Tax lawyers love when tax-exempt bond-financed projects owned by governmental entities[1] (“TEB Projects”) are also financed with qualified equity.  Why you ask?  Because it makes their job easier.  Since you are likely interested in making your tax lawyer’s life more pleasant, keep reading, as this blog post explains what qualified equity in a TEB Project is and why it is beneficial.

What is qualified equity?  Qualified equity is basically any funds that go into a TEB Project that are not from tax-advantaged bonds (the “Bonds”) – so it covers cash on hand, financing from a taxable line of credit,[2] donations, etc.   Another less obvious source of qualified equity is capitalized interest (from a federal income tax standpoint)[3] paid on the Bonds from sources other than Bond proceeds.

Why is qualified equity helpful?  Because it is the quicker picker upper (like the Bounty paper towel) of private business use (“PBU”).   Qualified equity in a TEB Project absorbs as much PBU as it can.  Once the qualified equity is fully soaked with the undesirable PBU, any excess PBU then gets allocated to the Bonds also financing the TEB Project.  For example, if a governmental entity owns a $10 million TEB Project financed in 2015 with $2 million of qualified equity and $8 million of Bonds, 20% of the TEB Project could be used for PBU without any portion of that PBU being allocated to the Bonds.  (Example 1).

When do you need to spend qualified equity?   Although there are exceptions, qualified equity can generally be spent as early as three years before the issuance date of the Bonds that also finance the TEB Project.   The latest date qualified equity can be spent is generally on the later of the issuance date of the Bonds or the date the TEB Project is placed in service.

Do you need to make an election?  No.  If the TEB Project includes qualified equity, per the Treasury Regulations, the qualified equity automatically absorbs as much PBU as it can.[4]  However, it is generally a good idea in the tax documents to note that a TEB Project has qualified equity when appropriate so that a future tax lawyer or an auditing IRS agent is aware of this fact.

What happens to the qualified equity if the Bonds are refunded?  The qualified equity gets pulled forward, but only to the portion of the TEB Project refinanced by the refunding bonds.  For example, expanding upon the facts in Example 1 described above, if the 2015 Bonds are refunded along with 2016 bonds in 2025, the $2 million of qualified equity is pulled forward and may be used to offset PBU for the TEB Project refinanced by the 2025 Bonds, but only with respect to the 2015 TEB Project.  Stated another way, if the 2015 qualified equity only absorbed $500,000 of PBU from the 2015 TEB Project, the remaining $1.5 million of 2015 qualified equity cannot be used to offset PBU from the 2016 TEB Project. 

Can you add qualified equity to a refunding?  Technically you cannot do so, because qualified equity must be spent by the later of the issuance date of the original tax-exempt issue that financed the TEB Project or the placed-in-service date of the TEB Project.  You can, however, achieve the same effect by using equity, rather than refunding bonds, to retire a portion of the refunded bond issue that financed the TEB Project.  Any such equity employed in the refinancing would absorb PBU from the refinanced TEB Project on a going-forward basis in the manner described above.

In sum, remember to tell your tax lawyer about any qualified equity in your TEB Project so that any PBU in such TEB project is measured accurately (i.e., after the qualified equity has absorbed as much PBU as possible.)

[1] For this purpose, a 501(c)(3) organization using the TEB Project for its exempt purposes qualifies as a “governmental entity.”

[2] Please note that Treasury Regulations Section 1.141-6(b)(3) is a bit confusing in this regard.  For example, it states that qualified equity includes “proceeds of bonds that are not tax-advantaged bonds and funds that are not derived from proceeds of a borrowing” that are spent on the TEB Project.  When you remember that IRC Section 150(a)(1) defines “bond” as including “any obligation,” the first clause above can be paraphrased to state that qualified equity includes “proceeds of obligations that are not tax-advantaged obligations.”  In other words, the first clause should be read to include all taxable borrowings.  

[3]  This is interest that accrues during the “production period” of the TEB Project (as that term is defined in IRC Section 263A(f)).

[4] See Treasury Regulations Section 1.141-6(b)(1).