Tax-Exempt Bonds for Affordable Housing: 4% LIHTC, TEFRA, and Compliance

Tax-exempt bonds for affordable housing are a federal financing tool that lets a state or local housing authority issue debt on a private developer’s behalf, with the interest paid to investors exempt from federal income tax under Section 142 of the Internal Revenue Code.¹ Investors accept a lower yield because of that tax break, and the developer captures the savings as cheaper debt service. When the bonds finance enough of the project, they also unlock the 4% Low-Income Housing Tax Credit automatically, delivering equity that closes the gap between what affordable housing costs to build and what lower-income tenants can pay.

How the Financing Works

The issuing authority sells the bonds. The developer repays them out of rental income. Because bondholders owe no federal tax on the interest, the coupon rate runs well below what a conventional construction or permanent loan would demand, and that spread is what makes below-market rents pencil out.

Federal law dictates how the money can be spent. At least 95% of net bond proceeds must go toward qualified project costs: construction, architecture and engineering, land acquisition, and eligible soft costs. The other 5% can cover financing-related expenses. Spending bond money outside those categories can strip the bonds of their tax-exempt status entirely, so use of proceeds gets scrutinized closely by bond counsel.

The 4% LIHTC Trigger

The real leverage in a bond deal is not the interest savings. It is the tax credit that comes with them. Most 9% Low-Income Housing Tax Credits are awarded through a fiercely competitive state process; the 4% credit is different. If your project meets the bond financing threshold, the credits are allocated automatically, and you can sell them to investors for upfront equity.

The traditional threshold under Section 42(h)(4)(B) is 50%: tax-exempt bonds must finance at least half of the project’s aggregate basis, meaning the combined cost of the building and the land underneath.²

Starting in 2026, there is a second path. For bonds issued after December 31, 2025, the threshold drops to 25% of aggregate basis, as long as at least 5% of that basis is financed by bonds issued after that date.² The lower threshold stretches state volume cap further and is expected to open the pipeline to more bond-financed projects.

The credit rate itself has a permanent 4% floor for buildings placed in service after December 31, 2020, set by the Consolidated Appropriations Act of 2021.² Before that fix, the rate floated with interest rates and often ran below 4%, weakening deal economics.

Who Can Live There and What Rent They Pay

To qualify as a residential rental project, the property must meet one of three occupancy tests. The developer picks at bond issuance, and the choice is locked in for the life of the project.

The two traditional tests come from Section 142(d):³

The 20-50 test: at least 20% of units are occupied by tenants earning 50% or less of area median gross income.
The 40-60 test: at least 40% of units are occupied by tenants earning 60% or less of area median gross income.

A third option, the average income test under Section 42(g)(1)(C), gives more flexibility. At least 40% of units must be rent-restricted and income-qualified, but individual unit designations can range from 20% to 80% of area median gross income in 10-percentage-point increments, so long as the average across all designated units does not exceed 60%.² This lets a developer serve some households at 80% while reserving deeply affordable units at 20% or 30% of median.

Whatever test you pick, gross rent on restricted units, including a utility allowance, cannot exceed 30% of the applicable income limit. HUD publishes area median income figures annually for every metropolitan area and non-metro county, and those figures drive both the income limits and the maximum rents.⁴

How Long the Restrictions Last

These are long commitments. The qualified project period under Section 142(d) starts when 10% of units are occupied and runs until the latest of three dates: 15 years after 50% of units are occupied, the date the last tax-exempt bond issued for the project is retired, or the date any Section 8 project-based assistance ends.⁵ Because bond maturities usually run 30 to 40 years, the restrictions typically outlast the 15-year floor by a wide margin.

Projects that also claim the 4% LIHTC carry a second layer. The tax credit compliance period is 15 taxable years, but the extended use agreement required for virtually all LIHTC allocations since 1990 pushes total affordability to 30 years from placed-in-service.² Some state agencies require longer. Plan accordingly: you cannot convert to market-rate for decades.

Getting an Allocation from the State

The federal government caps how much private activity bond volume each state can issue per year. Section 146 sets the ceiling as the greater of a per-capita amount times state population, or a fixed floor, both indexed for inflation.⁶ For 2026, the per-capita figure is $135 and the floor is $397,625,000, so less-populated states get a baseline even if their population math would produce less.

State housing finance agencies decide how the cap gets distributed. They score developer applications on criteria that vary by state but tend to favor projects serving very low-income tenants, projects in high-need areas, and energy-efficient designs. Competition is intense, because volume cap is the gate to the automatic 4% credits.

If a project receives an allocation but cannot issue bonds in the same calendar year, the agency can issue a carryforward designation preserving the allocation for up to three years. Miss the carryforward window and the allocation is gone. There is no appeal.

Federal Approvals Before Bonds Can Be Sold

Before any bonds are issued, three approval steps have to be handled in the right order, and each carries a deadline that can bite.

Inducement Resolution

The issuing authority adopts an inducement resolution, also called a declaration of official intent, signaling that it plans to issue bonds for the project. Under Treasury Regulation 1.150-2, the issuer must adopt this official intent no later than 60 days after the developer pays any project expense that will later be reimbursed from bond proceeds.⁷ Costs paid earlier than 60 days before the resolution cannot be reimbursed from bond proceeds. This is where developers most often trip up: spending starts, months pass, and predevelopment costs turn out to be permanently ineligible for reimbursement.

TEFRA Hearing and Elected Approval

Section 147(f) requires a public hearing before any private activity bond can qualify as tax-exempt. This is the TEFRA hearing, named for the Tax Equity and Fiscal Responsibility Act. The issuing authority must publish notice at least seven days before the hearing, either in a newspaper of general circulation or continuously on an appropriate government website.⁸

After the hearing, the bond issue needs approval from the applicable elected representative of the governmental unit. That can be the elected legislative body, the chief elected executive officer, or another elected official designated under state or local law.⁸ The approval has to occur within one year before the bonds are actually issued, so a project delayed past that window has to redo the TEFRA process.

Buying an Existing Building

Tax-exempt bonds can finance acquisition of existing buildings, not just new construction, but the deal has to include real renovation. Section 147(d) requires that rehabilitation expenditures equal or exceed 15% of the bond-financed portion of the acquisition cost for any building and its related equipment.⁹ For structures that are not buildings, the threshold rises to 100%.

Those rehab expenditures must be incurred within two years after the later of the acquisition date or the bond issuance date.⁹ When a project involves multiple buildings, the IRS applies the test project-wide rather than building by building, letting a developer concentrate spending where the property most needs it.

Ongoing Compliance and Recapture

Closing the bonds and claiming the credits is the beginning of the compliance obligation, not the end. Owners must file IRS Form 8703 every year to certify that the property still meets the requirements of a qualified residential rental project.¹⁰ State housing finance agencies also run their own physical inspections and file reviews, usually on a one- to three-year cycle.

The financial risk sits on the LIHTC side. Under Section 42(j), if the qualified basis of a building drops below what it was at the end of the prior year, the IRS claws back a portion of credits already claimed. The recapture amount is the “accelerated portion” of the credit, roughly one-third of the annual credit, plus interest at the federal overpayment rate running from the original due date of each affected return.² The interest compounds, and a modest compliance failure caught years later can produce a six- or seven-figure tax bill for the investor who claimed the credits.

Qualified basis can drop for several reasons: units that stop being rented to income-qualifying tenants, a building that falls below habitability standards, or a sale or transfer where the new owner does not keep operating the property as affordable housing. The statute carves out limited exceptions for casualty losses restored within a reasonable time, for dispositions where the building is reasonably expected to remain qualified low-income property through the end of the 15-year compliance period, and for noncompliance self-corrected within a reasonable period after discovery. The margin for error is narrow, and the burden of proof falls on the owner.

1
Office of the Law Revision Counsel. 26 U.S. Code 142 – Exempt Facility Bond
2
Office of the Law Revision Counsel. 26 USC 42 – Low-Income Housing Credit
3
Office of the Law Revision Counsel. 26 U.S. Code 142 – Exempt Facility Bond – Section: Qualified Residential Rental Project
4
HUD USER. Income Limits
5
Office of the Law Revision Counsel. 26 U.S. Code 142 – Exempt Facility Bond – Section: Qualified Project Period
6
Office of the Law Revision Counsel. 26 USC 146 – Volume Cap
7
eCFR. 26 CFR 1.150-2 – Proceeds of Bonds Used for Reimbursement
8
eCFR. 26 CFR 1.147(f)-1 – Public Approval of Private Activity Bonds
9
Internal Revenue Service. Rehabilitation Requirement Under IRC Section 147(d) for Financing Acquisitions of Existing Property
10
Internal Revenue Service. About Form 8703, Annual Certification of a Residential Rental Project