As the race to tax reform worked through the legislative process, an area that caught many by surprise is in the area of tax-exempt bonds (private activity bonds, in particular), advance refundings of bond issues and the interest income treatment related to those bonds. The final passage of the Tax Cuts and Jobs Act (TCJA) did not contain any provision related to the discontinuance of the issuance of private activity bonds. For now, private activity bond issues continue under the Internal Revenue Code. However, there is one provision related to tax-exempt bonds that is now law for issues after Dec. 31, 2017. For advance refunding issues after Dec. 31, 2017, the interest income received by investors and which is related to such refunding bonds will now be treated as taxable income to the bondholder.
Discussion
Section 103 generally provides that gross income does not include interest received on state or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental facilities or the debt is repaid with governmental funds. Private activity bonds are bonds in which the state or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). Bonds issued to finance the activities of charitable organizations described in section 501(c)(3) (qualified 501(c)(3) bonds) are one type of private activity bond. The exclusion from income for interest on state and local bonds only applies if certain Internal Revenue Code requirements are met.
The exclusion for income for interest on state and local bonds applied to refunding bonds but there were limits on advance refunding bonds. A refunding bond is defined as any bond used to pay principal, interest, or redemption price on a prior bond issue (the refunded bond). However, different rules apply to current as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as an advance refunding if it is issued more than 90 days before the redemption of the refunded bond. Proceeds of advance refunding bonds are generally invested in an escrow account and held until a future date when the refunded bond may be redeemed.
Although there is no statutory limitation on the number of times that tax-exempt bonds may be currently refunded, the Internal Revenue Code did limit the number of advance refundings that could occur. Generally, governmental bonds and qualified 501(c)(3) bonds could be advance refunded one time. Private activity bonds, other than qualified 501(c)(3) bonds, could not be advance refunded at all. Furthermore, in the case of an advance refunding bond that resulted in interest savings (e.g., a high interest rate to low interest rate refunding), the refunded bond must have been redeemed on the first call date 90 days after the issuance of the refunding bond that results in debt service savings. With the new law, advance refundings are not allowed. No exceptions are present, so if an advance refunding occurs after Dec. 31, 2017, the interest income received by investors will be taxable income.
We will keep you posted related to developments in this area of tax reform and its impact on tax-exempt organizations that have used tax-exempt bond financing to accomplish its goals.
