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Five Things Nonprofits Should Know About: Tax-Exempt Financing

Please note that the term “nonprofit” as used here specifically means entities holding 501(c)(3) status under the Internal Revenue Code.

  1. How it Works. “Tax-exempt bonds” are issued and sold by a governmental entity, the “issuer” (referred to in this type of financing as a conduit issuer). The bonds are purchased by a bank or by other investor(s). The proceeds from the sale of the bonds are then loaned to the nonprofit entity, which uses the borrowed funds to finance certain capital projects, such as constructing a new building, or, in some cases, to refinance existing taxable or tax-exempt debt.
  2. What the “Tax-Exempt” Part Means. The interest on the bonds that is received by the investor is exempt from federal income tax (and sometimes state income tax). Although “tax-exempt” financing does benefit tax-exempt 501(c)(3) entities, the term “tax-exempt” is really referring to the interest that investors receive on the bonds.
  3. How Tax-Exempt Financing Can Help Your Organization. Nonprofits can typically borrow at lower rates using tax-exempt financing, because banks and investors are generally willing to accept a lower rate of interest when they do not have to pay tax on the interest they receive on the bonds. The difference in tax-exempt financing rates versus taxable financing rates may be more or less dramatic depending on the market at any given time.
  4. What’s the Catch? There are many federal tax and other rules that must be followed in structuring the financing, as well as rules that the nonprofit must continue to follow as long as the bonds are outstanding. For example, the nonprofit borrower will need to track its use of the borrowed funds and its use of the property financed by those funds. The nonprofit will also be subject to restrictions on how the borrowed funds can be invested, how fast the funds must be spent, and how the bond-financed property can be used.
  5. How to Find More Information and Get Started. For additional detail about tax-exempt financing, including the basic people and documents involved, please see Tax-Exempt Borrowing Basics – A Quick Reference Guide to Tax-Exempt Bonds. Nonprofits typically start by discussing financing needs and tax-exempt financing options with an advisor and by applying for tax-exempt financing with the applicable state governmental entity that will serve as the conduit issuer for the bonds.