Unlocking the Benefits of Tax-Exempt Financing for 501(c)(3) Organizations

Tax Exempt Financing


Tax-exempt financing offers a powerful tool for 501(c)(3) organizations to fund essential capital improvements at significantly lower interest costs compared to conventional debt options. By issuing tax-exempt bonds, organizations can tap into a pool of investors who are not subject to federal income tax on interest payments, allowing for lower interest rates.

This article delves into the fundamentals of tax-exempt financing for 501(c)(3) organizations, covering key aspects such as eligible issuers, project selection, private use considerations, and the importance of effective planning.

What is Bond Financing?

Typically, bond financing will be in the form of a loan to a 501(c)(3) organization from a local government entity such as a development authority (the “elgibile issuer”). Tax-exempt bonds may be sold publicly or privately placed through an underwriter or placement agent. The money raised from the bonds is reloaned by the eligible issuer to the 501(c)(3) organization. 

Selecting Projects for Tax-Exempt Financing

Federal and state laws dictate the types of projects eligible for tax-exempt financing. State laws, in particular, outline eligible borrowers and projects. It’s crucial to carefully analyze these limitations early in the process. For instance, some state laws may restrict financing for working capital or projects that create jobs.

Additionally, projects must align with the exempt purpose of the 501(c)(3) organization. Typically, tax-exempt bonds may be issued to finance the acquisition of a 501(c)(3) organization’s facilities. Tax-exempt bond proceeds are prohibited from being used to finance airplanes, gambling facilities, liquor stores, or private luxury boxes.

Due Diligence Review

The 501(c)(3) organization will need to undergo a due diligence review as part of the financing to ensure its status as a 501(c)(3) entity and the project complies with the Internal Revenue Code. The 501(c)(3) organization’s tax information, corporate status, governance documents, history, financial information, and organizational information will be reviewed by the financing team. 

Understanding Private Use of Bond-Financed Facilities

Section 145 of the Internal Revenue Code sets forth the requirement that 95% of tax-exempt bond proceeds must be utilized for the 501(c)(3) organization’s exempt activities. Private business use, which is the use of tax-exempt bond-financed facilities by private businesses or the 501(c)(3) organization itself for non-exempt purposes, is strictly regulated.

Often part or all of the 501(c)(3) organization’s facilities will be managed by a for-profit company. “Safe harbor” guidelines must be followed to ensure such use doesn’t impair the tax exemption of the bonds. It’s important to be aware of situations where private use may occur, such as in leases or management contracts, and to take appropriate measures to ensure compliance.

Eligible Assets 

Tax-exempt bond proceeds are typically used for capital assets, interest during construction, attorneys’ fees, issuance costs, and related costs. However, no more than 2% of the tax exempt bond proceeds may be used to pay costs associated with the issuance of the bonds.

Further, bonds will not qualify for tax exemption if their average maturity exceeds 120% of the average reasonably expected economic useful life (based on IRS depreciation schedules) of the facilities and/or equipment being financed.

Arbitrage and Rebate

501(c)(3) organizations must adhere to federal tax rules governing the investment and expenditure of tax-exempt bond proceeds. The regulations aim to prevent organizations from realizing profits through arbitrage. Understanding these rules and planning accordingly can enhance the overall benefits of tax-exempt financing.

Planning a Capital Campaign

Effective coordination of fundraising efforts and project financing is crucial. Care should be taken to avoid inadvertently designating pledges or gifts as “replacement proceeds,” which could lead to tax-exempt status issues. Open-ended solicitations and careful crafting of campaign structures can help achieve this balance.


Tax-exempt financing offers significant advantages to 501(c)(3) organizations undertaking capital projects. With thorough planning and adherence to regulatory requirements, organizations can leverage this financing method to achieve their mission while minimizing costs. By understanding the intricacies of tax-exempt financing, 501(c)(3) organizations can unlock a valuable financial tool for their projects.

Ashley Spear is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Arizona. Ashley advises nonprofit and socially responsible businesses on corporate, tax, real property, and tax-exempt bond financing matters. Ashley also has significant experience advising charter schools and charter networks. To schedule a consultation with Ashley, call 602-456-0071 or email us through our contact form

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