Written by: Tanya M. Winchel
For a recent period of time, low-income housing projects financed by tax-exempt bonds were a rare occurrence in some areas. As the market starts to support these types of financings again, a little refresher on the compliance aspects of tax-exempt bonds is helpful. It can seem like once the deal is closed and the bond attorneys have done their job that it is time to sit back and relax and work on the next deal. But failure to meet bond compliance requirements, beyond affordability requirements normally required under Section 42, could have devastating effects.
Residential rental housing bonds with an affordable nature are qualified private activity bonds, as they serve a governmental purpose. The investors of these bonds receive interest on a tax-exempt basis. A governmental unit issues the bonds, and the low-income housing project is the “conduit borrower”. The conduit borrower is usually contractually responsible for maintaining the tax-exempt nature of the bonds. Sometimes the trustee provides reminders for compliance reporting requirements, but the responsibility needs to commence with the conduit borrower, the low-income entity.
The most overlooked compliance aspect is one that occurs normally on a five-year schedule, arbitrage and yield restriction testing. Most property management companies or general partners are used to reporting financial results on a quarterly or annual basis to the trustees. But the responsible party needs to conduct regular arbitrage and yield restriction testing to maintain the tax-exempt nature of the bonds.
Simplified, arbitrage is created when issuers, or conduit borrowers, take the proceeds of a bond issuance and invest them at a rate higher than what they are paying for debt service, or interest payments on the bonds. This would create an investment profit for the conduit borrower. Among other reasons beyond the scope of this article, Section 148 of the tax code was created to minimize the arbitrage benefits that could be gained. To achieve this goal, it requires payment back to the federal government of any “profit” earned on the bond proceeds above the bond yield.
The payment back to the federal government is due 60 days after every 5th anniversary of the bond issuance, or upon redemption or refunding (refinancing). Therefore, testing needs to be started well before that date to make a determination whether a payment is required. The mechanics behind the testing are generally conducted to ensure the rate of return of invested proceeds do not exceed a computed yield on the bonds. Many factors come into play during the computations and testing including examination of any hedges on variable rate bonds, review of construction spending schedules, and analysis of reserves and debt service funds.
The completed testing is to be provided to the trustee of the bonds, and maintained in the project’s records. The statute of limitation for the testing documentation is three years subsequent to bond redemption. If selected for IRS examination, the entity will need to provide proof of this testing at the required intervals. It will most likely be required to comment on the personnel assigned to tax-exempt bond due diligence and what efforts have been made to comply with the code and regulations.
Dauby, O’Connor & Zaleski LLC offers compliance testing, IRS audit representation, and consulting throughout construction to ensure spending requirements are meant. Feel free to call Tim Doyle at 317-819-6109 or Tanya Winchel at 317-819-6131 at anytime. We would be happy to assist you.
Tanya M Winchel is a tax principal at Dauby, O’Connor, & Zaleski, LLC. Tanya has worked in public and private accounting since 1994, and has been with Dauby O’Connor & Zaleski, LLC since 2006.