Senior Living Alert: Federal Tax Code’s Arbitrage Rules May Impact the Return on Certain Investments

March 26, 2024

Borrowing money to finance capital projects is always more challenging in a rising interest-rate environment. However, one silver lining is the ability to earn more on the investment of borrowed money during the construction period. For several years, there weren’t many investment options that provide a material return on a construction fund established for a capital project. In fact, earnings were so slim they often were largely ignored when developing a capital plan. 

Now the opposite is true. Consulting with financial advisers about the investment of a construction fund is an important part of the borrowing process, and the size of the borrowing should consider the expected earnings on the investments. If the borrowing is done on a tax-exempt basis, it is also necessary to consider all the federal tax code’s arbitrage rules when developing an investment plan. These rules are designed to limit the ability to maximize investment earnings in tax-exempt financings in certain situations. This alert will describe some of those rules and how they may impact the return on certain investments. 

Positive Arbitrage

When Congress permitted certain tax-exempt entities to borrow money at a lower tax-exempt rate, certain strings were attached, including restrictions on the investment of tax-exempt borrowed money. As a general rule, the tax code does not permit borrowers to invest tax-exempt debt proceeds at a rate exceeding the interest rate paid on the debt and keep the difference. For example, if money is borrowed at a tax-exempt 4% rate and invested at a 5% rate, the borrower may not keep any earnings above 4%. The difference between the 4% rate paid and the 5% rate earned is called “positive arbitrage.” 

If positive arbitrage is earned, the tax code generally requires that such earnings be “rebated” to the federal government. With such low investment rates in recent years, it has rarely been possible to earn positive arbitrage on a borrowing, so sending investment earnings to the government has not been a concern. In the current interest-rate environment, however, earning positive arbitrage is very much a possibility, so it is important to understand how these rules will affect a transaction.

Exceptions to the Rebate Rule

Absent any exceptions to the general rule, a borrower should be prepared to rebate any positive arbitrage to the government. Fortunately, the tax code contains important exceptions to the general rebate rule if the borrowed money is spent within a certain time frame (generally called “spend-down exceptions”). Congress made a policy decision that if the money in a construction fund is spent on a project quickly enough, the borrower could keep any investment earnings — even positive arbitrage. 

A couple of spend-down exceptions are most relevant for new capital projects. The first requires spending the money within 18 months while meeting certain spending benchmarks after six months and 12 months. The second exception requires spending the money within 24 months while meeting certain spending benchmarks at each six-month interval (this exception is available only for projects composed primarily of construction expenditures, as opposed to acquisitions of equipment or land). 

If the money is spent from the construction fund according to these spend-down exceptions, the borrower may keep any positive arbitrage and spend it on the financed project. If a borrower anticipates a significant amount of positive arbitrage, it could try to expedite a spend-down schedule to meet one of the exceptions. In either case, it is important to speak with a financial adviser and bond lawyer about the implications of higher investment earnings before entering into a tax-exempt borrowing. If earnings are great enough, it may make sense to reduce the borrowed amount to account for the earnings. 

From an administrative standpoint, borrowers without a lot of experience in tax-exempt borrowings (and even those with such experience) should consider hiring a professional rebate consultant to analyze whether a spend-down exception is met and to compute any positive arbitrage that is owed. If any positive arbitrage is not rebated to the federal government as required, the debt could lose its tax-exempt status.

Application of Arbitrage Rules

Positive arbitrage can have implications outside a construction fund context. The arbitrage rules don’t apply just to sale proceeds of a borrowing — they also apply to amounts held by a borrower that would have been used to finance the project in the absence of a borrowing. 

For example, if an organization borrows $10 million to finance a new $10 million building but later receives a $2 million donation that is restricted by the donor to be used on the same building, then the arbitrage rules will apply to the investment of the donation. Any positive arbitrage earned from the investment of the $2 million generally must be rebated to the federal government, under the theory that the borrower should have borrowed only $8 million and shouldn’t take advantage of arbitrage opportunities on the additional $2 million. 

Importantly, in this case, there is no spend-down exception to the general rebate rule. If positive arbitrage is not properly rebated to the government, the tax-exempt debt could lose its exemption. To avoid this scenario, a borrowing should be sized to account for any anticipated donations or other restricted amounts. It is important to discuss all possible sources of funding with an attorney when planning a tax-exempt borrowing to avoid any arbitrage pitfalls.    


Rising investment rates have created a great opportunity to establish an additional source of revenue for capital projects. At the same time, however, they have brought to the surface certain arbitrage issues in tax-exempt borrowings that haven’t been of concern for a long time. When planning a capital financing, it is important to consult with a financial adviser and bond counsel to make sure the arbitrage rules don’t jeopardize the tax-exempt status of the debt.