaring the entire issue taxable. Waiting for an audit risks the bonds being retroactively stripped of tax-exempt status, which harms not just the issuer but every bondholder who relied on the exemption. If you are sitting on a known compliance problem, VCAP is almost always the right call.13Internal Revenue Service. TEB Voluntary Closing Agreement Program