The 2-Year Construction Spending Exception: Benchmarks, Retainage and the 1.5% Penalty

The 2-year construction spending exception treats the available construction proceeds of a construction issue as meeting the arbitrage rebate requirement when the issuer spends at least 10 percent of those proceeds within 6 months of the issue date, 45 percent within 1 year, 75 percent within 18 months and 100 percent within 2 years.

It is one of three spending exceptions in the federal arbitrage rules, and it is the schedule written around a construction issue's available construction proceeds.

This page works through the construction issue test, the semiannual benchmarks, the 1.5 percent penalty election and what the schedule means for the investment that holds the money between draws.

What makes an issue a construction issue?

A construction issue is a non-refunding issue whose issuer reasonably expects, as of the issue date, that at least 75 percent of the issue's available construction proceeds will be allocated to construction expenditures for property owned by a governmental unit or a 501(c)(3) organization, under Treasury Regulation §1.148-7(f)(1) and section 148(f)(4)(C)(iv) of the Internal Revenue Code.

Any private activity bonds in the issue must be qualified 501(c)(3) bonds or private activity bonds financing property owned by a governmental unit or 501(c)(3) organization.

The ownership condition does the limiting work: construction expenditures for property owned by neither a governmental unit nor a 501(c)(3) organization do not count toward the 75 percent.

The test is judged on reasonable expectations as of the issue date rather than on actual spending.

Under Treasury Regulation §1.148-7(j), an issuer may elect to treat the construction portion of an issue as a separate issue for these purposes.

What counts as available construction proceeds?

Available construction proceeds are the issue price of the bonds plus earnings on that price and on certain reserve funds, reduced by the issue price placed in a reasonably required reserve fund and by the issuance costs the issue finances, under section 148(f)(4)(C)(vi) and Treasury Regulation §1.148-7(i).

That base matters because every percentage in the benchmark table below is measured against available construction proceeds, not against the total principal amount of the bonds.

What must be spent by each semiannual benchmark?

For a construction issue, section 148(f)(4)(C)(ii) and Treasury Regulation §1.148-7(e)(1) treat available construction proceeds as meeting the rebate requirement when at least 10 percent is spent within 6 months of the issue date, at least 45 percent within 1 year, at least 75 percent within 18 months and 100 percent within 2 years.

The rule is semiannual in the sense that the schedule runs in 6-month intervals from the issue date, and each benchmark keeps the exact percentage the regulation sets.

The percentages are floors, because the regulation says "at least" at the first three benchmarks, so spending faster than the schedule does not breach it.

A reasonable retainage of up to 5 percent of available construction proceeds may be spent within 3 years rather than 2, under Treasury Regulation §1.148-7(e)(2) and (h).

When the spending requirements are met, earnings on amounts in a bona fide debt service fund are also treated as exempt, under section 148(f)(4)(C).

The other two schedules fit different spending profiles: the 6-month exception turns on gross proceeds, as specially defined, being spent on the governmental purpose within 6 months of the issue date, with rebate still paid on amounts not required to be spent, under section 148(f)(4)(B) and Treasury Regulation §1.148-7(c).

The 18-month exception carries its own three-step schedule and conditions, and the spending exceptions overview compares all three.

What does the 1.5% penalty in lieu of rebate election do?

Under section 148(f)(4)(C)(vii) and Treasury Regulation §1.148-7(k), the issuer of a construction issue may elect, on or before the issue date, to pay a penalty instead of rebate on the issue's available construction proceeds.

The election is irrevocable once made.

The penalty is calculated separately for each 6-month spending period, including each semiannual period after the end of the fourth spending period, and it equals 1.5 percent of the underexpended proceeds for each period.

Each payment is due within 90 days after the spending period it relates to, under the statute and the Form 8038-T instructions.

The penalty is reported on Form 8038-T, with a separate form for each 6-month period, and Form 8038-G, line 40, records the election itself.

The IRS instructions for Form 8038-T describe it as the form issuers use to make arbitrage rebate and related payments, and the same form carries yield reduction payments, the penalty to end the election, and late-payment penalties and interest, one form per issue, with a check payable to United States Treasury.

The filing mechanics are covered on the Form 8038-T page.

How is the election ended?

Section 148(f)(4)(C)(viii) and Treasury Regulation §1.148-7(l) let an issuer terminate the election by paying 3 percent of the unspent proceeds multiplied by the number of years in the initial temporary period, together with the yield restriction and redemption requirements the provision states.

Whether to make the election, or to end it, is a legal and tax determination for bond counsel and tax counsel.

What happens if a rebate payment is late?

A failure to pay the correct rebate amount on time makes the bonds arbitrage bonds unless the failure was not due to willful neglect and the issuer promptly pays a penalty plus interest, under section 148(f)(7) and Treasury Regulation §1.148-3(h).

The penalty is 50 percent for governmental bonds and qualified 501(c)(3) bonds and 100 percent for other bonds, plus interest at the section 6621 underpayment rate.

The penalty is automatically waived when the missed amount plus interest is paid within 180 days after discovery of the failure, unless the Commissioner determines the failure was due to willful neglect or the issue is under examination during the specified window.

In the other direction, an issuer that overpays claims a refund on Form 8038-R no later than two years after the issue's final computation date, and overpayments under $5,000 generally cannot be recovered before that date, under Treasury Regulation §1.148-3(i).

Proposed regulations published in March 2026 would revise the time and manner for these refund claims.

The computation dates and payment schedule behind these rules are covered in the guide to arbitrage rebate.

Why does the 2-year schedule shape GIC draw schedules?

Because the four benchmarks are fixed dates measured from the issue date, the withdrawal schedule of an investment for a construction fund is specified against the same draw schedule the issuer needs to meet them.

A guaranteed investment contract, a full-flex repurchase agreement or a structured Treasury portfolio can each be sized and written around expected draws.

The solicitation terms for a GIC must take into account the issuer's reasonably expected deposit and drawdown schedule, under Treasury Regulation §1.148-5(d)(6)(iii)(A)(5), which is how providers can price withdrawal provisions against those draws.

When draws run behind the benchmarks and the election is in place, the 1.5 percent penalty applies to the underexpended proceeds of each spending period that misses the schedule, under Treasury Regulation §1.148-7(k), and where no election is in place, the general rebate rules govern the issue's earnings.

The gap between what the fund earns while it waits and the interest the bonds pay is the issue's negative arbitrage.

GFOA's published guidance links limiting negative arbitrage to spending pace: it recommends keeping an investment's duration no longer than the expected drawdown schedule and not issuing well before spending begins.

A project that finishes with money left over, or finishes early, raises a different set of questions covered in the guide to unspent proceeds.

Because the benchmarks start at the issue date, the investment decision runs against the tax calendar before the first draw, which is why bid timing is its own question for a construction fund.

mGIC's spending exception checker works through which schedule an issue's spending profile fits before an investment is bid.

As Bidding Agent and reinvestment advisor, mGIC reviews the fund's objectives, permitted investments and draw schedule, develops the bid specifications, solicits qualified providers, compares the bids on rate and non-rate terms, and coordinates documentation and settlement, delivering a compliance file when the transaction closes.

For an issue that has already closed, mGIC can check your proceeds against the rules as part of a free, no-obligation reinvestment review.

To start that review, or a conversation about a construction fund still being structured, use the contact page.

Whether an issue is a construction issue, whether its actual draws meet the semiannual benchmarks and how the penalty election applies to it are legal and tax determinations that belong to bond counsel and tax counsel.

Last updated 2026-10-06.

This page is general educational information about municipal finance and federal and state rules as of the date shown. It is not legal, tax or investment advice, and it is not a recommendation about any particular investment. Product availability, legality and suitability depend on the issuer, jurisdiction, governing documents and transaction-specific facts. Final legal and tax determinations remain with the issuer's bond counsel, tax counsel and other advisors.