Tax-Exempt Financing: How It Works, Who Qualifies, and Compliance

Tax-exempt financing lets state and local governments, qualifying 501(c)(3) nonprofits, and certain private projects serving a public purpose borrow at interest rates well below the private market. The mechanism is simple: because bondholders owe no federal income tax on the interest they receive, they accept a lower yield, and that discount passes through to the borrower as cheaper debt service.¹ Congress built the exemption into the tax code to steer private capital toward infrastructure, healthcare, education, and affordable housing.

Who Can Borrow

Three categories of borrowers can tap this market, and the requirements tighten as you move away from pure public purpose.

Governmental bonds are the simplest form. A state, city, county, or other political subdivision issues them directly for a traditional public purpose such as roads, water systems, or government buildings.¹ The government owns the asset, uses it, and repays the debt from public revenue.

Qualified 501(c)(3) bonds let recognized nonprofits finance facilities they own and operate, such as hospitals, universities, and charitable care centers. The Internal Revenue Code requires that all property financed by the bond proceeds be owned by either the nonprofit or a governmental unit.² The nonprofit must hold a current IRS determination letter confirming its tax-exempt status before a conduit issuer will proceed.

Exempt facility bonds cover projects owned or operated by private parties but serving a recognized public purpose. The tax code lists 17 eligible project types, including airports, mass transit, sewage facilities, affordable rental housing, solid waste disposal, broadband infrastructure, and high-speed rail.³ At least 95 percent of the bond proceeds must go toward the qualifying facility.

Private Activity Bonds and the Volume Cap

Any time bond-financed property involves private parties in its ownership, management, or use, the bonds may be classified as private activity bonds. The test has two parts: more than 10 percent of the proceeds used in a private trade or business, and more than 10 percent of debt service secured by or paid from that private use.⁴ Bonds that meet both prongs face extra requirements governmental bonds do not.

The biggest of those is the volume cap. Congress limits how much private activity bond debt each state can issue in a year. For 2026, the cap is the greater of $135 multiplied by state population or a floor of $397,625,000 for smaller states. Each state decides how to allocate its share among cities, counties, housing agencies, and other issuers. When a state’s cap runs out, borrowers wait or compete for the next year’s allocation. Issuers that don’t use their full share can carry forward the unused amount for certain designated purposes by filing IRS Form 8328.⁵

The TEFRA Public Approval Requirement

Private activity bonds also carry a public approval requirement that catches borrowers who don’t plan for the calendar it imposes. Before issuance, the bonds must be approved by the governmental unit that issues them (or on whose behalf they are issued) and by each governmental unit with jurisdiction over the area where the financed facility sits.⁶ This is the TEFRA approval, named for the Tax Equity and Fiscal Responsibility Act.

The process begins with a public notice describing the project, the maximum dollar amount of bonds, and the project’s location. Under Treasury Regulations, the notice must be published at least seven days before the hearing, either in a newspaper of general circulation or on the appropriate government entity’s website. A public hearing follows. After the hearing, the applicable elected representative or the legislative body must formally approve the issue. Approval must happen within one year before the bonds are actually issued; if the timeline slips, the approval lapses and the process starts over.⁶

What You Need to Put a Deal Together

Every borrower needs a documentation package: detailed engineering cost estimates and architectural descriptions of the facility, audited financial statements, proof of site control, and projections showing how the debt will be repaid. For 501(c)(3) borrowers, the package also includes the IRS determination letter and the original Form 1023 application.⁷ The conduit issuer, usually a state or local finance authority, provides its own application forms requesting the same information in its preferred format.

Bond counsel is central. This attorney drafts the legal opinions confirming the bonds qualify as tax-exempt and structures the documents to satisfy every Internal Revenue Code requirement. Conduit issuers often maintain lists of pre-approved bond counsel.

After closing, the issuer must file an information return with the IRS. Governmental obligations use Form 8038-G; other tax-exempt bonds use Form 8038. The filing deadline is the 15th day of the second calendar month after the close of the calendar quarter in which the bonds were issued.⁸ The statute says the interest on the bonds is not exempt from federal income tax unless the information return is properly filed.⁹

How the Bonds Reach Market and Close

With documentation complete and TEFRA approval secured where required, the bonds go to market. In a public offering, an underwriter buys the entire issue and resells the bonds to investors. In a direct or private placement, a single bank buys the bonds and holds them, which simplifies the process and usually works better for smaller deals. Interest rates lock in during this marketing phase, driven by prevailing market conditions and the borrower’s credit profile.

On closing day the money moves. The borrower and conduit issuer sign the loan agreement, the trust indenture governing the lender-borrower relationship is executed, and bond proceeds are deposited into a project fund or escrow account managed by an independent trustee. The borrower then draws on the project fund to pay construction costs and begins making debt service payments on schedule.

Compliance After Closing

The obligations that come with tax-exempt debt run for the full life of the bonds, and treating closing as the finish line is how issuers get into trouble years later.

Arbitrage Rebate

The federal government does not want borrowers profiting by investing bond proceeds at rates higher than what they pay on the bonds. Section 148 prohibits issuing bonds if any portion of the proceeds is reasonably expected to be invested in higher-yielding investments.¹⁰ When proceeds do earn more than the bond yield, which happens routinely during construction, the excess must be rebated to the U.S. Treasury.

Rebate payments are due in installments at least once every five years, with each installment covering at least 90 percent of the cumulative excess earnings calculated as of that date. A final payment is due within 60 days after the last bond in the issue is redeemed.¹⁰ The math is complex enough that most issuers hire a rebate consultant.

Smaller governmental issuers can escape the rebate rules entirely. If the issuer has general taxing powers, the bonds are not private activity bonds, and the issuer reasonably expects to issue no more than $5,000,000 of tax-exempt bonds during the calendar year, the issue is exempt. For public school construction bonds, that threshold rises to $15,000,000.¹⁰

Private Business Use

For governmental bonds and 501(c)(3) bonds, the 10 percent private business use threshold is an ongoing limit that applies for the entire life of the bonds, not just a classification test at issuance.¹¹ Management contracts with for-profit operators, leases to private tenants, and certain sponsored research agreements at universities all count. This is where issuers stumble years after closing, when someone leases space in a bond-financed building without thinking about tax consequences.

When private use exceeds the limit, the IRS provides remedial options rather than automatically declaring the bonds taxable. The main ones are redeeming or defeasing the affected bonds within 90 days of the problematic change in use, spending any disposition proceeds on a new qualifying purpose within two years, or converting the facility to an alternative qualifying use.¹² Issuers who discover a violation they cannot fix through remedial actions can apply to the IRS Voluntary Closing Agreement Program to negotiate a settlement rather than face an examination that could render the entire issue taxable.¹³

Continuing Disclosure and Record Retention

SEC Rule 15c2-12 requires underwriters in most municipal bond transactions to obtain a commitment from the issuer or borrower to provide ongoing information to the Municipal Securities Rulemaking Board. That includes annual financial statements and operating data, plus prompt notice of specified events such as rating changes, payment defaults, or adverse tax opinions.¹⁴ Failure to file these disclosures does not automatically make the bonds taxable, but it can shut a borrower out of future bond market access and trigger bondholder litigation.

IRS guidelines require all transaction documents, including the trust indenture, loan agreements, bond counsel opinions, construction contracts, management contracts, lease agreements, investment records, and arbitrage rebate calculations, to be maintained until three years after the final redemption of the bonds.¹⁵ For a 30-year issue that means holding records for 33 years. If the bonds are refunded by a later issue, the clock restarts and runs until three years after the last refunding issue is fully redeemed.

Bank-Qualified Bonds for Small Issuers

Banks that buy tax-exempt bonds ordinarily cannot deduct the cost of carrying those securities, which reduces their appeal. An exception exists for bonds designated as qualified tax-exempt obligations: banks can deduct up to 80 percent of their carrying costs, making these bonds noticeably more attractive to hold. To qualify, the issuer must reasonably expect to issue no more than $10,000,000 in tax-exempt bonds during the calendar year, and the bonds cannot be private activity bonds.¹⁶ For small cities, school districts, and local authorities that regularly borrow under $10 million, banks compete more aggressively for these bonds and interest rates come in noticeably lower than a comparable non-bank-qualified issue.

Two Planning Points Worth Knowing

Advance refunding is off the table. Before 2018, issuers could refinance outstanding tax-exempt bonds by issuing new tax-exempt bonds more than 90 days before the old bonds were callable. The Tax Cuts and Jobs Act of 2017 eliminated this option for bonds issued after December 31, 2017.⁸ Current refundings (at or within 90 days of the call date) are still permitted on a tax-exempt basis, and issuers can advance refund with taxable bonds if the rate savings justify it.

Alternative minimum tax applies to some private activity bonds. Interest on certain private activity bonds is a preference item for federal AMT, so investors subject to the AMT may owe tax on that interest even though it is excluded from regular gross income. The practical effect for borrowers is that private activity bonds typically carry slightly higher rates than otherwise comparable governmental bonds. Governmental bonds and 501(c)(3) bonds are not subject to this treatment, which is one reason government entities and nonprofits enjoy the lowest tax-exempt borrowing costs.

1
Office of the Law Revision Counsel. 26 U.S. Code 103 – Interest on State and Local Bonds
2
Office of the Law Revision Counsel. 26 U.S.C. 145 – Qualified 501(c)(3) Bond
3
Office of the Law Revision Counsel. 26 U.S. Code 142 – Exempt Facility Bond
4
Office of the Law Revision Counsel. 26 U.S. Code 141 – Private Activity Bond; Qualified Bond
5
Internal Revenue Service. About Form 8328, Carryforward Election of Unused Private Activity Bond Volume Cap
6
Office of the Law Revision Counsel. 26 U.S.C. 147 – Other Requirements for Private Activity Bonds
7
Internal Revenue Service. About Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code
8
Office of the Law Revision Counsel. 26 U.S.C. 149 – Bonds Must Be Registered To Be Tax Exempt; Other Requirements
9
Internal Revenue Service. About Form 8038-G, Information Return for Tax-Exempt Governmental Obligations
10
Office of the Law Revision Counsel. 26 U.S.C. 148 – Arbitrage
11
Internal Revenue Service. Lesson 3, Review of Government Bonds and 501(c)(3) Bonds
12
Internal Revenue Service. Lesson 7, Remedial Actions and Change in Use Rules
13
Internal Revenue Service. Tax Exempt Bonds Voluntary Closing Agreement Program
14
Municipal Securities Rulemaking Board. SEC Rule 15c2-12 Continuing Disclosure
15
Internal Revenue Service. Tax Exempt Bond FAQs Regarding Record Retention Requirements
16
Office of the Law Revision Counsel. 26 U.S.C. 265 – Expenses and Interest Relating to Tax-Exempt Income