Tax Law Eliminates Advance Refunding

Thoughtware Article Published: Mar 01, 2018
Government Buildings

The Tax Cuts and Jobs Act (TCJA) makes previously tax-exempt interest on advance refunding bonds taxable, essentially eliminating the advantages and appeal of advance refunding bonds after December 31, 2017.

A refunding occurs when an issuer refinances outstanding bonds before the original bonds mature or are callable. Essentially, the issuers sell new bonds to retire or buy back outstanding bonds. The purpose of a refunding is to take advantage of favorable interest rates to reduce borrowing costs (similar to individuals refinancing mortgages), restructure debt and/or free up resources for other projects or investments. Bonds issued after the Tax Reform Act of 1986 only could be advance refunded once.

Under the new law, interest on advance refunding bonds—refunding bonds issued more than 90 days before the redemption or call date of the refunded bonds—will now be taxable. Interest on current refunding bonds—refunding bonds issued within 90 days or less of the redemption or call date of the refunded bonds—will remain tax-exempt.

The new law will ultimately force issuers to accept market conditions in the 90-day current refunding window and will take away issuers’ ability to refinance for debt service savings when interest rates are favorable outside the 90-day window. Prior to January 1, 2018, tax-exempt bondholders used advanced refunding as a financial management tool to save on interest costs. By reducing debt services expenses through advance refunding, tax-exempt bond holders could free up borrowing capacity for new investments, typically in infrastructure.

The TCJA also reduced the corporate income tax rate to a flat 21 percent. This means the relative yield on future issues of tax-exempt bonds must rise and rates must be more comparable to taxable rates for bonds to remain attractive to banks, insurance companies and other corporations as a competitive investment choice. The 21 percent tax also could generate a spike in the interest rates on outstanding tax-exempt bonds that were privately placed with banks or other corporate holders. Private placements often feature interest rate modifications, which take effect when a reduction in the corporate income tax rate occurs.

For organizations with bonds issued before December 31, 2017, which were originally financed at higher rates but structured and sold on the basis they would get an advance refunding at a lower rate in the future, this strategy has now been negated. Organizations planning to issue new bonds after December 31, 2017, will need to consider how to preserve interest cost savings that were previously available with advance refunding. Issuers may evaluate shorter, nontraditional call periods, which may better accommodate a refinancing down the road. The use of variable rate debt and interest rate derivatives may rise, which could hedge interest rate exposure but also increase complexity and risk. Taxable bonds could rise in popularity.

Much depends on how investors will react to the new tax law rules, which is still unknown.

For more information contact Amber or your trusted BKD advisor.

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