D.C. Bond Financing Opportunities
June 1, 1999
Tax-Exempt Bonds
Tax-exempt bonds are issued by state or local governmental bodies, and the
bond proceeds usually are loaned to borrowers to achieve a purpose authorized
under both D.C. and federal tax laws. In the District of Columbia, those
purposes are broad, and every type of for-profit and nonprofit entity can be
borrowers.
Bonds aren't magic: they come in all shapes and sizes and can be tailored for
individual fit. Their marketability is based on the perceived quality of the
source for their repayment. In D.C., there is no statutory requirement for any
specific type of security for bond repayment, i.e. a deed of trust or assignment
of leases, so bonds can be secured in any manner which the borrower determines
will make them saleable. Therefore, major trade associations, charitable
nonprofits and businesses can market bonds secured merely by their general
credit and not by a pledge of specific assets.
Don't be confused by references to "floaters," "put
bonds," "multi-modal" or "credit-enhanced" bonds.
Financial ingenuity knows no bounds, but it all comes down to having sufficient
creditworthiness to entice financial institutions and/or bond purchasers to take
a level of risk in return for their reward. Follow this general rule: if you can
get a loan from a financial institution to finance your project, you can finance
it with bonds at a lower interest rate.
The ability to finance facilities with tax-exempt bonds under federal tax law
requires either the construction or acquisition and rehabilitation of the
facilities be caused or "induced" by the availability of tax-exempt
financing. In order to finance new construction for for-profit entities, it's
important that the D.C. Chief Financial Officer preliminarily approves your
project not less than 60 days after you take any major step which evidences your
commitment to it, i.e. signing a real estate purchase contract, construction
contract or other binding agreement. The same type of "inducement" can
be performed by exempt organizations by adopting a resolution or unanimous
consent to memorialize its intent to finance costs with tax-exempt bonds. All
funds which are paid, and all obligations incurred, after the adoption of such
an official "inducement resolution" will be reimbursable with proceeds
of tax-exempt bonds issued at a later date.
In order to finance the acquisition of existing property with tax-exempt
bonds, it is necessary for the acquirer to be a new tax owner of the property
for federal tax purposes, so proceeds of tax-exempt bonds cannot be used merely
for refinancing an existing owner's debt. It is possible to change tax ownership
to a new entity but not cause the existing owner to lose control of the new
entity, i.e. retain the position as managing general partner in a partnership or
managing member in an LLC. Change of tax ownership necessitates creation of new
capital basis in the property, which may be unattractive to long-term owners
with low bases. Once tax ownership changes, existing property acquired by a
for-profit entity is eligible for tax-exempt financing as long as not less than
15% of the acquisition cost of any buildings so acquired and not less than 100%
of the acquisition cost of any equipment so acquired, in each case, is spent on
capitalizable costs of such items within two years after acquisition with bond
proceeds and a nonprofit entity is eligible for tax-exempt financing as long as
it is owned by the nonprofit, which carries out a charitable activity with the
bond proceeds.
Enterprise Zone Bonds
At last, a government-sponsored financing tool which is labeled as "EZ"
may prove to be so. The majority of the central business district in the
District of Columbia has been designated as an "enterprise zone,"
which brings numerous benefits to those who develop or redevelop property there.
Existing property which is acquired from an unrelated person after August 5,
1997, constitutes qualified enterprise zone property. For properties built or
rehabbed after that date in the 65 census tract districts so designated, owners
can obtain the following benefits: the option to cause up to $15MM of tax-exempt
financing to be issued for qualifying projects; various employment tax credits
for employees who live and work in D.C.; the right to expense otherwise
depreciable business assets; and the exemption from federal capital gains taxes
for real property, stock, partnership interests or other evidence of ownership
of real property in the enterprise zone which is held more than five years. In
addition, the requirements for acquiring existing property with bonds have been
relaxed a bit for property financed by EZ bonds. Instead of needing to spend at
least 15% of a building's acquisition cost and 100% of equipment's acquisition
cost, only the greater of 15% of the basis of the acquired property or $5,000
need be spent.
The big opportunity is to get tax-exempt bonds issued to finance your project
in an amount up to $15MM, rather than limited to $3MM as in the rest of the
nation. Only "enterprise zone" projects are eligible, and are defined
as any property (i) owned by a for-profit entity, which derives at least 50% of
its business income from the active conduct of a trade or business in an
enterprise zone, (ii) a substantial part of such entity's tangible property
(likely a majority) is located and used in the enterprise zone and (iii) a
substantial portion (likely a majority) of such entity's intangible property is
used in the active conduct of its business. Rental apartments are excluded from
participating (except in special situations), and commercial rental property
must have at least 50% of its gross rental income produced by tenants which
themselves satisfy the foregoing tests. Otherwise, any type of facility is
financeable in the D.C. enterprise zone, and that gives D.C. a competitive
advantage over its surrounding jurisdictions, which only are able to finance
for-profit projects which constitute "manufacturing facilities" with
private activity tax-exempt bonds.
The tests must be satisfied during the three tax years commencing after a
"start up" period to get the project into compliance. The start-up
period commences on the date that bonds are issued to finance a project and runs
for no more than three years thereafter. Property in an enterprise zone is
conclusively presumed to be qualified as long as the owner reasonably expects it
to qualify at the end of the start-up period. After the end of the three year
compliance period, no further tests need to be satisfied for properties in D.C.
(a more liberal test than for enterprise zones outside of D.C., in which at
least 35% of the employees in the project are required to be residents of
certain poverty-struck areas).
(C)(3) Bonds
Tax-exempt bonds can be issued by D.C. for any type of charitable activity
which is conducted by a nonprofit and which has been determined to be exempt
from federal income tax under Section 501(c)(3) of the Internal Revenue Code.
These activities are not restricted to any particular area of D.C., have no
relation to enterprise zones and need not consist of real estate or tangible
property. In order to qualify for bond financing, not less than 95% of the bond
proceeds must be spent on uses which constitute "exempt activities"
and not "unrelated trades or businesses" under the federal tax laws.
Therefore, facilities which are not more than 95% used by the nonprofit owner
will not be able to be 100% financed with tax-exempt bonds. For example, a
501(c)(3) organization may occupy 70% of the space in a building, lease 10% of
the space to an affiliated for-profit or trade association and lease 20% of the
space to tenants which are unrelated to the nonprofit and which are not
501(c)(3) organizations having the same scope of charitable activities as the
nonprofit owner. In this instance, only 70% of the acquisition and development
costs of the facility can be financed with tax-exempt bonds, and the balance
must be financed in another way, including taxable bonds.
D.C. will welcome exempt organizations that request tax-exempt bonds, since
such bonds are not subject to any dollar limitation normally imposed by the
federal tax code on bonds with respect to for-profits. Most nonprofits will want
to finance capital facilities located in D.C. and which will add to the ad
valorem tax base (until an application for exemption is submitted and acted on).
It also is possible for intangibles and working capital to be financed with
tax-exempt bonds. An interesting possibility: the needs of a national nonprofit,
whose headquarters is located in D.C., may be able to be financed with minimal
direct connection, either under the federal tax law or D.C. law, between the
purpose for which bonds are issued and the benefits directly achieved by D.C.
Tax-Increment Financing
Costs of capital facilities owned by for-profit entities can be financed by
D.C.'s issuance of tax increment bonds, which are repayable solely from
dedicated portions of ad valorem and/or sales tax revenues generated within a
specified tax-increment financing district and not from any source pledged by a
for-profit owner of a facility. It may be possible for the district to be
co-extensive with the individual project proposed to be financed. For-profit
entities can obtain the benefit of such financing when D.C. or one of its
governmental instrumentalities acquires land, pays for permitted
"development costs" and all related financing, working capital,
administrative and relocation costs, and sells the improved property to a
private user for a price which is below the cost of such acquisition and
improvements. "Development costs" include hard and soft costs of land
acquisition, building demolition and/or rehabilitation, public infrastructure
and facilities for parking, museums, educational institutions, retail,
entertainment, recreation and housing (but not the cost of constructing new
buildings for uses other than as summarized in this sentence). It is necessary
to go through this governmental improvement and sale process in order to avoid
having the tax increment bonds be treated either as "private-activity"
bonds for federal tax purposes, which would limit their dollar amount to $10MM
and their use for manufacturing facilities, or "enterprise zone"
bonds, which would limit their dollar amount to $15MM and their use for
qualified facilities only within designated enterprise zones.
In order for tax-increment bonds to be issued, an applicant must apply to the
D.C. Chief Financial Officer (or to the National Capital Revitalization
Corporation after it is activated) for certification that a proposed project
complies with the D.C. Tax Increment Financing Authorization Act of 1998. The
application needs to describe the proposed increment financing area, project,
use of financing proceeds, financial feasibility of the project, zoning and
comprehensive plan compliance and potential tax revenues from the project. If
the CFO approves the project, the CFO is required to certify the project to the
Mayor, who will transmit a resolution to the City Council approving the project
if he determines it to comply with the requirements of the financing act. If the
council approves the financing plan, it must determine the portion of the
increases in pledged tax revenues which will be available to pay bonds secured
by such sources, based on the D.C. Assessor's certification as to the initial
assessed value of each lot of taxable property within the assessment area, and
the D.C. Collector's certification as to the initial sales tax amount for the
assessment area. Since the D.C. billing and collection information system can
track increases in lot assessed valuation better than the source of sales tax
revenues, it is likely that tax-increment bonds will be limited to being secured
by ad valorem taxes until D.C.'s billing and collection system changes.
Tax-increment financing will not reduce the taxes paid by the owners of
individual facilities; it merely will permit the use of a portion of their own
tax revenues, together with taxes on other land and improvements located in the
taxing district, to repay increment bonds. The process of negotiating approval
of specific proposed projects, the boundaries of the increment district, the
portion of taxes allocated to repayment of financing and other benefits to the
property owner will be lengthy; however, financing will become more difficult to
obtain when several bonds have been issued for facilities in the same district.
This is one time when being a pioneer has its rewards, so get moving early.
There are more questions than answers about bond financing; call us with
questions, and we'll find the answers.
Mr. Baber is a Partner in the Washington, D.C., office and can be reached at
202- 457-7169, or at bbaber@hklaw.com.