A tax-exempt loan is money a borrower receives from the proceeds of bonds issued by a state or local government entity, where federal law excludes the interest paid to bondholders from federal income tax under Section 103 of the Internal Revenue Code.1Office of the Law Revision Counsel. 26 U.S. Code 103 – Interest on State and Local Bonds Because investors accept lower yields on interest they don’t have to pay tax on, the borrower ends up paying a rate meaningfully below what a conventional commercial lender would charge. In exchange, the borrower accepts federal restrictions on who qualifies, what the money can build, how fast it must be spent, and how the financed property may be used for as long as the bonds remain outstanding.
The Three Parties in a Tax-Exempt Loan
Every tax-exempt loan involves a borrower who needs capital, a government entity that issues the bonds, and investors or banks that buy them and supply the cash. The government entity usually doesn’t keep the money. It acts as a conduit issuer, passing the bond proceeds through to the borrower under a loan agreement that mirrors the bond terms.2Internal Revenue Service. Your Responsibilities as a Conduit Issuer of Tax-Exempt Bonds Conduit issuers include local development authorities, housing finance agencies, and hospital authorities, and each has specific powers under state law. A health facilities authority typically cannot issue bonds for a housing project, and a housing agency cannot finance a hospital.
The savings flow one direction and the risk flows the other. Investors get tax-free interest and accept a lower yield. The borrower gets a lower rate and accepts federal tax rules governing the property for the life of the bonds. Break one of those rules and the IRS can strip the tax exemption retroactively, which leaves everyone facing penalties and, often, a rate reset.
Who Qualifies to Borrow
Government entities, including counties, cities, school districts, and utility authorities, can borrow directly through tax-exempt bonds for public infrastructure. Private borrowers only reach this market if they fit into a narrow set of federally approved categories.
The most common private borrower is a nonprofit organized under Section 501(c)(3). Section 145 allows these organizations to finance facilities tied to their charitable mission through what the code calls qualified 501(c)(3) bonds.3Office of the Law Revision Counsel. 26 U.S. Code 145 – Qualified 501(c)(3) Bond All property financed by the proceeds must be owned by the nonprofit or a government unit, and no more than 5 percent of the proceeds can support private business use unrelated to the nonprofit’s exempt purpose. Nonprofits cannot issue the bonds themselves; they work through a conduit issuer with authority to issue on their behalf.
For-profit businesses have a much narrower path. They can only participate through specific categories of exempt facility bonds covering projects such as airports, solid waste disposal facilities, affordable rental housing, and certain manufacturing operations. These are classified as private activity bonds and come with extra restrictions, including the state volume cap discussed below.
Bank-Qualified Bonds for Small Issues
When an issuer expects to issue no more than $10 million in tax-exempt bonds during the calendar year, the bonds can qualify as bank-qualified under Section 265(b)(3).4Internal Revenue Service. Lesson 13 Bank Qualified Bonds – Section 265 Banks that buy bank-qualified bonds can deduct 80 percent of the interest expense they incur to carry them, a deduction they lose on larger issues. That advantage makes local banks more willing to buy the bonds and often translates into an even lower rate for the borrower. Small governmental units and small nonprofits benefit the most.
What the Money Can Fund
Tax-exempt proceeds can only pay for projects that provide a public benefit. Common uses include roads, water and sewer systems, public schools, nonprofit hospitals and nursing facilities, university buildings, and affordable multi-family housing. The project must fall within the issuing authority’s scope under state law and satisfy federal requirements for the type of bond being issued.
Section 141 sets the boundary between public use and prohibited private use through the private business use test.5Office of the Law Revision Counsel. 26 U.S. Code 141 – Private Activity Bond; Qualified Bond For governmental bonds, no more than 10 percent of proceeds can be used in a private trade or business, with a stricter 5 percent cap on private use unrelated to the governmental purpose of the bond.6eCFR. 26 CFR 1.141-3 – Definition of Private Business Use For qualified 501(c)(3) bonds, the same 5 percent limit applies to use by anyone other than the nonprofit or a government unit.3Office of the Law Revision Counsel. 26 U.S. Code 145 – Qualified 501(c)(3) Bond Crossing either threshold can make the entire issue taxable, not just the portion tied to the excess use.
This is where borrowers get tripped up years after closing. Leasing space to a for-profit tenant, signing a concession agreement with a private vendor, or entering into certain management contracts can all count as private business use. The test looks at the whole life of the bonds, so a facility that starts out compliant can drift out of compliance through operational decisions made long after the money was spent.
Cost Limits: Volume Cap and Issuance Costs
Federal law caps the total amount of private activity bonds a state can issue in a given year. Section 146 sets this volume cap and each state allocates its share among issuers.7Internal Revenue Service. Publication 4078 – Tax-Exempt Private Activity Bonds For 2026, the cap is the greater of $135 multiplied by the state’s population or a floor of $397,625,000. Bonds issued above an issuer’s allocation lose tax-exempt status. Not every bond counts against the cap: qualified 501(c)(3) bonds, certain government-owned exempt facility bonds, and some refunding bonds are excluded.
Section 147(g) limits how much of the proceeds can pay for issuance costs like legal fees, underwriting, and printing. For most private activity bonds, those costs cannot exceed 2 percent of the issue’s proceeds.8Office of the Law Revision Counsel. 26 U.S. Code 147 – Other Requirements Applicable to Certain Private Activity Bonds Anything above that has to be paid from other funds. On a $10 million issue, the 2 percent ceiling leaves no more than $200,000 of proceeds for closing costs.
Closing, Public Approval, and How Proceeds Reach the Borrower
Preparing a tax-exempt bond issue takes substantial legal and financial documentation. Bond counsel drafts a formal tax opinion confirming the bonds meet all Internal Revenue Code requirements based on the borrower’s finances and the project’s intended use. The conduit issuer files IRS Form 8038 for private activity bonds, or Form 8038-G for governmental issues, by the 15th day of the second calendar month after the close of the calendar quarter in which the bonds were issued.9Internal Revenue Service. Instructions for Form 8038 – Information Return for Tax-Exempt Private Activity Bond Issues The issuer’s name goes on the form, but the borrower supplies most of the underlying data.
Private activity bonds also require public approval under Section 147(f), commonly called the TEFRA hearing. The issuer must publish notice at least seven days before the hearing in a newspaper of general circulation or on the appropriate governmental entity’s website.10Federal Register. Public Approval of Tax-Exempt Private Activity Bonds The notice must include the time and place of the hearing, the maximum principal amount of the bonds, the name of the borrower, a description of the project, and its location. An elected representative of the governmental unit then approves the bonds after the hearing. Skipping this step or publishing deficient notice can jeopardize the whole issue.
Once the bonds close, proceeds typically go into a project fund held by a trustee rather than straight to the borrower. The borrower submits draw requests, or requisitions, documenting specific project costs, and the trustee releases funds after reviewing each requisition against the bond documents. That controlled disbursement builds the paper trail the IRS expects to see in an audit years later.
Arbitrage: The Three-Year Spending Window and the Rebate
The federal government does not let borrowers pocket the spread between low tax-exempt borrowing rates and higher investment yields. Section 148 defines an arbitrage bond as any bond whose proceeds are invested in higher-yielding securities, and arbitrage bonds lose their tax-exempt status.11Office of the Law Revision Counsel. 26 U.S. Code 148 – Arbitrage The yield on investments purchased with bond proceeds generally cannot exceed the yield on the bonds.
Treasury regulations create a three-year temporary period for capital projects. During those three years, proceeds can be invested at unrestricted rates while the borrower spends them on construction or acquisition.12eCFR. 26 CFR 1.148-2 – General Arbitrage Yield Restriction Rules To qualify, the issuer must reasonably expect to spend at least 85 percent of net sale proceeds on the project within three years, must enter a substantial binding obligation to spend at least 5 percent within six months of issuance, and must proceed with due diligence to finish the project.
Even inside that window, investment earnings above the bond yield are not free money. Section 148(f) requires the issuer to rebate excess earnings to the U.S. Treasury in installments at least every five years, with a final payment due within 60 days after the last bond is redeemed.11Office of the Law Revision Counsel. 26 U.S. Code 148 – Arbitrage The calculation is technical enough that most borrowers hire a specialized arbitrage consultant. Missing a rebate payment can turn the bonds into arbitrage bonds retroactively.
Ongoing Compliance After Closing
Closing is not the finish line. The IRS expects issuers and conduit borrowers to maintain written procedures for monitoring compliance throughout the life of the bonds.13Internal Revenue Service. TEB Post-Issuance Compliance: Some Basic Concepts Forms 8038 and 8038-G now ask whether the issuer has established such procedures, and the absence of a written policy is a red flag in audits. Good procedures cover regular reviews of private business use, arbitrage, and project fund expenditures; a named official responsible for compliance; ongoing training, especially as staff turns over; record retention; and early detection so violations can still be corrected.
The IRS recommends keeping records for as long as the bonds are outstanding plus three years after final redemption.14Internal Revenue Service. Tax Exempt Bond FAQs Regarding Record Retention Requirements For a 30-year bond, that is 33 years or more of expenditure documentation, investment records, and use agreements. Borrowers who let records lapse have a much harder time defending compliance if the IRS examines the issue.
What Noncompliance Costs the Borrower
Section 150(b) puts a penalty on the borrower’s own tax return rather than on the bondholder. If a bond-financed facility stops meeting the requirements for its tax-exempt classification, the borrower loses the deduction for interest paid on the financing during the period of noncompliance.15Office of the Law Revision Counsel. 26 U.S. Code 150 – Definitions and Special Rules This applies to 501(c)(3) bonds, exempt facility bonds, and qualified residential rental projects. The suspension runs from the date the facility falls out of compliance to the date it comes back into compliance, and for a nonprofit with significant debt service, losing that deduction can be a substantial hit on top of whatever caused the violation.
Fixing a Problem After the Fact
When a bond-financed facility falls out of compliance with the private business use test, the situation is not always fatal. Treasury Regulation 1.141-12 sets out remedial actions that, if taken promptly, prevent the violation from being treated as a deliberate action that would make the bonds taxable.16eCFR. 26 CFR 1.141-12 – Remedial Actions The most straightforward remedy is redeeming or defeasing the affected bonds within 90 days of the action that caused the violation. If the violation came from a property sale, the issuer can also use the sale proceeds for an alternative qualifying purpose within two years.
For violations that do not fit the regulatory remedies, the IRS offers the Tax-Exempt Bonds Voluntary Closing Agreement Program. VCAP lets an issuer come forward, disclose the violation, and negotiate a closing agreement that resolves the issue without a full audit.17Internal Revenue Service. TEB Voluntary Closing Agreement Program Resolution usually involves a payment to the IRS based on the tax benefit that would have been lost. Discovering a violation five or ten years into a bond issue is not unusual, and VCAP is often the least costly way to fix it.
Refinancing a Tax-Exempt Loan
Borrowers can refinance outstanding bonds to capture lower rates, but the options are narrow. A current refunding uses new bond proceeds to pay off old bonds within 90 days of the new issue date and remains permitted on a tax-exempt basis. That is the standard route to reduce debt service.
An advance refunding, where new bonds are issued more than 90 days before the old bonds are redeemed, is off the table. The Tax Cuts and Jobs Act of 2017 eliminated tax-exempt advance refunding entirely. Section 149(d) now provides that interest on any bond issued to advance refund another bond does not qualify for the federal exclusion.18Office of the Law Revision Counsel. 26 U.S. Code 149 – Bonds Must Be Registered to Be Tax Exempt; Other Requirements Before 2018, issuers had one shot at a tax-exempt advance refunding of governmental and 501(c)(3) bonds. That door is closed. Issuers who want to lock in current rates before the call date on existing bonds now have to use taxable advance refundings or forward delivery structures, both of which give up some or all of the interest cost savings.