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Davis Brown Tax Law Blog

Tax Law Blog: Using Tax-Exempt Bonds as a Way to Finance Your Next Project - October 11, 2012

Interest earned on certain types of Municipal Bonds is exempt from federal income tax.  Investors will buy tax-exempt municipal bonds at a lower interest rate than a taxable bond on which they will have to pay federal income tax on the interest.  A lower tax rate for the borrower of tax-exempt bonds means a lower cost of borrowing.

For example, if the taxable rate on bonds is 7% and an investor has a 33% marginal tax rate, then the investor will make the same amount of interest with a 7% taxable bond as with a 4.69% tax-exempt bond.  The calculation is 7% multiplied by (1 minus the marginal tax rate) or .67 which equals 4.69%.  A borrower would much rather pay 4.69% on $10,000,000 than 7%.  In the first year alone, the borrower would save $231,000 in this example.

So what types of projects qualify for this type of financing?  There are several different types but I will stick to a few examples including Exempt Facility Bonds, Qualified Small Issue Bonds and Qualified 501(c)(3) Bonds.

Exempt Facility Bonds include a borrowing where at least 95% of the proceeds are used to finance one of the following: airport, docks and wharves, mass commuting facilities, facilities for furnishing of water, sewage facilities, solid waste disposal facilities, qualified residential rental facilities, facilities for the local furnishing of electric energy or gas, local district heating and cooling facilities, qualified hazardous waste facilities, high-speed intercity rail facilities, environmental enhancements of hydroelectric generating facilities, or qualified public educational facilities.

Qualified Small Issue Bonds are bonds issued in the aggregate face amount of $1 million or less and where 95% of the proceeds are used to acquire, construct, or improve land or depreciable property, or to redeem bonds previously issued for such purposes.  After 1986, small issue bonds can finance only manufacturing facilities or land or property for first-time farmers.

Qualified 501(c)(3) Bonds can typically be used to finance facilities utilized for the exempt purposes of an organization which has obtained a 501(c)(3) status.

By using tax-exempt financing, borrowers can save a lot of money on the cost of borrowing.  There are several requirements that a borrower must meet in order to qualify for the tax-exemption but if you think you have a project that may qualify, it is worth looking into.