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A Detailed Look at Midwestern Disaster Area Bonds

by Dean Spina, Attorney

February 2010 -- Tax-exempt bonds enable a business to make certain capital investments at a lower rate of interest. The tax-exempt interest rate may be only 70 percent of the taxable interest rate. This information on tax-exempt bonds will address the opportunity for flood impacted businesses AND other businesses to use tax-exempt bond financing for certain capital investments.

Timing, as will be shown, is critical to the effective use of tax-exempt bond financing. Recent action by the Internal Revenue Service has provided an opportunity for many businesses to use tax-exempt bond financing for a variety of projects.

(Click here if you would like to view a slide show with more information.)

Midwestern Disaster Area tax-exempt bond financing is available for residential rental housing or nonresidential property and certain public utility property. The property may be located anywhere within the 78 counties in Iowa that have the necessary disaster declaration.

Other forms of tax-exempt bond financing may be available in a given situation: (1) small issue manufacturing bonds (including production of intangible property such as software), (2) residential rental housing, (3) American Recovery Zone Facility bonds, and (4) Qualified 501(c)(3) bonds.

Tax-exempt bond financing may be at interest rates that are fixed, variable, variable with the option to fix, or adjustable. The maturity is negotiable and the outer limit is an average maturity no more than 120% of the economic life of property acquired with bond proceeds.

To overcome exclusions and have one financing, it is possible to issue taxable and tax-exempt bonds for one financing of an entire project.

Midwestern Disaster Area tax-exempt bond financing is not available (1) for working capital financing or to finance property where 50% bonus depreciation is to be taken, (2) for moveable fixtures or equipment, (3) after December 31, 2012, (4) to acquire existing property unless there is rehabilitation of at least 50% of the cost of acquiring the building, and (5) for certain uses. This debt is not exempt from state income tax.

EXPLANATION OF TAX-EXEMPT BOND FINANCING

Bonds issued by local or state government are generally tax-exempt under the federal tax code. These bonds are tax-exempt when used for an appropriate purpose, e.g., construction of streets or schools. Bonds are not tax-exempt if proceeds are used by a private person (e.g. business or non profit) unless several criteria are satisfied. Industrial development bonds, private activity bonds, conduit financing and qualified 501(c)(3) bonds are terms associated with tax-exempt bond financing for non-governmental persons.

Tax-exempt bond financing such as Midwestern Disaster Area bonds involves a state or local governmental body as the issuer of a bond, the loan of the proceeds of the bond to a business, and the agreement of the business to repay the loan, thus producing the revenue to repay the bond. State and local tax dollars are not involved or at risk. State or local credit is not pledged or impacted in any way. The obligation is a limited one of the issuer.

Tax-exempt bonds may be issued by the city where a project is located, the county where the project is located, the Iowa Finance Authority and a city within 8 miles of the project location.

Tax-exempt bonds are available for manufacturing (including intangible property) and residential rental housing, but these uses are subject to a state volume limit. [Intangible property means the creation or production of intangible property defined as any patent, copyright, formula, process, design, pattern, know-how, format or other similar item.] Tax-exempt bonds are also available for 501(c)(3) organizations with no state volume limit.

MIDWESTERN DISASTER AREA BONDS

Midwestern Disaster Area bonds were authorized by Congress on October 3, 2008 in the Heartland Disaster Tax Relief Act of 2008. There was an original $2,615,995,000 of Midwestern Disaster Area Bond capacity in Iowa. This financing is limited to 78 counties in Iowa. This financing is also available in certain counties in Wisconsin, Illinois, Indiana, Missouri, Nebraska and Arkansas. A similar program was adopted following Hurricane Ike for parts of Texas and Louisiana. These Bonds follow similar, but not identical, authorization of tax-exempt bonds in the New York Liberty Zone following 9/11 and in the Gulf Opportunity Zone following Hurricane Katrina.

Proceeds of these bonds are used for (1) qualified residential rental property (some income restrictions apply), (2) nonresidential real property (cost of acquisition, construction, reconstruction, and renovation) and (3) utility property.

Requirements for use of Midwestern Disaster Area Bonds are those that are generally applicable to tax-exempt bond financing. In addition, these bonds require a determination relating to the disasters. This requirement will be discussed in the following section.

There has been very little use of Midwestern Disaster Area bonds. In 2009, only two Borrowers obtained financing in Iowa. Projects are now lining up for financing.

BUSINESS THAT SUFFERED A LOSS

In the Heartland Disaster Tax Relief Act of 2008, Congress imposed the following specific requirement:

“[except that in determining whether a bond is a qualified Midwestern disaster area bond--paragraph (2)(A)(i) shall be applied by only treating costs as qualified project costs if -- in the case of a project involving a private business use (as defined in section 141(b)(6)), either the person using the property suffered a loss in a trade or business attributable to the severe storms, tornados, or flooding giving rise to any Presidential declaration described in subsection (b)(1)(A) or is a person designated for purposes of this section by the Governor of the State in which the project is located as a person carrying on a trade or business replacing a trade or business with respect to which another person suffered such a loss, and in the case of a project relating to public utility property, the project involves repair or reconstruction of public utility property damaged by such severe storms, tornados, or flooding…]"

and “such bond is designated for purposes of this section (on the basis of providing assistance to areas in the order in which such assistance is most needed).”

The above statutory language was not included in the tax-exempt bond provisions for the New York Liberty Zone or the Gulf Opportunity Zone following, respectively, 911 and Hurricane Katrina. Thus, there was initial uncertainty regarding the application of the new tests to qualify a project. This was compounded by some indication that the IRS might take a very narrow interpretation and severely limit the use of the Midwestern Disaster Area bonds.

A great opportunity to now use Midwestern Disaster Area bonds is based on Notice 2010-10 issued by the Internal Revenue Service on December 18, 2009. In Notice 2010-10 the IRS adopted the position that the qualification of projects for financing is left to the Governor of the state to make the necessary determinations in “a reasonable manner as the Governor shall determine in good faith in such Governor’s discretion.” On February 1, 2010, Governor Culver issued an Executive Order designating the Iowa Finance Authority as the Governor’s designee to make the necessary determinations.

On February 3, 2010, the Iowa Finance Authority (IFA) adopted emergency rules regarding the Midwestern Disaster Area Bonds. IFA set-aside $300,000,000 of bonds for applicants to be selected by the Iowa Department of Economic Development. IFA also set a cap of $200,000,000 per applicant through December 31, 2011.

In addition to recognizing the discretion of the Governor to determine which projects qualify, the IRS did something more in Notice 2010-10 that we advocated for and which is of great significance. One of the requirements of tax-exempt bond financing is to have a “reimbursement resolution” in place before significant commitment to a project, and certainly prior to acquisition and construction. Following the flooding there was no reason to seek a reimbursement resolution because there were several months before this form of tax-exempt bond financing was enacted into law. Thereafter the uncertainty regarding the interpretation of the statute dampened enthusiasm for the financing.

The IRS concluded in the Notice that expenditures PAID on or before December 31, 2009, could be reimbursed despite the absence of any reimbursement resolution. This opens up the opportunity to use tax-exempt bond financing for projects that were undertaken after the flooding and paid for prior to the end of 2009. In addition, projects that are underway can be funded, although it is essential that a reimbursement resolution be adopted as soon as possible. More on this is set forth below.

REIMBURSEMENT OF EXPENDITURES

Expenditures to be financed or refinanced from bond proceeds are tricky. Normally, a reimbursement resolution is required to include the expenditures and interim financing in the bond financing. Once a reimbursement resolution is in place, expenditures during the prior 60 days and those after the adoption of the resolution can be reimbursed.

IRS Notice 2010-10 deemed a reimbursement resolution to have been adopted for expenditures PAID on or prior to December 31, 2009. A project fully financed and constructed prior to December 31, 2009, can be fully reimbursed/refinanced with bond proceeds if all expenditures were paid on or before that date.

However, a project that has expenditures paid AFTER December 31, 2009, requires a reimbursement resolution adopted by the Issuer to reimburse/refinance the post 2009 expenditures.

Thus, there is time to have a seamless financing by obtaining a reimbursement resolution quickly. The course of action for a project partially completed at the end of 2009 is to have the reimbursement resolution in place on or before March 1, 2010. If that is not possible, there may be certain expenditures that cannot be reimbursed with a Midwestern Disaster Area bond.

Reimbursement must be completed by a certain date (not later than 18 months after later of the date the expenditure is paid or the date the project is first placed in service).

There are exceptions to the reimbursement resolution requirement (1) for reimbursement of a de minimis amount and (2) certain preliminary expenditures up to 20% of the issue.

MARKETING THE BONDS

The Borrower is responsible for the marketing of the bonds. The Issuer is not involved in the choosing how the bonds are marketed.

Under current law, we have the opportunity to market Midwestern Disaster Area Bonds to banks. This law currently only extends to bonds issued in 2010. [It is possible this sunset date will be extended.]

An alternative to marketing to banks is a private placement with a bond purchaser. This could be one or more individuals or a non-bank institution.

The final method of marketing is through an underwriter, which adds expense resulting in a minimum size of three or more million dollars.

COSTS AND BENEFITS

Costs associated with bonds that are purchased by a bank: (1) Issuer application fee [e.g., IFA $100]; (2) IFA allocation fee of 2 basis points [$200 per $1,000,000]; (3) Issuer fee; (4) bond counsel fee; (5) Issuer counsel fee; (6) Borrower counsel fee; (7) bank fee and bank counsel fee; (8) documentation and recording and (9) financial advisor fee.

Costs that may be associated with marketing through an underwriter: (1) Issuer application fee [e.g., IFA $100]; (2) IFA allocation fee of 2 basis points [$200 per $1,000,000]; (3) Issuer fee; (4) bond counsel fee; (5) Issuer counsel fee; (6) Borrower counsel fee; (7) documentation and recording; (8) letter of credit bank fee and counsel fee; (9) underwriter discount, (10) underwriter counsel fee; (11) corporate trustee fee; (12) rating agency fee, (13) registrar fee and (14) financial advisor fee.

The benefit of tax-exempt bond financing is the reduced interest expense when compared to the costs of issuance and ongoing fees. The tax-exempt interest rate will generally be approximately 70% of the taxable interest rate. Thus, a taxable rate of 7% would be 4.9% to 5% tax-exempt. Borrowing $1,000,000 at 5% with a twenty year amortization compared to borrowing at 7% means an interest savings of more than $280,000 over the life of the loan. Two-thirds of the interest savings is in the first 10 years of a 20 year amortization.

There are a number of structures that can be designed to meet project needs. In addition, there is an alternative minimum tax (AMT) exception.

Midwestern Disaster Area bonds may be combined with New Market Tax Credits for qualifying projects.

LIMITATIONS ON USE OF MIDWESTERN DISASTER AREA BONDS

There are several limitations on use of tax-exempt Midwestern Disaster Area bonds including:

1. bonds cannot be used to refinance debt incurred prior to the disaster;
2. 95% of proceeds must be for land and buildings - working capital, including issuance costs, is limited to 5%;
3. bonus depreciation (e.g., 50%) is not available if a project is financed with tax-exempt bonds;
4. moveable fixtures and equipment cannot be financed [the scope of this exclusion is not clear, although fixtures and equipment that could be removed for use elsewhere is found in the legislative history; however, the exclusion does not apply to “components that are assembled to construct an industrial plant” or consumer appliances in residential rental property];
5. only 25% of bond proceeds may be used for land and an interest in land;
6. the acquisition of an existing building requires rehabilitation of at least 50% of the portion of the cost of acquiring such building;
7. no more than 2% of bond proceeds may be used for costs of issuance (actual costs of issuance can exceed 2%);
8. SBA 504 program interface is problematic because SBA requires the same priority as the bank;
9. there are a number of prohibited uses: racetrack or other gambling facility, golf course, country club, massage parlor, suntan facility, hot tub facility, or store the principal business of which is the sale of alcoholic beverages for consumption off premises;
10. issuance involves a public body, thus some information is a public record;
11. must be issued on or before December 31, 2012;
12. bonds may not be owned by a substantial user of the property;
13. arbitrage restrictions apply;
14. a federal guarantee of the issue is generally prohibited; and
15. maturity is limited to 120% of the economic life of the assets acquired.

BONDS FOR AFFORDABLE HOUSING

Midwestern Disaster Area bonds issued for residential rental real estate must meet a requirement that 20% of the units be leased to persons at or below 60%* of Area Median Income (AMI) or 40% of the units be leased to persons at or below 70%* of AMI [*higher income tenants than under existing bond finance law].

RECOVERY ZONE FACILITY TAX-EXEMPT BONDS

This type of tax-exempt bond is allocated to the local level based on unemployment. These bonds are available for virtually any private activity involving the purchase of depreciable property located in a recovery zone. In Iowa, $135,000,000 has been allocated to 64 counties and two cities. These bonds must be issued in 2010. More information is available upon request.

THANK YOU

A great deal of gratitude is owed Senator Charles Grassley for providing federal tax relief following the disasters of 2008. Within days of the floods cresting in Iowa, legislation was introduced by Midwestern Senators to provide disaster tax relief comparable to that which was adopted for two prior disaster situations: 911 and Katrina.

However, much more needed to be done and the persistence of Senator Grassley was of critical importance to the eventual adoption of tax relief on October 3, 2008. Senator Grassley’s staff continued to take an active role in resolving some issues that arose with respect to the tax-exempt bond financing. More recently, some tax relief measures that expired at the end of 2009 are on Senator Grassley’s legislative agenda.

The Cedar Rapids and Iowa City Area Chambers of Commerce each deserve a thank you because of the timely and diligent efforts to follow disaster tax relief from the original introduction of legislation by Senator Grassley. After adoption of the legislation, the Cedar Rapids Chamber sponsored a Senate Finance Committee staff attorney’s presentation to the community on the scope of the tax relief.

The joint lobbying trip to Washington is a valuable opportunity to advocate for the Corridor. The Cedar Rapids Chamber allowed some issues regarding the disaster tax relief to be included in the 2009 lobbying trip. The access to a Senate Finance Committee staff attorney during the 2009 lobbying trip enabled us to advocate for a favorable IRS notice to enable the use of the tax-exempt bonds as a tool for full recovery from the devastation caused by the floods.

MOVING FORWARD

Steps to take:

1. contact a knowledgeable advisor;
2. analyze limitations applicable to tax-exempt bond financing;
3. determine Issuer and financing group, including bond counsel, Borrower counsel; financial advisor if desired, bank or underwriter;
4. determine deadlines;
5. contact Issuer and arrange for a reimbursement resolution and eventually a public hearing;
6. contact Iowa Finance Authority (if not the Issuer) and apply for an allocation of bonds;
7. obtain an allocation from Iowa Finance Authority (be prepared to close within 150 days); and
8. obtain final authorization by the Issuer and proceed to close.

NOTICE: Internal Revenue Service Regulations require that certain types of written advice include a disclaimer. To the extent that this article contains tax advice relating to a federal tax issue, unless expressly stated otherwise, the advice is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer for the purpose of avoiding federal tax penalties, and was not written to support the promotion or marketing of any transaction or matter discussed herein.

This article is intended for information purposes only. It is not intended to be comprehensive with respect to the subject matter, and it is not intended to create an attorney-client relationship with any participant or recipient. This article is not designed or intended to provide legal or other professional advice, as any such advice requires the consideration of specific facts.

QUESTIONS and ANSWERS

1. Do Midwestern Disaster Area bonds have to be used within cities where flooding occurred?
   NO, bond financed projects may be located anywhere within 78 counties in Iowa.



2. Must the user of bond financed property be a business that was flooded or have suffered a loss as a result of flooding?
   NO.



3. Must there be any connection to the flooding?
   YES, the business must have suffered as loss attributed to the disaster OR there must be a designation that the user of the bond financed project is replacing a business that suffered a loss as a result of the flooding.



4. Who can be the issuer?
   The city or county where the project is located, a city within 8 miles of the project, or the Iowa Finance Authority.



5. Can this be used for a hotel, bank, office building, warehouse, etc. owned by a newly formed entity?
   YES.



6. Can debt be refinanced if incurred prior to flood?
   NO.



7. Can debt be refinanced if incurred after flood?
   YES, however the timing of the debt and the taking of certain actions are critical.



8. Can moveable fixtures and equipment be financed?
   NO - not at tax-exempt rates; yes in same financing at taxable rate.



9. How long does this financing take to complete?
   75+/- days.



10. What are the loan to value requirements?
    Banks 80%, maybe 85%; the public market for Midwestern Disaster Area bonds is untested.



11. What is the maturity limit for bonds?
    The maximum maturity is 120% of the economic life of the assets acquired with bond proceeds. The actual limit will be less, perhaps a maximum of 10 – 20 years in some cases. The maturity of a bank purchased bond may be less than a bond sold through an underwriter.



12. Can bonds be used if a business can claim bonus depreciation?
    Tax-exempt bonds can be used in lieu of bonus depreciation.

Information can also be found at the Iowa Finance Authority website.