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KSM Blog | Katz, Sapper & Miller CPA

Tax-Exempt or Taxable Financing? The Impact on Investment Recovery.

Posted 8:43 PM by

Competition remains fierce between communities to attract or retain business that drives employment, revenues and overall development. The offer of issuing bonds for project financing is frequently used by local governments or agencies to incentivize location in a particular area. For businesses, the availability of such financing, often accompanied by lower borrowing costs or reductions in risk, creates advantages that are difficult to ignore. If given the option of financing a project with either tax-exempt bonds or taxable bonds, what factors should a company consider? One issue that should always be considered is the rate at which businesses can recover their investment through tax depreciation.

Tax-exempt bonds are those on which interest payments to bondholders are exempt from federal income tax. Because of this exemption from tax, interest rates paid by the issuer are generally lower, but restrictions on the use of the bonds are much more stringent. In general, tax-exempt bonds may finance only manufacturing facilities or certain "exempt facilities" such as sewage treatment plants, domestic water facilities and solid waste facilities. As defined under federal law, a manufacturing facility is one which facilitates "the manufacturing or production of tangible property (including processing resulting in a change in condition of such property)." Federal law requires that at least 75% of the bond proceeds be used for manufacturing activities (i.e., on the plant floor).  No more than 25% of bond proceeds may be used for office, research and development, or warehousing, and any such areas must be on the same site as the manufacturing facility. Federal law also restricts the size of the bond issue to $1 million, although in certain cases the bond issue can be as much as $10 million.

Unlike tax-exempt bonds, taxable bonds (those not exempt from federal income tax) carry few, if any, restrictions. Businesses are not limited by regulations in the amount borrowed nor by the use of the proceeds. The flexibility of taxable bonds is a significant advantage when compared to tax-exempt financing. Another frequently overlooked but very important advantage of taxable financing is the availability of accelerated tax depreciation.

The Internal Revenue Code requires that projects funded by tax-exempt sources of financing be depreciated using the alternative depreciation system (ADS). ADS rules require longer recovery periods and the slower straight-line method method of calculating tax depreciation. In years where bonus depreciation is available, projects placed in service and funded by tax-exempt financing do not benefit because bonus depreciation is not allowed for assets required to be depreciated using ADS rules. Taxable financing, on the other hand, allows the use of the general depreciation system and faster, accelerated methods of calculating tax depreciation. In addition, bonus depreciation may be taken advantage of.

The availability of accelerated tax depreciation creates significant value compared to slower methods of recovering investments in facilities. To illustrate, consider a $10,000,000 manufacturing facility where, for tax depreciation purposes, 10% of the facility is personal property, 15% is land improvement, 75% is nonresidential real estate, the combined federal and state tax rate is 40%, and the assumed discount rate is 5%. The net present value of the difference in timing of depreciation deductions for projects funded by taxable bonds, as compared to tax-exempt bonds, is approximately $147,000. In years where 50% bonus depreciation is available, the net present value of those depreciation deductions is nearly $243,000.

Given the restrictive federal rules on tax-exempt financing, and given the impact of tax-exempt financing on the recovery of investment in fixed assets, businesses should analyze their options carefully before choosing tax-exempt financing over taxable financing.

About the Author
Christopher Bradburn is a director in Katz, Sapper & Miller's Real Estate Services Group. Christopher leads the firm's cost segregation practice. He also provides accounting and tax support for a wide variety of practices. Connect with him on LinkedIn.

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