Tax Exempt Bond Financing and Mortgages

Note: This post is technical in nature and not necessarily intended for the accounting faint of heart.

In today's finance world, developers of affordable housing often leverage LIHTC projects with other forms of public financing. (For more information on LIHTC's see previous posting "What the Heck is LIHTC? (Lie-Tech)".)

One form of financing that is commonly used it the tax exempt bond. Tax exempt bonds are issued by government agencies as a means of underwriting affordable housing. There is normally a series of bonds issued to cover both the construction and permanent loan phases of a project (approximately 30 years on average). The construction loan phase is paid at or near "conversion" to permanent financing with equity contributions from the LIHTC investor and the permanent bonds are paid off in phases over the life of the debt service. Interest rates will vary for each of the bonds depending on the length of the bond terms.

Being involved in a bond financed project comes with additional costs, including but not limited to annual Trustee fees, regular arbitrage calculations, state agency monitoring fees and remarketing fees. Not all issues have the same fees, but it is important to understand that interest and principal are not the only period costs incurred in the case of bond financing.

Despite the underlying debt being composed of bond financing, it is becoming more typical to structure the debt service on the Project in the same manner as an amortizable mortgage to cover all of the interest, principal and related fees. It is at this point that the accounting can get tricky.

When a servicer is used for the purposes of collecting the "mortgage payment", the Project will often get a monthly mortgage statement which covers debt service and monthly additions to the required reserves. Sometimes this statement will break out all the fees and reserve payments in addition to the interest and principal and sometimes it won't (believe me, I have seen everything!); but either way, that mortgage payment is not recorded in the same manner as other mortgages.

For a very basic example, here is what’s happening:

1. The Project pays the mortgage and escrow payments to the Servicer.
2. The Servicer transmits payments to the Trustee under some schedule they have and you don’t. Sometimes they keep a portion for their fee (called “interest”) and sometimes they don’t.
3. The Trustee puts the payments in reserve accounts typically labeled as follows: Replacement Reserve, Debt Service Reserve, and Operating Reserve.
4. The Trustee pays interest earnings on the Reserve accounts and sends statements to the Project.
5. On January July 1st, the Trustee makes interest and bond pay downs as required on the face of the bond coupon.
6. Throughout the year, the Trustee either makes payments or sends invoices to the Projects for payments on fees.

If you were following this narrative above, you might consider the fact that the Project has paid its mortgage, but it has ended up in bank accounts on the Project’s books (the Trustee accounts). And because bond pay downs are typically made around January 1; at a December year-end, a number of accountants would show large cash balances held by the Trustee (confirmed) and a large accrued interest and bond payable (due to the bondholders the next day).

If you are already lost on the accounting technology, turn back now!

Now consider this: the Project has paid its mortgage payments on time. There should be at most one month of accrued interest for January's payment in accordance with the mortgage agreement (if the servicer keeps a portion of the interest, none if they don’t). However, the bondholders are still owed their interest, so there would be up to 6 months of accrued interest according to the bond documents.

Both these statements are true, but you have a conflict if you try to account for both since you can’t have both one month and six month’s of accrued interest. That would be weird. So, here is how I have handled this situation in the past (with auditor blessing):

Assuming the servicer is not being paid out of the mortgage payment, the accrued interest is zero. The bond principal (debt) should be reduced to reflect the payment that the Trustee will make the next day. Interest expense should equal the amount paid to the bondholders on July 1st and January 1st (of the next year). The offset for this entry would be a contra-account to the Trustee balances for the amounts due to bondholders. The entries would look like this:

Monthly Mortgage payments:
Debit Trustee Accounts
Credit Cash

Debit Interest Expense
Debit Bond Payable
Credit "Due to Bondholders" (Contra to Trustee Accounts) in accordance with the bond pay down schedule (yes, you need this schedule)

January 1 and July 1 Bond Payments:
Debit "Due to Bondholders"
Credit Trustee Accounts

Monthly Trustee Statement:
Debit Trustee Accounts
Credit Interest income

Debit Any fees (Note: Fees should be analyzed for prepaid accruals as needed)
Credit Trustee Accounts

At year-end, there should be no accrued interest, the balance on the bonds payable should be reduced by the next day's payment, and the Trustee accounts should be shown net of the payment of principal and interest due January 1. This reflects that the required payments have been made by the Project, and there is no other period expense to the project requiring operating cash. This also reflects that the money paid, while still in the Project's name at the Trustee, is not under the Project’s control and is therefore reduced by the TRUSTEE'S obligation to the Bondholders.

I would like to say that the preceding example covers all situations, but alas, each one is slightly different, so you will need to use your noggin. My general advice would be – make sure you get activity statements regularly from both the Servicer and the Trustee. Once you have those, you should FOLLOW THE CASH.

Before submitting financial statements for audit, step back and do a reasonableness test – does interest expense make sense based on the underlying debt obligation and the mortgage payment? If no, go back to the statements and trace it through again until it does make sense.

Next time: Why you should sweep cash from the management company and how you should record it.