Tax-Exempt Bonds: A Quick Guide to Reimbursement Rules

State and local governments, including cities, counties, ports, municipal utilities, public utility districts, fire districts, regional fire authorities, school districts, and other local governments, often turn to tax-exempt bonds to finance capital projects. In many cases, the bonds are issued after preliminary expenses for the project have been paid or even after construction of the project has started. Issuers often hope to use proceeds of tax-exempt bonds to reimburse their general funds for these out-of-pocket-costs and can be surprised by the limitations placed on reimbursements by the Internal Revenue Code of 1986, as amended (the “Code”) and the related Treasury regulations (the “Regulations”).

This quick guide provides a summary of the general tax requirements for qualifying reimbursements. These rules are primarily found at Section 1.150-2 of the Regulations.

Reimbursement Bonds

In general, bond proceeds are considered expended when they are allocated to a cash outlay made by the issuer. This allocation can be done directly – with a check written from the bond proceeds account, for instance – or indirectly – with an allocation of bond proceeds to a cost initially paid from the issuer’s revenues. Proceeds of a reimbursement bond are allocated to cash outlays made prior to the issue date of the bonds and are considered allocated once there is written evidence of an issuer’s[1] use of the proceeds to reimburse a pre-issuance expenditure. The form 8038 or 8038-G filed with respect to the bond issue generally includes the expected reimbursement allocation, and an allocation made within 30 days of issuance of the reimbursement bonds may be treated as made on the date of issuance.

The allocation process is significant because bond proceeds may be subject to yield restriction or to rebate until they are allocated to expenditures. Following allocation, those amounts are no longer treated as proceeds and are not subject to investment limitations. If a proper allocation to reimbursable costs is made at closing, the bond proceeds allocated to reimbursement will not be subject to investment limitations and are released to be used for any other purposes of the issuer. Under the Code and Regulations, reimbursement is only available for certain types of expenditures and the reimbursement allocation must occur within a specified time period.

Eligible Expenditures

Generally, the expenditures to be reimbursed must be “capital expenditures.” A capital expenditure is any cost of a type that is properly chargeable to a capital account (or would be so chargeable with a proper election) under general federal income tax principles. The Regulations also include extraordinary working capital expenditures, bond costs of issuance, grants, qualified student loans, and qualified mortgage loans as expenditures eligible for reimbursement. Non-extraordinary working capital expenditures are typically not eligible. The determination of whether an expenditure is a capital expenditure is made at the time the expenditure is made, not at the time of issuance of the reimbursement bonds.

Preliminary Expenditures and Other Exceptions

The following types of expenditures may be reimbursed with bond proceeds without following the reimbursement bond timing rules described below:

• costs of issuance for a bond issue;
• an amount not in excess of the lesser of $100,000 or 5% of the bond proceeds (“De Minimis Expenses”); or
• preliminary expenditures not in excess of 20% of the aggregate issue price of the related reimbursement bond issue. “Preliminary expenditures” include architectural, engineering, surveying, soil testing, reimbursement bond issuance, and similar costs that are incurred before commencement of acquisition, construction or rehabilitation of the financed property. Land acquisition, site preparation and other costs incident to commencement of construction do not constitute preliminary expenditures.

Eligible expenditures that are not exempt from the timing rules are called “Non-Exempt Expenditures” below.

Official Intent Declaration Requirement

With respect to Non-Exempt Expenditures, the issuer must declare its “official intent” to reimburse itself not later than 60 days after payment of the original expenditure. The declaration of official intent will essentially “start the clock” for purposes of Non-Exempt Expenditures and must:

• contain a general functional description of the project, property or program to be financed by the reimbursement bonds (for instance, highway capital improvement program or school building renovation). The project description is sufficient if it identifies, by name and functional purpose, the fund or account from which the original expenditure is paid (for instance, parks and recreation fund-recreational facility capital improvement program); and
• state the maximum principal amount of the obligations expected to be issued for the project.

The Regulations allow for reasonable deviations in the project description, so long as the actual project is reasonably related in function to the described project.

The declaration of intent must be “reasonable.”  Reasonableness is based on the relevant facts and circumstances, including the issuer’s history of making declarations and actually reimbursing expenditures. For instance, declarations of intent made as a matter of course or in amounts substantially in excess of the amounts expected to be necessary for the project are not reasonable.  Similarly, a pattern of failing to reimburse original expenditures covered by declarations of official intent (other than due to extraordinary circumstances) may be evidence of unreasonableness.

The declaration may be made in any reasonable form, including a resolution or other legislative authorization. The legislative action may specifically declare the intent to reimburse for a particular project or projects or may delegate to an individual the general authority to make declarations of intent on behalf of the issuer.

Reimbursement Period

For Non-Exempt Expenditures, bond proceeds must be allocated to the reimbursement not later than 18 months after the later of:

• The date on which the original expenditure is paid, or
• The date that the project to be financed was placed in service (or abandoned). A facility is placed in service when, based on all the facts and circumstances, the facility has reached a degree of completion which would permit its operation at substantially its design level, and the facility is in operation at such level.

In addition, reimbursement cannot be made more than three years after the original expenditure is paid.

Special rules apply for governmental issuers that expect to issue no more than $5 million of governmental bonds in any calendar year, and for long term construction projects.

Reimbursement vs. Refinancing

The Regulations provide that once an expenditure is financed, it cannot be reimbursed.[2]  If an issuer enters into a debt obligation, such as a construction loan from a bank, bond proceeds cannot be used to reimburse the expenditures paid from the construction loan. It may be possible, however, to refund the construction loan with bond proceeds. Certain refunding rules will apply, but the reimbursement rules will not.  In contrast, expenditures from interfund loans are generally not considered to be “financed” for these purposes (because they are not third-party debt), so the reimbursement rules will apply. Issuers should talk with bond counsel to discuss the timing requirements prior to using an interfund loan to pay for project costs in anticipation of the issuance of bonds.

Example

City A is building a new city hall. The project has been many years in the making. The first expenditures for architecture and design were made in January 2022. On December 1, 2023, construction commenced and City A made its first construction payments by borrowing from its general fund. On March 1, 2024, City A adopted an intent resolution stating its intent to issue bonds to finance the city hall.  On March 1, 2025, the city hall is placed in service. Bonds are issued in December 1, 2025, to reimburse City A for the expenditures relating to the city hall.

In this case, City A can reimburse for any architecture and design costs because they are preliminary expenditures. They are not subject to the 60-day official intent rule or to the three year outside limit on reimbursement of Non-Exempt Expenditures. Because City A used interfund borrowing and not external debt, an allocation of bond proceeds to prior expenditures will be a reimbursement and not a refinancing. On the issue date, City A can reimburse itself for capital expenses that are Non-Exempt Expenditures that were paid on or after January 1, 2024 (60 days before the date the official intent was adopted). The city hall was placed in service less than 18 months prior to the issue date and the expenditures were made less than three years prior to the issue date, so the reimbursement is being made within the allowable time frame. Construction expenses from December 2023 will not be eligible for reimbursement, unless they are De Minimis Expenses, because they are Non-Exempt Expenditures made more than 60 days before the official intent was adopted.

For questions regarding tax exempt bonds, please contact Alison Benge or any member of Pacifica’s Public Finance team.

[1] This guide refers to the municipal issuer, but in some circumstances, the references to “issuer” could also include a conduit borrower.
[2] Note that this rule does not apply to certain qualified private activity bonds.