Tax-exempt bond financing for 4% LIHTC deals, explained
A 4% LIHTC deal gets its credits without a competitive allocation because tax-exempt private activity bonds, issued under the state's volume cap, finance enough of the building and land: 50% of aggregate basis, or, for buildings placed in service in taxable years beginning after December 31, 2025, 25% if one or more of those bonds, from an issue dated after December 31, 2025, together finance at least 5% of that basis. The 50% test still applies as an alternative. The bonds can be bought directly by a bank or GSE, sold publicly with credit enhancement, or issued short-term and cash-collateralized just long enough to pass the test.
Bonds and 4% credits are linked by one sentence of the tax code. If enough of a building’s cost is financed with tax-exempt private activity bonds that count against the state’s volume cap, the building’s credit doesn’t come out of the state housing credit ceiling at all (IRC 42(h)(4)). The housing agency still has to find the credit necessary for feasibility under 42(m)(2), but there’s no 9% competition. The constraint shifts to bond cap.
The bond test, exactly
Under 42(h)(4)(B) as amended by Pub. L. 119-21 sec. 70422(b), a building qualifies if either:
(i) the 50% test: 50% or more of the aggregate basis of the building and the land it sits on is financed by volume-cap tax-exempt bonds; or
(ii) the 25% test, which has three conditions, all required:
- 25% or more of the aggregate basis of the building and its land is financed by volume-cap tax-exempt bonds;
- one or more of those bond obligations are part of an issue with an issue date after December 31, 2025; and
- those post-2025 obligations together provide the financing for not less than 5% of the aggregate basis of the building and land.
The 25% test is available for buildings placed in service in taxable years beginning after December 31, 2025. For rehabilitation treated as a new building under 42(e), section 70422(b)(2) sets the placed-in-service timing for both the existing building and the rehab. The 25% bond test guide walks through the effective date, and the bond test calculator checks a deal.
“Aggregate basis” is broader than eligible basis. It includes land and depreciable costs that never enter eligible basis, such as commercial space. It excludes costs that aren’t basis at all, like syndication fees. Get it from the cost estimate the same way the cost certifier will.
Volume cap: the real constraint
Each state’s 2026 private activity bond ceiling is the greater of $135 per resident or $397,625,000 (Rev. Proc. 2025-32 sec. 4.19; 26 U.S.C. 146(d)). Multifamily housing competes for that cap with single-family mortgage bonds, student loans and other exempt facilities, and each state decides how to split it under 146(e). Unused cap can be carried forward for a stated purpose, including qualified residential rental projects, and used during the following 3 calendar years (146(f)).
Where cap is oversubscribed, the 25% test roughly halves the cap a deal needs. Whether an issuer will award cap sized to 25% is a policy choice each state makes, so read the current allocation rules before sizing; start from the state pages.
Who buys the bonds
| Execution | How it works | Typical use |
|---|---|---|
| Private placement or direct purchase | A bank, Freddie Mac (through its Tax-Exempt Loan, funded via a governmental lender note) or another institution buys the bonds or note and holds them as a loan | Construction and permanent financing in one lender relationship; fewer disclosure costs |
| Drawdown bonds | A private placement funded in pieces as costs are incurred, so the buyer earns interest only on what is drawn | Bank construction financing |
| Public offering with credit enhancement | Bonds are rated on the strength of an enhancer, such as Fannie Mae MBS under its M.TEB execution, an FHA-insured mortgage, or a bank letter of credit, and sold to investors | Larger deals; fixed-rate long-term debt |
| Short-term cash-collateralized bonds | Short-term fixed-rate bonds are sold publicly and their proceeds held in escrow; a taxable construction loan funds the work, and bond proceeds are released only as an equal amount of loan proceeds replaces them, so the bonds are always backed by cash or highly rated investments. Redeemed at or before conversion | Deals whose permanent loan is a taxable Fannie, Freddie or FHA loan, where bonds exist to pass the test |
Freddie Mac’s TEL term sheet (dated 02/25) shows the private-placement terms for a stabilized or forward 4% deal: up to 30-year term, minimum 1.15x coverage, maximum LTV the lower of 85% of adjusted value or 90% of market value, up to 40-year amortization, and a forward commitment term of up to 48 months (Freddie Mac). Compare executions in permanent loans and forward commitments.
The cost of short-term bonds: negative arbitrage
With cash-collateralized bonds, the developer pays the bond coupon while the escrowed proceeds earn whatever the collateral earns. The spread is a real cost.
Example, assumptions only: $11,500,000 of short-term bonds outstanding 24 months at a 3.50% coupon, with escrow earning 3.00% on average. Negative arbitrage = 11,500,000 x (3.50% - 3.00%) x 2 = $115,000, plus issuer fees and cost of issuance. Under the old 50% test the same deal (aggregate basis $46,000,000) needed $23,000,000 of bonds and twice the carry. Sizing at the 25% minimum is often the cheapest way through.
Rules every bond-financed project lives with
| Rule | Requirement | Source |
|---|---|---|
| Qualified residential rental project | 20% of units at 50% AMI, or 40% at 60%, or the average income test, for the qualified project period | 26 U.S.C. 142(d)(1) |
| Qualified project period | Starts when 10% of units are occupied; ends on the latest of 15 years after 50% occupancy, the day no bonds are outstanding, or the end of any Section 8 assistance | 142(d)(2)(A) |
| Good costs | 95% or more of net proceeds must be spent on the exempt facility | 142(a) |
| Issuance costs | Financed issuance costs capped at 2% of proceeds | 147(g) |
| Maturity | Average maturity no more than 120% of the facilities’ average expected economic life | 147(b) |
| Public approval | TEFRA hearing and approval by an elected official or voter referendum | 147(f) |
The bond set-aside and the LIHTC minimum set-aside are separate elections. Most sponsors match them so one rent roll satisfies both; see set-aside elections.
Recycling
When a bond-financed loan is repaid, the repayment can fund a new loan to another qualified residential rental project within 6 months, and the new bonds are treated as a refunding that needs no new cap, but only once per original issue, only if the refunding is issued within 4 years of the original issue, and only if no refunding bond matures more than 34 years after the original issue (146(i)(6)). Agencies that recycle aggressively stretch their cap. Whether a recycled bond can supply the post-2025 piece of the 25% test turns on its issue date and how it is treated under 146; get a bond counsel opinion before relying on it.
Timeline of a bond deal
- Inducement resolution from the issuer, which lets costs paid before issuance be reimbursed from bond proceeds.
- Volume cap application to the state allocator, often with a 4% credit application to the housing agency at the same time.
- TEFRA hearing and approval.
- Cap award, usually with a deadline to close.
- Closing: bonds issued, construction begins. If you elect, the 4% applicable percentage for a bond-financed building can be fixed in the month the bonds are issued (42(b)(1)(A)), though the 4% floor in 42(b)(3) makes that election mostly moot today.
- Placed in service, cost certification, Form 8609. Part I line 4 of Form 8609 reports the percentage of aggregate basis financed by tax-exempt bonds (Form 8609).
Getting the size right
Size the bonds to the test with a cushion. Cost overruns raise aggregate basis after closing, which lowers the bond percentage; a deal that closed at 25.2% can fail at 24.8%. Bond counsel and the cost certifier should agree early on the aggregate basis definition. The capital stack builder shows the bond percentage as the budget moves, and the Janover Capital desk can compare a direct-purchase bond with a short-term structure and a GSE forward for the same deal.
Questions people ask
Do the bonds have to stay outstanding for the whole compliance period?
No. The test is about financing the basis, and short-term bonds redeemed at conversion are a standard structure. But the credit stays outside the state ceiling only if principal payments on the bond-financed loan are used within a reasonable period to redeem bonds, or the financing is refunded under section 146(i)(6) (IRC 42(h)(4)(A)(ii)). Bond counsel documents this at closing.
Does the 25% test mean a deal only needs 25% bonds?
It needs at least 25% of the aggregate basis of the building and land financed by tax-exempt private activity bonds subject to the volume cap, and one or more of those bonds, from an issue dated after December 31, 2025, together finance at least 5% of that basis. It applies to buildings placed in service in taxable years beginning after December 31, 2025, and the 50% test still applies as an alternative.
Who issues the bonds?
A state or local governmental issuer, usually the state housing finance agency or a city or county housing authority, that has received an allocation of the state's private activity bond volume cap. The developer's project is the conduit borrower; the issuer has no liability beyond the project's revenues.
Do the bonds lower the interest rate?
They can, because bondholders don't pay federal tax on the interest. In practice the benefit depends on the market, the credit enhancement and the cost of issuance, and on many deals the bonds exist mainly to qualify the building for the 4% credit rather than to cut the rate.