Tax Increment Financing Districts andSpecial Taxing Districts: Tools forInfrastructure Finance

John R. Orrick, Jr

Tax increment �nancing districts and special taxing districts are a means

whereby developers may utilize the public �nance markets to �nance o�-balance

sheet the costs of public infrastructure for various types of real estate

development projects. The local jurisdictions creating the districts stand to

bene�t as well through the encouragement of targeted growth. This article

summarizes the basic mechanics behind the formation and operation of these

vehicles for real estate development.

In many jurisdictions around the country, the demandsfor development of both commercial and residentialreal estate projects have overwhelmed the ability ofthe local jurisdictions to provide the necessary roads,water and sewer, schools and other public infrastruc-ture to satisfy the users of the new projects. Raisingtaxes across the board to �nance the necessary infra-structure is oftentimes politically unfeasible, andrequiring the private developer to �nance such costsout of the project may be commercially impracticable.

A solution to the above conundrum has emerged inthe form of specially created taxing districts which relyupon the dedication of a stream of tax revenues derivedfrom the bene�ted properties to �nance the necessarypublic infrastructure costs. These districts represent a‘‘public-private partnership,’’ which can providebene�ts to the developer seeing to obtain developmentapprovals and the funds to complete its project, to the

local jurisdiction seeking to accommodate growthwhile maintaining a constant tax base, and to the prop-erty owners who ultimately use the completeddevelopment.

The two types of taxing districts described in thisarticle are Tax Increment Financing (‘‘TIF’’) districtsand special taxing districts. While structured in a simi-lar manner, they are often used in di�erent ways andcan, under certain circumstances, be used in combina-tion to accommodate development projects.

Tax Increment Financing Districts

A TIF district involves the creation by a municipality,county or other local governmental body of a districtcomprising a de�ned geographic area wherein the realproperty taxes, sales taxes, or other general taxes areused to �nance the desired improvements. The struc-ture involves the establishment of a base year for thetaxes in question, generally the year the district isestablished, with the increment of such taxes over andabove that existing tax base diverted from the generalgovernmental accounts into a special account where it

John R. Orrick, Jr. is a partner in the Bethesda, Maryland, law �rm ofLinowes and Blocher LLP. Mr. Orrick represents developers and otherproperty owners in connection with the formation of TIF districts andspecial taxing districts in Maryland, Virginia, the District of Columbia,and Delaware. He can be reached at jorrick@linowes-law.com.

56 THE REAL ESTATE FINANCE JOURNAL/SPRING 2006

may be used directly to pay for the necessary infra-structure, or used to retire bonds issued by the localgovernmental authority, the proceeds of which bondsare used to �nance the infrastructure.

Since the local jurisdiction is surrendering, at leasttemporarily during the life of the bonds, the additionaltax revenues generated by the new development in thedistrict, TIF districts are generally only utilized wherethe properties are subject to economic depression orthe development represents a signi�cantly higherpotential for growth, and where concomitant economicbene�ts to the local jurisdiction are likely to accruethrough higher property taxes on surrounding proper-ties, or increased sales taxes, income taxes and othertax receipts projected to be realized from the bene�tedproperties. The common test referred to in the contextof TIF districts is the ‘‘but for’’ test whereby theincreased tax base would not occur but for the realestate development, and accordingly, the local govern-mental jurisdiction is not giving up tax revenues that itwould otherwise have.

Enabling statutes which permit the formation of TIFdistricts exist in almost every state.1 The statutes di�erwith respect to the types of taxes which can be utilizedin TIF �nancing districts, varying among real property,personal property, or sales taxes. The state statutes gen-erally authorize a local governmental instrumentalityto create the TIF district through the adoption of a res-olution or ordinance which designates the de�ned areaas a TIF district, sets the base tax year, and authorizesthe capturing of the portion of the general tax revenuesabove the base tax year to be applied toward thedesignated infrastructure construction or debt retire-ment purpose.

Where a project is located in two or more overlap-ping jurisdictions, such as a municipality within acounty, the incremental revenues from each of thegovernmental entities may be diverted towards �nanc-ing the improvements.

Since the owners of the properties located within aTIF district will pay the same rate of property or salestax as would any other property owner of the sameclass of property within the jurisdiction, there is noneed for property owner approval of a TIF district, andtypically state enabling statutes allow for the jurisdic-tion to unilaterally create the TIF district without therequirement for property owner consent. Nonetheless,the creation of a TIF district is often a bargained for el-ement when the developer approaches the governmen-tal authority and can be a useful tool in the arsenal ofthe local governmental authority in attracting newprojects.

Special Taxing Districts

Special taxing districts (originally referred to as‘‘Mello-Roos’’ districts in California, and also referredto in various state enabling statutes as communitydevelopment authority districts, community facilities

districts, local improvement districts, municipal utilitydistricts, or development districts) di�er from TIFdistricts by virtue of the fact that an additional layer ofspecial taxes or special assessments is imposed on thebene�ted properties over and above the general realproperty taxes, which revenues are in turn used to payfor the required infrastructure improvements. In virtu-ally all state enabling statutes, special taxing districtsmay only be created after a speci�ed percentage (rang-ing from 51 percent to 80 percent, by value and bynumber) of the owners of the bene�ted properties peti-tion for, or ultimately consent to, the creation of thedistrict.

As is the case with TIF districts, the local govern-mental authority is generally required to establish byresolution or ordinance the boundaries of the specialtaxing district. In addition, the authority must developa methodology for the assessment of the special taxesand/or assessments which are imposed through the �l-ing of a declaration recorded in the land records of thejurisdiction.

The state enabling statutes for special taxing dis-tricts generally provide that the special taxes and or as-sessments bear the same priority as general real prop-erty taxes and may be enforced, in terms of foreclosureprocedures, in the same manner as the collection of de-linquent real property taxes. Generally, in the event ofa property owner default in the payment of specialtaxes or assessments, the property owner will be as-sessed a delinquency charge, and failing the paymentof this tax by a date certain, the property will be subjectto the local jurisdiction's tax sale procedures. Sincereal property taxes are senior to private liens, the localgovernment is assured that it will have the ability toultimately collect the delinquent special taxes and as-sessments through the local jurisdiction's tax sale ofthe property or a private property owner's redemptionof the right to enforce a tax sale.

Some jurisdictions require advance disclosure inthe real estate sales contracts to purchasers of proper-ties located in special taxing districts as a precaution-ary method, although such taxes will generally appearon the real property tax bills sent to property owners.

Over 30 states currently have enacted enablingstatutes to authorize the creation of special taxingdistricts, and depending upon state law, special taxingdistricts may be approved by municipalities and/orcounty governments.2 In some jurisdictions, a quasi-governmental authority is authorized to be created bythe enabling statute to administer the special taxingdistrict and to issue bonds on behalf of the taxingdistrict, while in others, the governmental authorityitself maintains this authority.

It is possible to utilize TIF districts and special tax-ing districts in combination whereby the tax incrementrevenues are used as the primary source of repaymentof the municipal bond obligations with the authority toimpose special taxes and assessments as a ‘‘back-up’’source of revenues. In such circumstances, the local

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governmental jurisdiction creates separate TIF �nanc-ing and special taxing districts with the sameboundaries.

Municipal Finance Considerations For TIF

Districts And Special Taxing Districts

The state enabling laws for TIF districts and specialtaxing districts generally authorize local governmentalauthorities (or quasi-governmental authorities) to issuebonds, which are supported by the tax revenues derivedfrom TIF districts and special taxing districts to �nancepublic infrastructure. The infrastructure eligible forsuch �nancing is speci�ed in the enabling legislationand often includes roads, sidewalks, bridges, tunnels,culverts, intersection improvements, streetscape im-provements, street lighting, transit facilities or systems,water and sewer pumping stations and force mains,stormwater management facilities, schools, police sta-tions, �re stations, libraries, civic or governmentalcenters, parks, recreational facilities and other publicfacilities. Oftentimes, the cost of acquisition of the landon which such facilities are to be sited, and in the caseof TIF districts, the cost of demolition and removal ofexisting vacant or underutilized buildings on suchproperties, is also authorized to be �nanced.

Depending upon the state enabling statute, the issu-ance of bonds on behalf of a TIF district or special tax-ing district will require the adoption of a separate reso-lution or ordinance by the local governmental authoritywhich will specify the terms and conditions underwhich the governmental authority will issue the debt.Generally the bonds have maturities of upwards tothirty or forty years. Bonds issued on behalf of suchdistricts may be given an investment grade rating bycommercial credit rating authorities if there is a suf-�cient amount of development completed and a suf-�cient diversity of ownership of the underlying proper-ties; however, in many cases, the debt is unrated.

Bonds issued on behalf of these forms of taxingdistricts are subject to a host of federal tax require-ments, as well as municipal underwriting criteria,which may increase the cost of using this type of�nancing to the project. The primary bene�t to thedeveloper, however, which cannot be overlooked, isthat bonds issued by local governmental authorities areo�-balance sheet obligations for the developer, withrecourse only to the bene�ted property owner. Further,most state enabling statutes provide that the failure ofa single property owner to pay its dedicated taxes willnot permit acceleration of the taxes owed by any otherproperty owner, and accordingly, will not jeopardizean entire project if an individual property owner hasdi�culty paying its taxes. It is often possible to buildin a period of ‘‘capitalized interest’’ whereby the inter-est on the bonds is paid out of bond proceeds pendingthe completion of a larger portion of the developmentand the increase in the tax base resulting therefrom dur-

ing which time the obligation of the property ownersto pay special taxes or assessments is deferred.

Federal Income Tax Considerations

Municipal bonds issued by local governmental authori-ties may be issued on both a taxable and a tax-exemptbasis from the standpoint of federal income taxes(likewise, interest on bonds can receive exemptionsfrom state and local income taxes). While there is alimited market for taxable municipal debt, in mostcases, the o�ering will be structured to insure that theinterest on the bonds will qualify as tax exempt underSection 103 of the Internal Revenue Code of 1986, asamended (the ‘‘Code’’). In order to achieve tax exemp-tion, the bonds must not be deemed to be ‘‘privateactivity bonds’’ under Section 141 of the Code. In gen-eral, to avoid having a bond be treated as a privateactivity bond, no more than 10 percent of the proceedsof the bonds may be used for any private business use.A related test is that no more than 10 percent of theproceeds of the bonds may be secured by an interest inproperty to be used for a private business use or derivedfrom payments in respect of property or borrowedmoney used or to be used for a private business use.For purposes of these tests, the term ‘‘private businessuse’’ means used in a trade or business carried on byany person other than a governmental unit.3

Accordingly, in order for the interest on bonds is-sued on behalf of TIF districts or special taxing districtsto maintain their tax-exempt status, the proceeds of thebonds must be utilized to �nance infrastructure whichis owned and maintained, in substantial part, by agovernmental entity. IRS Regulations issued underSection 141 state that the use during an initial develop-ment period by a developer of an improvement thatcarries out an ‘‘essential governmental function,’’ suchas a road, water system or recreational facility, is notconsidered private business use if the issuer and thedeveloper reasonably expect on the issue date for thebonds to proceed with all reasonable speed to developthe improvement and the property bene�ted by thatimprovement, and to transfer the improvement to agovernmental person, and the improvement is ulti-mately transferred to a governmental person promptlyafter the property bene�ted by the improvement isdeveloped.4 The bonds cannot be used to �nanceprivately owned facilities, such as recreational facili-ties owned by a home owners association, or privatestreets and alleyways, however, and certain jurisdic-tions as a matter of public policy look to see that theinfrastructure is serving a wider population than theowners of the bene�ted development.

Certain other federal income tax requirements ap-plicable to municipal debt may impact the structuringof bonds issued on behalf of TIF districts and specialtaxing districts. For example, the Internal Revenue Ser-vice regulations generally require that the proceeds ofmunicipal bonds be disbursed by the issuer within a

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de�ned period of time, generally ranging from three to�ve years from the date of issuance. These restrictionswill limit the ability to �nance projects with longconstruction periods through a single bond issuance,and may mandate the use of two or more series ofbonds to complete the �nancing of a given infrastruc-ture project. Further, restrictions on arbitrage, or thereinvestment of bond proceeds, will require that bondproceeds be held in yield-restricted accounts pendingdisposition through construction draws or the purchaseof completed infrastructure.5 This in turn may alsolimit the ability of a developer to �nance infrastructurefor a development which will not be constructed orcompleted in close proximity to the date of issuance ofthe bonds.

Municipal Bond Underwriting Criteria

The municipal debt markets have developed a set ofunderwriting criteria which are applied to most TIFdistricts and special taxing districts, whether rated orunrated.6 For example, in most cases, bond underwrit-ers will require that a debt service reserve fund of up to10 percent of the principal amount of the bonds beestablished at the inception of the �nancing, which willbe available to pay debt service on the bonds during aperiod of default or delinquency in the payment of theunderlying tax revenues. The funds in the debt servicereserve may be used to pay debt service during the lifeof the �nancing, or may be applied at the end of the�nancing to reduce the property owner's/taxing juris-diction's funding requirements.

Depending on whether or not an investment gradebond rating is desired, the value of the underlying prop-erty in relation to the annual debt service will need tosatisfy a minimum debt-to-value ratio. For unrateddebt, the minimum value of the land must generally beat least two or three times the amount of the principalamount of the bonds at the time the bonds are issued. Ifthis ratio cannot be supported, which may be the casein the early years of a project, a portion of the bondproceeds may be escrowed and not made immediatelyavailable to the project. Rated debt will require a muchhigher debt-to-value ratio.

Another criteria to be examined is the debt servicecoverage based upon the expected tax revenues. Often-times, the methodology for imposition of the taxes willpermit the increase in special taxes and/or assessmentsup to a certain limit, but generally, there will be restric-tions on the ability to increase taxes if property valuesare not su�cient to supply the necessary debt coverage.Accordingly, underwriters will need to evaluate theunderlying economics of the bene�ted development, aswell as the economic health of the area in question toassess the �nancial viability of the taxing district.

A competing concern for special taxing districts isoften the desire of the local governmental authority tocap the amount of special taxes and assessments whichmay be assessed in any given year to property owners

from an a�ordability standpoint. Since a local jurisdic-tion will have the responsibility for collecting thetaxes, and enforcing the tax sale procedures upon a de-linquency of the property owner, from a politicalstandpoint, it will generally seek to keep the specialtaxes at a reasonable rate.

The ownership of the properties in the district willbe evaluated to see what entities will ultimately beresponsible for paying the taxes on the properties. Gen-erally, the greater the number of property owners,particularly in a residential development, the safer thedistrict is considered. The closer the properties are tocompletion and ultimate sale to third party purchasers,the greater the assurance will be that a single develop-er's deteriorating economic condition will not result ina default in the payment of the taxes and assessments.

In order to assess these criteria, underwriters willoften require appraisals of the underlying property, aswell as engineering studies to assess the cost and feasi-bility of construction of the public infrastructure andmarket studies on the development potential of theproject, to be conducted prior to the sale of the bonds.

Limitations on State and Local Debt Issuance

In addition to the enabling laws which authorize the is-suance of municipal debt for TIF districts and specialtaxing districts, there may be constitutional or other lo-cal law restrictions on the issuance of municipal debtwhich must be considered. Bonds issued on behalf ofTIF districts and special taxing districts are special rev-enue bonds and are not considered general obligationdebt supported by the full faith and credit of the issu-ing authority. However, there may be limitations uponthe ability of the jurisdiction to issue so-called ‘‘over-lapping debt’’ or debt which is considered to be thedebt of another governmental entity payable in wholeor in part by the taxpayers of the jurisdiction. Due tothe concern that taxpayers may have problems payingthe general real property taxes which support the juris-diction when they are also subject to special taxes orassessments, many jurisdictions have adopted �scalpolicies which limit the total amount of overlappingdebt, or at least overlapping debt which is not consid-ered ‘‘self-supporting.’’ In any event, the credit ratingagencies which evaluate the general obligation debt ofa jurisdiction will evaluate the total amount of otherforms of municipal bonds when assigning credit rat-ings to the jurisdiction's general obligation debt, andthe desire of many jurisdictions to maintain as high ageneral obligation bond rating as possible will in�u-ence the appetite of the jurisdiction for the issuance ofrevenue bonds to support TIF districts and special tax-ing districts.

Political Considerations

It goes without saying that given the public nature ofthe �nancing process of special taxing districts and TIF

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districts, the creation of such districts is an inherentlypolitical process. The determination of whether a proj-ect is truly in the public interest when competing forscarce public resources involves a delicate politicalbalancing act by the community, and developers seek-ing to establish these districts need to carefully culti-vate the political leaders in the local jurisdiction andbe prepared for the ancillary political fallout if theirprojects involve particular community concerns. Underthe provisions of many state enabling statutes, theadoption of the resolution or ordinance necessary toestablish the taxing district and/or to issue the bondsrequires that the local jurisdiction conduct a publichearing, which must be generally advertised in the lo-cal media. Further, as noted, the establishment of aspecial taxing district will require the consent of aspeci�ed percentage of property owners. It is notalways possible to anticipate concerns that may beexpressed by persons attending such public hearings orotherwise being alerted to the development by the pub-lication of the notice of the public hearing that a taxingdistrict is being contemplated.

In some jurisdictions, the approval of special taxingdistricts may carry additional bene�ts, including thevesting of development rights, which are tied to the ap-proval of these districts. Further, the approval of adistrict may work in a positive fashion from a govern-mental standpoint, serving as a galvanizing forcebehind obtaining the approval of other governmentalagencies for development approvals and entitlements.

Time Considerations

The creation of TIF �nancing districts and/or specialtaxing districts and the issuance of municipal bonds to�nance such districts will generally take more timethan conventional �nancing due to the requirementsfor the political process, as well as the need to preparethe �nancing documents and to market the bonds toinvestors. With respect to the latter, the following�nancing documents are generally required in order toissue municipal bonds:

E A trust indenture between the issuing governmen-tal authority and a banking institution to providefor the payment of monies owed to the bond hold-ers (which includes the form of bonds);

E A bond purchase agreement between the govern-mental issuer and the ultimate purchaser or pur-chasers of the bonds;

E A disclosure document (O�cial Statement orLimited O�ering Memorandum) and continuingdisclosure agreement wherein the developer andlocal governmental issuer provide disclosures tothe bond purchasers concerning the bond struc-ture and the project, and agree to provide ongo-ing disclosure reports concerning same duringthe life of the bonds;

E A development agreement or other �nancing doc-

ument between the developer and the local gov-ernmental issuer which provides for the disburse-ment of bond proceeds to �nance the constructionof the public infrastructure.

The complexity of the �nancing documentationinvolved and the extended time period needed to cre-ate a TIF district and/or special taxing district and tomarket the bonds generally mandates building in leadtimes of at least six months before bond proceeds canbe disbursed, and makes this process generally imprac-ticable for developments with public infrastructurerequirements of less than $5 to $10 million. The actualtime and cost to create such districts will vary exten-sively from jurisdiction to jurisdiction.

Conclusion

TIF districts and special taxing districts can be a win/win/win situation for the local jurisdiction, the devel-oper, and the ultimate owners of the bene�teddevelopment.

The local jurisdiction is able to ensure that infra-structure necessary to sustain growth in the communitywill be built when it is needed, and not tied to thedevelopment schedule or �nancial condition of thedeveloper. The infrastructure delivery can be acceler-ated from the timetable seen under the typical pro�erarrangement whereby the developer is required to buildcertain public infrastructure only based upon the prog-ress of the development. Further, these �nancial toolscan be used as a carrot that can be used to attractdevelopment to a desired area. In the case of a specialtaxing district, the government is not giving up any taxrevenues it would otherwise get, and in fact will bene-�t from increased general real estate tax receipts andother local taxes that are generated through the in-creased valuation of the properties. In the case of a taxincrement �nancing district, the local jurisdiction isstill gaining properties with increased value, which willultimately result in an increased tax revenue, and whichin the meantime may generate additional sources ofother tax revenues, whether they be personal property,income, sales or other local tax revenues.

For the developer of properties located within suchdistricts, a huge advantage is that the cost of construct-ing the public infrastructure is removed from thedeveloper's balance sheet, which in turn reducesdevelopment cost and frees up capital resources. Thedeveloper is able to pass along the debt service obliga-tion on such infrastructure to the ultimate propertyowners as the property is improved. Further, the inter-est coupon on the tax-exempt bonds is often lower thanthe cost of capital provided through private institutionallenders and private equity, although given the require-ments for debt service reserve funds and the other mu-nicipal debt underwriting criteria discussed, the overallcost of the �nancing may or may not be less expensive.

The ultimate property owners will be bene�ted fromthe assurance that the public infrastructure will be

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provided on a more certain basis without regard to the�nancial condition of the developer. Further, since thedeveloper will not be �nancing the cost of the infra-structure through its own capital resources, the ultimatecost of the project will be reduced, and the developermay be able to pass along the cost savings to the prop-erty owners. In the case of tax increment �nanceddistricts, the owners will pay no additional propertytaxes to the local jurisdiction. While they will incursome additional taxes in the case of special taxingdistricts, such taxes are paid on an annual (or semi-annual) basis, are often escrowed along with other realestate property taxes and are only incurred during theperiod of time that the property is owned by eachpurchaser. Finally, depending upon the type of specialtax or assessment, the property owners may also obtainfederal and state income tax deductions for such taxes.

1 A Summary of State Legislation to Encourage Innova-tive Infrastructure Finance Options, prepared for NationalAssociation of Homebuilders by National Conference ofState Legislatures, August 2005.

2 Building for Tomorrow: Innovative Infrastructure Solu-tions, National Association of Homebuilders, 2003.

3 I.R.C. § 141(b)(6).4 Treasury Regulation § 1.141-3(d)(4).5 I.R.C. § 148.6 Many credit rating agencies, such as Standard and

Poor's, Moody's and Fitch, as well as many municipal bondunderwriters, publish internal guidelines for this type of mu-nicipal debt, and the speci�c circumstances of each districtmust be evaluated by the agencies and underwriters. Theauthor is providing a summary of the factors most commonlyconsidered by such agencies and underwriters in evaluatingthis type of �nancing.

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