Tax Code 144T: Small Issue Bonds, Volume Cap, and TEFRA

Section 144 private activity bonds are tax-exempt debt that a state or local government issues on behalf of a private borrower for one of three specific purposes: small manufacturing and similar capital projects, student loans, or redevelopment of blighted areas. Bondholders pay no federal income tax on the interest, which lets the borrower access capital at a lower rate than a conventional taxable loan. The trade-off is a set of eligibility, dollar-limit, and compliance rules that apply from the day the bonds are issued through the day they are retired, and violating any of them can strip the interest of its tax exemption retroactively.

The three categories sit in separate subsections of the statute and operate independently. Qualified small issue bonds under Section 144(a) finance the purchase, construction, or improvement of land or depreciable property. Qualified student loan bonds under Section 144(b) fund student loan programs. Qualified redevelopment bonds under Section 144(c) pay for land acquisition, clearance, and rehabilitation in officially designated blighted areas. All three count against the state volume cap, all three require public approval, and all three require an information return filed with the IRS.

Qualified Small Issue Bonds

A qualified small issue bond has to satisfy two tests at the same time. At least 95 percent of the net bond proceeds must go toward acquiring, constructing, or improving land or depreciable property, and the total face amount of the issue cannot exceed $1 million.¹ The $1 million ceiling keeps the subsidy pointed at smaller localized projects rather than large corporate financings.

That 95 percent floor leaves only a five-point cushion for everything else, and Section 147(g) narrows the room further. Costs of issuance paid from bond proceeds, including legal fees, underwriting fees, and financial advisory costs, cannot exceed 2 percent of the issue’s proceeds.² An issuer can spend more than 2 percent on those costs, but any excess has to be paid from the issuer’s own funds or from taxable borrowing. Bond insurance premiums may qualify as interest rather than issuance cost, which puts them outside the 2 percent cap.

The $10 Million Manufacturing Election

Manufacturing facilities routinely need more capital than $1 million. Section 144(a)(4) lets the issuer elect a higher $10 million ceiling, but the definition of what counts against that ceiling expands significantly.¹ Under the election, the $10 million includes the bond issue itself and all capital expenditures related to the facility during a six-year window that runs three years before issuance and three years after.

Every dollar the principal user or any related person spends on equipment, land, buildings, or improvements during that window counts. If the running total exceeds $10 million, the bonds lose their tax-exempt status entirely. Routine facility upgrades that seem unconnected to the bond-financed project can still push an issuer past the limit if they fall inside the six-year window, which is why capital planning matters as much as the bond structuring itself.

Who Counts as a Related Person

The related-person definition is broad. Two entities are related if their relationship would trigger loss disallowance under the tax code’s related-party rules, or if they sit in the same controlled group of corporations at more than 50 percent common ownership.¹ That 50 percent standard is lower than the 80 percent threshold used elsewhere in the code, so entities that would not be considered related in other contexts get pulled in here. Their capital spending during the six-year window counts against the $10 million cap even if they have nothing to do with the bond-financed project.

Qualified Student Loan Bonds

Section 144(b) covers bonds whose proceeds finance student loan programs, and it recognizes two qualifying pathways.

The first covers programs subject to the Higher Education Act of 1965. Loans must carry limits on the maximum amount any student can borrow and on the maximum interest rate, and the federal government must directly or indirectly guarantee them.¹ At least 90 percent of net proceeds have to fund those loans.

The second covers state-approved programs that are not subject to the Higher Education Act. No individual loan can exceed the difference between the student’s total cost of attendance and other available aid. The threshold is stricter here: 95 percent of net proceeds must fund loans. Each borrower must be either a resident of the state whose volume cap covers the bonds or enrolled at a school in that state, and the program cannot discriminate based on where a school sits within the United States.

Qualified Redevelopment Bonds

Section 144(c) authorizes bonds to revitalize areas that a local government has officially designated as blighted. At least 95 percent of net proceeds must fund redevelopment activities within the designated area.¹ Eligible activities are narrowly listed: a governmental unit with eminent domain power acquiring real property, clearing and preparing acquired land, rehabilitating acquired property, and relocating the people who lived there.

New construction is explicitly excluded. An existing building can be rehabilitated, but bond proceeds cannot pay to build a new structure or enlarge an existing one. The bonds have to be issued under a state law that authorizes redevelopment bonds and pursuant to a redevelopment plan the local governing body adopted before issuance. Any real property acquired with bond proceeds and later transferred to a private party must be sold at fair market value.

The local government determines what counts as a blighted area, weighing factors like excessive vacant lots where buildings once stood, abandoned structures, substandard buildings, and delinquent property taxes.³ Bond proceeds generally cannot fund land purchased for farming. An exception exists for first-time farmers up to an inflation-adjusted dollar limit, with a base amount of $450,000 that has been adjusted annually for cost of living since 2008.⁴

State Volume Cap

Section 146 imposes a statewide annual ceiling on the total volume of private activity bonds that can be issued in a calendar year. The cap is the greater of a per-capita dollar amount times state population or a flat floor amount, and both figures adjust for inflation.⁵ For 2026 the ceiling is the greater of $135 per resident or $397,625,000.

Every private activity bond issuer in the state competes for allocation out of that single pool. State housing finance agencies, industrial development authorities, and local issuers all draw from the same well, which is why securing cap early in the calendar year matters. Some states allocate on a first-come, first-served basis, others run a formal scored application.

TEFRA Hearing and Public Approval

Section 147(f) requires public approval before any private activity bond can be issued. Approval can come through a voter referendum or, far more commonly, through an elected representative approving the issue after a public hearing.⁶ That hearing is generally called a TEFRA hearing.

Reasonable public notice has to be published at least seven days before the hearing, either in a newspaper of general circulation within the issuer’s jurisdiction or on the governmental entity’s website. The notice must state the time, place, and general purpose of the proposed issue so the public can comment. After the hearing, an elected official or the relevant legislative body grants formal approval. Bonds issued without proper public approval do not qualify as tax-exempt, so a botched notice period is not just a procedural nuisance.

Filing Form 8038

Section 149(e) states plainly that no bond qualifies for tax-exempt interest unless the issuer files the required information return.⁷ For private activity bonds, that return is Form 8038.⁸

The form captures the issuer’s identifying information, the issue date, net proceeds, stated interest rate, face amount, issuance costs, and the issue price broken down by bond type. It also has to name each initial principal user of any bond-financed facility, describe the property being financed, and carry a certification from a designated state official confirming that the bonds fall within the state volume cap. Identifying every principal user is how the IRS tracks whether the private-use and private-payment tests keep being satisfied.

The deadline is the 15th day of the second calendar month after the close of the quarter in which the bond was issued.⁹ A bond issued in March, for example, has an August 15 filing deadline. The IRS can grant an extension when the delay is not due to willful neglect, but that discretion is not a plan.

Arbitrage and Rebate

Bond proceeds are usually invested for some period before they are spent on the financed project. Section 148 limits the yield the issuer can earn on those temporary investments so the issuer cannot profit by borrowing at tax-exempt rates and reinvesting at higher taxable rates. When investment earnings exceed the bond yield, the excess generally has to be rebated to the federal government.¹⁰

Two main exceptions can lift the rebate obligation. The small issuer exception applies to governmental bonds where the issuer reasonably expects to issue no more than $5 million in tax-exempt governmental bonds during the calendar year, and it generally is not available for private activity bonds because it requires that no part of the issue be a private activity bond. The spending exceptions apply when the issuer deploys proceeds on a prescribed timeline, typically within 6 months, 18 months, or 2 years of issuance depending on the exception claimed, and those remain available to private activity issuers. Missing a rebate payment does not automatically strip tax-exempt status, but it creates a compliance violation the IRS can pursue.

Post-Issuance Compliance

Compliance work does not stop at closing. Issuers have to track how proceeds are spent, monitor whether the financed property continues to be used for its qualifying purpose, and keep records long enough to demonstrate compliance. IRS guidance indicates records should be retained until at least three years after the final redemption of the bonds, with the clock resetting if a later issue refunds the original.

The most common failures involve change in use. A manufacturing facility financed with small issue bonds that is later converted to a retail store triggers a change in use that can strip the bonds of their tax-exempt status retroactively to the date of issuance.¹¹ These problems often surface years after issuance, which is why ongoing monitoring matters more at year five than it feels like it should at closing.

When something goes wrong, the IRS offers remedial action procedures that can preserve the tax exemption if the issuer moves quickly. Typical remedial actions include redeeming the nonqualifying bonds or redirecting proceeds to an alternative qualifying purpose within specified timeframes. Where remedial action is unavailable or the violation is more serious, the Tax Exempt Bonds Voluntary Closing Agreement Program lets issuers negotiate a settlement without a full audit.¹² The program exists to encourage issuers to come forward instead of waiting to be found.

What Happens When Bonds Lose Tax-Exempt Status

The consequences reach multiple parties. For bondholders, interest becomes taxable retroactive to the original issuance date, not just from the date of the violation.¹¹ Bondholders can end up owing back taxes on years of interest they had treated as exempt.

For users of the bond-financed facility, Section 150(b) adds a separate penalty. They lose the ability to deduct the interest they pay on the financing during the period of noncompliance. Where small issue bonds exceed the $10 million capital expenditure limit, the principal user loses the interest deduction on payments made to the issuer. The bondholder penalty and the user penalty operate independently, so one violation can trigger both.

1
Office of the Law Revision Counsel. 26 USC 144 – Qualified Small Issue Bond; Qualified Student Loan Bond; Qualified Redevelopment Bond
2
Internal Revenue Service. Excess Costs of Issuance for Private Activity Bonds
3
Internal Revenue Service. IRC 144(c) – Qualified Redevelopment Bonds
4
Office of the Law Revision Counsel. 26 USC 147 – Other Requirements Applicable to Certain Private Activity Bonds
5
Office of the Law Revision Counsel. 26 USC 146 – Volume Cap
6
Federal Register. Public Approval of Tax-Exempt Private Activity Bonds
7
Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered To Be Tax Exempt; Other Requirements
8
Internal Revenue Service. Form 8038 – Information Return for Tax-Exempt Private Activity Bond Issues
9
Internal Revenue Service. Instructions for Form 8038
10
Internal Revenue Service. Lesson 5 Arbitrage and Rebate
11
Internal Revenue Service. Lesson 10 Change in Use Rules for Private Activity Bonds
12
Internal Revenue Service. TEB Voluntary Closing Agreement Program