THE SHORT ANSWER
Three spending exceptions can exempt bond proceeds from arbitrage rebate: the 6-month exception under Section 148(f)(4)(B), the 18-month exception under Treasury Regulation §1.148-7(d), and the 2-year construction exception under Section 148(f)(4)(C)(ii). Each requires proceeds to be spent on schedule; rebate is still owed on amounts not required to be spent.
The federal arbitrage rules give an issuer three spending exceptions that treat bond proceeds as meeting the rebate requirement when the proceeds are spent on schedule: the 6-month exception, the 18-month exception and the 2-year construction exception.
Each exception removes the rebate on the proceeds its schedule requires to be spent, while rebate continues to apply to amounts not required to be spent, under Section 148(f)(4) of the Internal Revenue Code and Treasury Regulation §1.148-7.
This page is part of mGIC's guide to arbitrage, yield restriction and rebate.
The spending exceptions at a glance
A spending exception is a spending schedule measured from the issue date, and an issue meets the rebate requirement for scheduled proceeds by following it.
| Exception | Where the rule is | Applies to | Schedule |
|---|---|---|---|
| 6-month | Section 148(f)(4)(B); Treas. Reg. §1.148-7(c) | Any issue, including refunding issues | 100% of specially defined gross proceeds within 6 months |
| 18-month | Treas. Reg. §1.148-7(d)(1) | Issues whose gross proceeds all qualify for the 3-year capital project temporary period | At least 15% within 6 months, at least 60% within 12 months, 100% within 18 months |
| 2-year construction | Section 148(f)(4)(C)(ii); Treas. Reg. §1.148-7(e)(1) | Construction issues, on available construction proceeds | At least 10% within 6 months, at least 45% within 1 year, at least 75% within 18 months, 100% within 2 years |
Only the 6-month exception applies to refunding issues, under Treasury Regulation §1.148-7(b)(1)(ii)(A).
What about the bona fide debt service fund exception?
A separate rebate exception excludes earnings on a bona fide debt service fund when gross earnings on the fund for the bond year are less than $100,000, under Section 148(f)(4)(A)(ii).
The $100,000 limit does not apply to an issue that is not a private activity bond and that has an average maturity of at least 5 years with fixed interest rates.
IRS Publication 5271 adds that an issue meets the $100,000 test if its average annual debt service is not greater than $2,500,000.
The $100,000 amount is not indexed for inflation.
How does the 6-month exception work?
The 6-month exception treats an issue as meeting the rebate requirement when its gross proceeds, as specially defined for this exception, are allocated to expenditures for the governmental purposes of the issue within the 6-month period beginning on the issue date, under Section 148(f)(4)(B) and Treasury Regulation §1.148-7(c).
For this exception, gross proceeds are specially defined: the definition excludes amounts in a bona fide debt service fund, amounts in a reasonably required reserve fund, amounts not expected at issuance that arise after 6 months, and certain purpose-investment receipts and grant repayments.
Reserve fund earnings remain subject to rebate even though reserve fund amounts sit outside the spending test.
Section 148(f)(4)(B)(ii) allows 1 year instead of 6 months for up to 5 percent of the proceeds of certain governmental issues.
Rebate is still paid on amounts the exception does not require to be spent.
If rebate has already been paid on proceeds that an exception covers, Treasury Regulation §1.148-3(i) lets the issuer request a refund of the overpayment on Form 8038-R no later than 2 years after the issue's final computation date.
Overpayments under $5,000 generally cannot be recovered before the final computation date.
Treasury's March 2026 proposed regulations would revise the time and manner for refund claims, so the claim mechanics may change if the proposals are finalized.
The detailed mechanics are on the 6-month exception page.
What does the 18-month exception require?
The 18-month exception treats an issue as meeting the rebate requirement when at least 15 percent of gross proceeds are spent within 6 months, at least 60 percent within 12 months and 100 percent within 18 months, under Treasury Regulation §1.148-7(d)(1).
Rebate still applies to amounts the schedule does not require the issuer to spend.
All gross proceeds must qualify for the 3-year capital project temporary period for the exception to be available.
The exception also cannot be used if any portion of the issue uses the 2-year exception, under Treasury Regulation §1.148-7(d)(4).
Investment earnings for the first two spending periods are based on the issuer's expectations on the issue date, under §1.148-7(d)(3)(ii).
A reasonable retainage does not cause failure of the third spending period if it is spent within 30 months of the issue date, under §1.148-7(d)(2), with the retainage measured against net sale proceeds 18 months after the issue date.
The 18-month exception appears in the regulations rather than the statute, so the operative text is §1.148-7(d).
The full conditions are on the 18-month exception page.
How does the 2-year construction exception work?
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, at least 45 percent within 1 year, at least 75 percent within 18 months and 100 percent within 2 years.
A reasonable retainage of up to 5 percent of available construction proceeds may be spent within 3 years, under Treasury Regulation §1.148-7(e)(2) and (h).
When the spending requirements are met, earnings on a bona fide debt service fund are also exempt, under Section 148(f)(4)(C).
The regulations provide an accommodation for a miss on the final spending deadline: Treasury Regulation §1.148-7(b)(4) disregards a shortfall from the final spending requirement of the 18-month or 2-year exception when the issuer used due diligence to complete the project and the shortfall is no more than the lesser of 3 percent of the issue price or $250,000.
Because the schedule measures spending against fixed dates, the construction fund investment can be built around the project's draw schedule.
The retainage rules and the rest of the schedule are on the 2-year exception page.
Which elections does an issuer make at issuance?
The construction issue's penalty in lieu of rebate must be elected on or before the issue date, under Section 148(f)(4)(C)(vii), and it is irrevocable once made.
The schedule choice is also constrained: Treasury Regulation §1.148-7(d)(4) makes the 18-month exception unavailable when any portion of the issue uses the 2-year exception.
Form 8038-G line 40 records the election.
Whether an issue follows one schedule or the other, and whether to elect the penalty, are legal and tax determinations for bond counsel and tax counsel.
How does the 1.5% penalty in lieu of rebate work?
Section 148(f)(4)(C)(vii) and Treasury Regulation §1.148-7(k) let the issuer of a construction issue elect, on or before the issue date, to pay a penalty instead of rebate on available construction proceeds.
The penalty is 1.5 percent of the underexpended proceeds for each 6-month spending period, calculated separately for each period, including each semiannual period after the end of the fourth spending 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 issuer reports the penalty on Form 8038-T, with a separate form for each 6-month period.
Section 148(f)(4)(C)(viii) and Treasury Regulation §1.148-7(l) let the issuer terminate the penalty by paying 3 percent of the unspent proceeds times the number of years in the initial temporary period, together with the rule's yield restriction and redemption conditions.
The filing mechanics are covered on the Form 8038-T page.
Before an investment is bid, the issue's expected draws can be mapped against the schedule it will follow, and mGIC's spending exception checker works through that question for a specific issue.
An independent Bidding Agent can then structure and competitively bid the construction fund investment around the dates the schedule sets.
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 a review or a conversation about a construction fund investment, contact mGIC.
Final determinations about which exception an issue meets, and whether to elect the penalty, belong to bond counsel and tax counsel.
Frequently asked questions
Can a refunding issue use the 18-month or 2-year exception?
No. Treasury Regulation §1.148-7(b)(1)(ii)(A), restated in the Form 8038-T instructions, makes the 6-month exception the only spending exception applicable to refunding issues.
Is the $100,000 debt service fund earnings limit adjusted for inflation?
No. Section 148(f)(4)(A)(ii) sets the limit at $100,000 of gross earnings for the bond year, and the statute does not index the amount.
What happens if an issuer misses the final spending deadline by a small amount?
Treasury Regulation §1.148-7(b)(4) disregards a shortfall on the final spending requirement of the 18-month or 2-year exception when the issuer used due diligence to complete the project and the shortfall is no more than the lesser of 3 percent of the issue price or $250,000.
Does meeting a spending schedule also lift yield restriction?
No. Rebate and yield restriction are separate sets of rules: bonds are tested under both the yield restriction rules of Section 148(a) and the rebate rules of Section 148(f), and failing either set makes the bonds arbitrage bonds. The 18-month exception, for example, is available only when all gross proceeds qualify for the 3-year capital project temporary period, so the issue has to fit both sets of conditions.
Who determines which spending exception an issue can use?
The legal and tax conclusions, including whether an issue meets a spending schedule and whether to elect the 1.5 percent penalty, belong to bond counsel and tax counsel. An advisor can model the schedule and structure the investment around the dates it sets.
Sources
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.
