On October 27, 2015 the U.S. Treasury Department and Internal Revenue Service published final regulations concerning the treatment of “mixed-use” projects financed with tax-exempt bonds. These new regulations have particular importance for tax planning and tax compliance of 501(c)(3) health care organizations that are borrowers of tax-exempt bonds.

Although this alert focuses on nonprofit health care organizations, the new regulations apply to tax-exempt bonds issued for the benefit of health care facilities owned by State or local governments in a similar manner.

A copy of the new final regulations can be obtained here.

See 80 FR 65637.

Below is a more detailed supplement of our previous alert, dated October 28, 2015, regarding the new regulations, available here.

The new regulations most importantly facilitate the use of projects financed with tax-exempt bonds for “mixed-use” purposes (that is, uses that are treated as furthering exempt purposes of a section 501(c)(3) organization and “private use” purposes not generally permitted for projects financed with tax-exempt bonds). The “private uses” which are generally not permitted for property financed with qualified bonds include any unrelated trade or business use of a 501(c)(3) organization and certain uses pursuant to contracts with entities other than 501(c)(3) organizations and State or local governments. The new regulations have particular importance for nonprofit health care organizations because those organizations commonly have extensive contractual arrangements with private entities, and commonly have complex operations which include some amount of unrelated trade or business activity.


The Internal Revenue Code generally restricts the amount of “private business use” of projects to small amounts (generally, 5% for qualified 501(c)(3) bonds). Although tax-exempt bond issues technically fail to comply only if the bond issue also fails to comply with a second “private security or payment” test, in most cases organizations rely on the private business use test to comply. In addition, a separate requirement provides that 100% of the property financed with qualified 501(c)(3) bonds must be owned by a 501(c)(3) organization or a State or local government. Over the years, application of these “private business tests” and “ownership test” has become increasingly burdensome and complex. In particular, in 1997 the Treasury Department published final regulations that require private use compliance to take into account “deliberate actions” after the date of issuance, which rule requires tax compliance monitoring throughout the term of a bond issue.

One of the most helpful strategies that organizations use to manage compliance with these complex rules is to finance the costs of a project that will be used for private uses with funds other than proceeds of tax-exempt bonds. Under that approach, the proceeds of the tax-exempt bonds are not treated as used for private uses, because the portion of the project paid with the “equity carve out” is instead treated as privately used. The new regulations set forth detailed new rules for how and when this commonly-used “equity carve out” approach works.

Summary of the Final Regulations

Rules for equity contributions that are generally more flexible, but not in all cases more favorable. The new regulations provide that private business use of a project is allocated first to the portion of the project financed with “qualified equity.”

Qualified equity generally means proceeds of taxable bonds and funds that are not derived from proceeds of a borrowing. For example, qualified equity includes an organization’s cash derived from revenues and cash donations. Qualified equity does not include equity interests in real property or personal property. This approach is consistent with prior prevailing practice.

“Floating use” is expressly permitted. The new regulations expressly and helpfully permit “floating” use of the portion of a project treated as financed with qualified equity. For example, suppose the costs of a 10-story building are funded 70% with tax-exempt bonds and 30% with an organization’s cash. The new regulations generally provide that private use of three floors will not be treated as private use of the tax-exempt bonds, even if the particular three floors change from year to year. This “floating use” rule will be particularly helpful for many bond-financed health care facilities with dynamic and changing operations.

A “project” that may be treated as funded in part with qualified equity is defined very broadly. One of the most favorable rules in the new regulations is a very flexible definition of a “project.” This rule is particularly important in light of the rules that permit private use to “float” within a mixed-use project. The new regulations permit an organization to treat as a single “project” one or more facilities or capital projects, including land, buildings, equipment, or other property financed in whole or in part with the proceeds of a bond issue. Proposed regulations generally permitted only certain functionally related facilities, such as adjacent buildings, to be treated as part of the same project. The more flexible rule in the new regulations may present significant tax planning opportunities and tax compliance relief, although it may in some cases be complex to apply.

Because tax-exempt bond issues often finance a large number of different assets (often at many different sites), this flexibility to define a “project” is likely to present many tax planning and tax compliance opportunities in health care finance. For any particular bond issue there could be a very large number of different possible combinations for making best use of this rule.

Important limitations mostly concern timing. The rules for “qualified equity” also contain new limitations that may be problematic in some cases. Qualified equity must be contributed to a project as part of the “same plan of financing” as the tax-exempt bonds and must pay for capital expenditures of the project on a date that is not earlier than the date on which the expenditures would be applicable to reimbursement by proceeds of the applicable tax-exempt bonds. Among other things, this appears to mean that the tax-exempt bonds generally can qualify for the “qualified equity” benefits only to the extent bonds are issued no later than 18 months after the date of the expenditure (or 18 months after the placed in service date of the project, if later, but no more than three years after the date of the expenditure), although a definitive interpretation of certain aspects of this timing limitation may require clarification from the Service. This timing rule is new, and may raise a number of problems, including particular problems for projects that have a long construction period. Similarly, the new regulations may present difficulties in some cases where a single project is financed with a series of bond issues.

The new regulations also state that qualified equity contributions must be made before the placed in service date of the financed project, except for reasonable retainage.

Annual measurement is required. The final regulations expressly provide that the “qualified equity” rule must be applied on an annual basis to qualified 501(c)(3) bonds.

Favorable treatment of partnerships. The new regulations facilitate “public-private partnerships” by permitting tax-exempt bonds to be used to finance a nonprofit health care organization’s contribution to a partnership which includes private persons. Under this new rule, the amount of private business use by a private person resulting from the use of property by a partnership is the private partner’s greatest percentage of any partnership item of income, gain, loss, deduction, or credit attributable to the period the partnership uses the property during the period private use needs to be taken into account. The rule generally requires that, in the case of qualified 501(c)(3) bonds, a 501(c)(3) organization must be one of the partners.

Also, ownership by a partnership does not in itself violate the requirement that all bond-financed property needs to be owned by a 501(c)(3) organization or a State or local government.

This rule can be expected to make tax-exempt financing eligible to some extent for partnerships including a 501(c)(3) health care organization and a for-profit partner not previously eligible for tax-exempt bond financing to any extent.

For example, tax-exempt bond financing is now possible to some extent for a nonprofit hospital organization’s contribution to a “whole hospital” joint venture with a for-profit hospital. In 1998, the IRS published Rev. Rul. 98-15, which provided that, under certain circumstances, a 501(c)(3) hospital organization can enter into a “whole hospital” joint venture with a for-profit hospital in a manner consistent with its charitable purposes. In general, Rev. Rul. 98-15 focuses on whether the nonprofit hospital organization retains sufficient control over its contributed facilities to assure that its exempt purposes will be furthered. Rev. Rul. 98-15, however, does not interpret the federal tax requirements for tax-exempt bonds. Prior to publication of the new regulations, the IRS took the position that the participation by a 501(c)(3) hospital organization in such a “whole hospital” joint venture generally would cause all of the tax-exempt bonds issued for its benefit to fail to qualify as tax-exempt, and would prevent the hospital organization from issuing any additional tax-exempt bonds to benefit the facility. The new regulations reverse the prior IRS position in a manner that is in some respects similar to the more flexible approach of Rev. Rul. 98-15.

Also, the new favorable rule for partnerships possibly may facilitate use of tax-exempt bond financed property by accountable care organizations and similar arrangements with private entities in some circumstances.

The application of this new favorable rule for partnerships will require careful analysis and legal interpretation in many cases. The measurement of the amount of private use of contributed tax-exempt bond financed property (based on the greatest amount of any private partner’s greatest share of any partnership item of income, gain, loss, deduction, or credit) may in particular require careful analysis and interpretation. Also, an anti-abuse rule in the existing regulations possibly may apply to prevent favorable treatment if a for-profit partner derives a financial benefit directly based on the tax-exempt interest rates of the nonprofit organization’s bonds.

No special elections or recordkeeping requirements. The new regulations helpfully do not require any special elections or record retention requirements to make use of the “qualified equity” rules. Proposed regulations contained a number of such requirements that could have been traps for the unwary. Thorough and rigorous identification of qualified equity contributions to projects and retention of records relating to such contributions and identifications, however, will continue to be important in practice. In addition, the time limits for making allocations of bond proceeds in the existing final regulations may have relevance for taking actions under the new regulations. The existing regulations generally require that an organization must allocate proceeds to expenditures no later than 18 months after a project is placed in service. In that light, organizations may benefit in particular by considering whether to apply favorable rules in the new regulations to recently issued bonds, is as further discussed below.

Clarification of “remedial action” rules. Since 1997, the regulations have permitted certain remedial actions to correct noncompliance with the private use rules. One remedial action is the redemption or defeasance of “nonqualified bonds.” The new regulations make important revisions and corrections to these remedial action rules, and in particular clarify the steps an organization must use to take a remedial action in anticipation of a future remedial action.

Effective dates. Organizations are generally required to apply the new regulations to bonds that are sold on or after January 25, 2016, although certain special effective date rules apply. 

Organizations are generally required to apply the rules for remedial actions to any “deliberate actions” that occur on or after January 25, 2016, even if the bonds were sold before that date. In this regard, it is important to note that, although the remedial action rules in the new regulations are generally favorable, the new regulations contain certain new requirements. In particular, the new rule for “anticipatory” remedial actions will generally apply to any deliberate action occurring on or after January 25, 2016.

Organizations may apply the new regulations to bonds sold before that date, but the effective date rules impose certain limitations on such retroactive application. An important limitation is that the effective date provisions provide that retroactive application is generally permitted only if all of the provisions of the new regulations are applied in whole.

The rule that permits retroactive application of the new regulations may present many health care organizations with the opportunity to revisit and possibly favorably re-determine the amount of private use of a bond issue reported in the past. For example, if a hospital organization reported on Schedule K of Form 990 that one or more of its tax-exempt bond issues had “private business use”, it is possible that reporting position could be revisited.

Except as described above, the application of the new regulations to bonds sold before the effective date is expressly permissive. There is no implication that bonds sold before the effective date need to comply with the new regulations, although as a practical matter organizations and practitioners may look to principles in the new regulations in taking positions with respect to pre-effective date bonds.