Some Muni Bonds Lose Tax Exemption

Your options for financing local projects just got a little more limited. An obscure provision in Public Law No: 115-97, the federal tax cut bill adopted in December 2017, all but eliminated a longstanding and important municipal finance tool known as “advance refunding."

The Government Finance Officers Association (GFOA) warned city, county and state officials about this potential late last year but, unfortunately, Congress did not act to maintain the tax-exempt status of advance refunding bonds.

What is advance refunding?

The GFOA web site includes this brief explanation about advance refunding that might be helpful in explaining this to your policymakers or the public:

An advance refunding occurs when issuers refinance outstanding bonds before the original bonds mature or are callable. In effect, issuers sell new bonds to "retire" or buy back out-standing bonds. Borrowers advance refund their outstanding debt to take advantage of favorable interest rate environment (similar to individuals refinancing their home mortgage) thus reducing their borrowing costs and freeing up resources for new projects. 

… allowing bonds to have one advance refunding over the lifetime of the bonds (which in many cases is 30 years), would provide governments the ability to restructure debt and lower borrowing costs which ultimately would be a savings to tax and rate payers. 

This is obviously of most benefit to local governments when interest rates have fallen since the time of the original bond issue.

With tax-exempt interest rates at historic lows for several years, perhaps some staff at all levels of government considered this change to be inconsequential. However, those of us with some experience know better. During my career there have been times when tax-exempt interest rates have been in the double digits. That’s great for the investor but costs tax and ratepayers dearly. Advance refunding is an important option to have when rates drop. Losing the tax-exempt status of the refunding bonds means every local project may ultimately cost more, and when that happens, everyone loses.

Why advanced refunding?

According to a March 2018 article in Route Fifty, the folks in Congress who supported this idea reckoned that by making bondholders pay income tax on this type of municipal bond, the Federal treasury would collect over $17 billion over 10 years to help offset the tax cuts doled out in the bill.

For the time being, enjoy the historic low interest rates on municipal bonds while they last and get those vital infrastructure projects built. But remember, the economy is cyclical; interest rates will rise and fall again and the advantages of advance refunding will become obvious once more.

Questions? Comments

If you have questions about this or other local government issues, please use our Ask MRSC form or call us at (206) 625-1300 or (800) 933-6772. If you have comments about this blog post, please comment below or email me at lnordby@mrsc.org.