Clark Hill 2026 Commercial Real Estate Market Update: Real Estate Project Financing with Qualified 501(c)(3) Bonds

As debt, equity and other funding sources for real estate developments dwindle and become scarce and competitive, developers and real estate owners are becoming more creative in their project financing strategies and mix. Depending on the nature of the project (e.g., affordable housing, hospital, charter school, etc.) and other key factors, sponsors are turning to the use of tax-exempt bonds as a primary financing source. A real estate development financed with tax-exempt bonds issued for a §501(c)(3) organization (often called “Qualified 501(c)(3) Bonds”) offers several significant advantages over conventional taxable debt financing, such as lower interest rates, access to the municipal markets, long-term fixed-rate financing and the potential for larger or higher quality projects. Despite these unique benefits, financing with Qualified 501(c)(3) Bonds requires attorneys and experts that understand a mix of tax, securities, real estate and nonprofit law, and early coordination among these professionals is critical.

Attorneys play many roles in these projects, including bond counsel, underwriter’s counsel, borrower’s counsel and issuer’s counsel. This writing discusses some of the benefits and key legal considerations of using Qualified 501(c)(3) Bonds for project financing.

Key Benefits

Lower Interest Rates and the Potential for Larger and Higher-Quality Projects

Because interest on Qualified 501(c)(3) Bonds is generally exempt from federal income tax, investors are willing to accept lower yields. This typically results in interest rates 1–2% lower than comparable taxable debt (varies by market conditions). Lower borrowing costs can significantly reduce long-term project expenses. Lower financing costs often allow for the building of larger facilities, investment in higher-quality construction and the inclusion of mission-enhancing project components (e.g., community spaces, expanded services, etc.). In some cases, it can even make projects financially feasible that otherwise would not be.

Access to the Municipal Markets and Long-Term, Fixed-Rate Financing

Qualified 501(c)(3) Bonds allow the borrowers to access capital typically reserved for public infrastructure. This means larger pools of capital from institutional investors (including pension funds, insurance companies and certain mutual funds) and the ability to finance large projects (tens or even hundreds of millions). These municipal markets often also offer longer amortization periods than typical banks loans (often maturities of 20-40 years), with fixed interest rates and predictable debt service schedules.

Key Legal Considerations

The central legal focus of any project financed with Qualified 501(C)(3) Bonds is maintaining the tax-exempt status of the bonds, while ensuring securities compliance and proper real estate risk allocation. Running afoul of the tax-exempt requirements of the borrower or the operation of the project can have serious adverse legal and financial consequences for the nonprofit/borrower, the bond issuer and investors, converting an otherwise low-cost financing into a much more expensive tax obligation. One of the most severe consequences of noncompliance with tax-exempt requirements is that the interest on the bonds becomes taxable, which may result in investor demands for compensation for the lost tax benefit, indemnification claims against the nonprofit under the bond documents and/or the redemption or refinance of the bonds at higher taxable rates.

As such, these projects require an understanding of the key legal considerations involved and careful structuring and compliance to preserve the tax-exempt status of the bonds.

Tax-Exempt Requirements

Qualified 501(c)(3) Bonds are issued by a conduit governmental issuer, such as a state or local government development authority, industrial development agency, housing development authority, or economic development entity.  Upon issuing the bonds, the conduit issuer loans the bond proceeds to the borrower in the transaction.  In general, the borrower must be a nonprofit recognized under Internal Revenue Service rules as tax-exempt under Internal Revenue Code Section 501(c)(3). However, in some instances, projects can be carefully structured using a wholly owned newco subsidiary of the nonprofit borrower that is formed for the sole purpose of engaging in the project and is a disregarded entity for tax purposes.  The bond-financed facilities must be owned by a governmental entity, the 501(c)(3) nonprofit or its wholly owned disregarded subsidiary.  At least 95% of the bond proceeds must be used for activities that further the nonprofit’s exempt purpose (e.g., healthcare, education, affordable housing through a charitable structure) and that are not an unrelated trade or business of the nonprofit, and the project must adhere to certain private business use limits (e.g., there are limits on uses related to leases to for-profit tenants, management or service provider contracts, sponsorships, research in the facilities, etc.). Therefore, careful structuring of leases and service agreements for the project is critical. The project must also adhere to federal arbitrage and rebate rules and other requirements (including some project operation requirements) in order to maintain its tax-exempt status.  For bonds other than qualified hospital bonds, in certain cases, the total amount of outstanding Qualified 501(c)(3) Bonds for a borrower and its related parties must not exceed $150,000,000 in the aggregate.   Finally, Qualified 501(c)(3) Bonds issued to finance residential rental housing have additional requirements under the Internal Revenue Code to maintain tax-exempt status. Non-compliance with any of the tax law requirements may lead to serious adverse legal and financial consequences for the nonprofit borrower, the bond issuer and the investors.

Real Estate & Land Use Issues

The typical real estate and land-use considerations in any customary real estate transaction are also present in projects financed with Qualified 501(c)(3) Bonds. Clean title, title insurance and survey reviews remain essential to the success of the transaction, and attorneys must confirm compliance with local zoning, permits, environmental approvals and existing development agreements. As expected, owners and their legal counsels still need to perform their usual and customary due diligence reviews, such as property conditions reports, financial analysis, title and survey reviews and any phase I/II assessments to address any liability under environmental laws.

Federal Tax Law Compliance Process

Projects financed with tax-exempt bonds require a public hearing under the Tax Equity and Fiscal Responsibility Act (i.e., a TEFRA hearing) and approval by an elected official before issuance of the bonds. The primary purposes of the TEFRA hearing are public transparency and governmental oversight. The hearing ensures that the public is informed about the proposed bond-financed project and gives members of the public the opportunity to comment on the proposed project, whether regarding the project’s impact, community benefits or other public concerns. The TEFRA hearing process is typically coordinated by the conduit governmental issuer, along with the local government officials/entities. After the TEFRA hearing, the bond issuance must then be approved by the highest elected official or the elected governing body of the governmental entity or entities that has or have jurisdiction over the project location(s).  The bond issuance must also be approved by the highest elected official or elected governing body of the governmental unit that issues the bonds or on behalf of which the bonds are issued. Without these approvals, the bonds cannot qualify for tax-exempt treatment.

Securities Law & Disclosure

Attorneys specializing in securities law should ensure that the official statement or other offering document for the bonds contains adequate disclosures and is in accordance with federal securities laws. The official statement, or OS, is the central disclosure document in publicly sold municipal bond offerings, designed to provide investors with all material information about the bonds, the borrower, the project and the associated risks, so that investors can make an informed investment decision while ensuring compliance with federal securities laws. The OS also serves as a comprehensive record of the financing structure, including the project, bond terms, security and legal framework. For privately placed bonds sold to a specific lender or a small number of qualified investors, an offering document will be prepared that will serve a similar function. While there is no single mandated format, market practice and securities law require disclosure of all material information that could affect an investor’s decision. Typical sections include the following:

• Description of the Bonds (e.g., principal amount, interest rates, maturity schedule, payments dates, etc.).
• Purpose of the Financing (i.e., how the bond proceeds will be used) (e.g., acquisition of land, construction/renovation of facilities, cost of issuance, reserves, etc.).
• Description of the Project (e.g., location and scope of the project, construction status and timeline, major contractors and developers, conflicts of interest, expected revenues, etc.).
• Security for the Bonds (e.g., mortgage, assignment of rents, guaranties, etc.)
• Description of the Borrower (e.g., organizational structure and governance, mission and operations, financial statements and operating history, management team, etc.)
• Risk Factors (e.g., construction risks, revenue/occupancy risks, regulatory risks, market conditions, tax law risk, etc.).
• Tax Matters.
• Legal and Regulatory Matters.
• Continuing Disclosure Obligations (the OS must also describe the borrower’s commitment to ongoing financial reporting under SEC Rule 15c2-12, including annual financial statements and notices of certain material events).

Other Legal Considerations

Other legal considerations in projects financed with Qualified 501(c)(3) Bonds include credit and security considerations, corporate governance and nonprofit law, state and local law issues, including state tax exemption rules (which may differ from federal), and local incentives (such as PILOTS, abatements, grants) and other common risks such as excess private use from commercial tenants or joint ventures, failure to monitor post-issuance compliance and construction delays or cost overruns.

Conclusion

Despite their unique tax and other benefits, the use of Qualified 501(c)(3) Bonds requires careful planning and an understanding of the related tax, securities, real estate and nonprofit laws, and owners and developers should consult with attorneys and other pertinent professionals very early on in the process to discuss and understand the various benefits and legal considerations involved.