THE SHORT ANSWER
A debt service fund is where an issuer deposits to pay debt service on time. One used primarily to match revenues with those payments, depleted at least once each bond year apart from a reasonable carryover, is bona fide. It gets a 13-month temporary period. Bond-year gross earnings under $100,000 keep earnings out of rebate, a limit lifted for non-PAB fixed-rate issues of 5-year or longer average maturity.
How a debt service fund can be invested depends on where the account sits under the federal arbitrage rules, and those rules treat a bona fide debt service fund differently from an ordinary proceeds fund: amounts in a bona fide debt service fund qualify for a 13-month temporary period under Treasury Regulation §1.148-2(e)(5)(i), and earnings on such a fund are excluded from rebate when the fund's gross earnings for the bond year are under $100,000 under section 148(f)(4)(A)(ii) of the Internal Revenue Code.
The MSRB glossary describes a debt service fund as the account an issuer makes periodic deposits into so that debt service is paid on time, and notes that it may contain a separate principal account and interest account in which funds for those respective purposes are held.
This guide covers what makes the fund bona fide, what its 13-month period does, when its earnings stay out of rebate, and what the short-term investment choices look like; the funds overview maps the construction fund, the debt service reserve fund and the rest of the flow of funds.
What makes a debt service fund bona fide?
Treasury Regulation §1.148-1(b) treats a debt service fund as bona fide when it is used primarily to match revenues with principal and interest within each bond year and, apart from a reasonable carryover amount, is depleted at least once each bond year.
The regulation allows one exception to the depletion requirement: a reasonable carryover amount, not to exceed the greater of the earnings on the fund for the immediately preceding bond year or one-twelfth of the principal and interest payments for that year.
The arbitrage definitions also reach accounts with other names: Treasury Regulation §1.148-1(c)(2) says a sinking fund includes a debt service fund, redemption fund, reserve fund, replacement fund or any similar fund, to the extent reasonably expected to be used directly or indirectly to pay principal or interest on the issue.
The replacement proceeds guide covers when those funds count as gross proceeds of an issue.
The classification carries weight because the tax exclusion sits beside it: section 103(a) of the Internal Revenue Code excludes interest on state and local bonds from gross income, and section 103(b)(2) withdraws that exclusion from any arbitrage bond within the meaning of section 148.
Whether anything a fund holds or earns affects an issue's tax status depends on all of sections 103 and 141 through 150, and that conclusion belongs to bond counsel and tax counsel.
What is the 13-month temporary period for a debt service fund?
Amounts in a bona fide debt service fund qualify for a temporary period of 13 months under Treasury Regulation §1.148-2(e)(5)(i).
The period matters because of what it suspends: outside a temporary period, Treasury Regulation §1.148-2(d)(2)(ii) treats the yield on investments allocable to replacement proceeds as materially higher than the bond yield when it exceeds the bond yield by more than one-thousandth of 1 percentage point, and whether a fund's amounts are replacement proceeds is a determination for bond counsel.
How temporary periods work across the fund types, and what happens when one ends, is the subject of the guide to the 13-month temporary period.
The 13 months is the length of the window amounts qualify for, not a required holding period for the fund's balances.
The same regulation paragraph pairs the debt service rule with a much shorter window: other replacement proceeds generally get 30 days from the date they first become replacement proceeds under §1.148-2(e)(5)(ii).
If only part of a fund qualifies as a bona fide debt service fund, only that part gets the 13 months.
The period also should not be confused with the working capital temporary period: proceeds reasonably expected to be allocated to working capital expenditures within 13 months after the issue date qualify for 13 months under Treasury Regulation §1.148-2(e)(3)(i), a rule that runs from the issue date and addresses a different category of spending.
| Amounts | Temporary period | Rule |
|---|---|---|
| Bona fide debt service fund | 13 months | Treas. Reg. §1.148-2(e)(5)(i) |
| Other replacement proceeds | 30 days from the date they first become replacement proceeds | Treas. Reg. §1.148-2(e)(5)(ii) |
| Working capital, reasonably expected to be allocated to working capital expenditures within 13 months after the issue date | 13 months from the issue date | Treas. Reg. §1.148-2(e)(3)(i) |
When are earnings on a bona fide debt service fund excluded from rebate?
Section 148(f)(4)(A)(ii) of the Internal Revenue Code excludes earnings on a bona fide debt service fund from rebate when the gross earnings on the fund for the bond year are less than $100,000.
The statute tests gross earnings on the fund for the bond year, so the measurement runs bond year by bond year.
That is a fund-specific exclusion rather than the general rebate machinery; the rebate requirement guide covers how rebate is computed, when installments are due and how it is paid.
The statute then lifts the dollar limit for one category: the $100,000 limit does not apply to non-PAB issues with an average maturity of at least 5 years and fixed interest rates, where PAB stands for private activity bond.
IRS Publication 5271 adds that an issue meets the $100,000 test if average annual debt service is not greater than $2,500,000.
The $100,000 figure is not indexed for inflation.
| Route through the exclusion | Condition | Source |
|---|---|---|
| Gross earnings test | Gross earnings on the fund for the bond year are less than $100,000 | 26 U.S.C. §148(f)(4)(A)(ii) |
| Dollar limit lifted | The issue is not a private activity bond, has fixed interest rates and an average maturity of at least 5 years | 26 U.S.C. §148(f)(4)(A), flush language |
| Pub. 5271 sizing measure | Average annual debt service is not greater than $2,500,000, which IRS Publication 5271 says meets the $100,000 test | IRS Pub. 5271 |
The exclusion is written for the fund itself, and the rebate exceptions keyed to how quickly proceeds are spent are the separate subject of the spending exceptions guide.
Whether a particular issue meets the exclusion in a given bond year is a conclusion for tax counsel.
What are the short-term investment choices for a debt service fund?
GFOA's guidance on investing bond proceeds describes typical horizons of about 6 months for a debt service fund's interest account and about 12 months for the principal account.
GFOA presents those figures as typical rather than as rules, notes that expectations vary, and directs issuers to their advisory team and investment policy.
The horizons run to the payments the fund exists to cover, the principal and interest dates, rather than to a market view.
One structure built around dated payments is the forward: the MSRB glossary describes a forward, also called a forward delivery agreement, as a contract that may provide for the delivery of specific types of securities on specified future dates at fixed yields, a purpose it illustrates with the investment of a debt service reserve fund.
The forward delivery agreement guide covers how those arrangements are specified and bid.
Treasury's State and Local Government Series (SLGS) program was established in 1972, TreasuryDirect notes, as the result of federal legislation enacted in 1969 that restricted state and local governments from earning arbitrage profits on bond proceeds.
The SLGS guide covers the program's securities and subscription mechanics.
The products guide lists the wider set of instruments, including guaranteed investment contracts, repurchase agreements and structured Treasury portfolios, and the guides on money market funds and local government investment pools cover the options for balances that must stay available on short notice.
Where a debt service fund already holds an investment, mGIC's free reinvestment review looks at the fund's objectives, permitted investments and timing, and the contact page is where that conversation starts.
The final determinations, including a fund's bona fide status, its temporary period and its rebate treatment, belong to bond counsel and tax counsel.
Frequently asked questions
Why does depletion each bond year matter for the fund's treatment?
Depletion at least once each bond year is part of the bona fide definition in Treasury Regulation §1.148-1(b), subject to the carryover allowance. The 13-month temporary period of §1.148-2(e)(5)(i) and the rebate exclusion of section 148(f)(4)(A)(ii) are both written for bona fide debt service funds. Whether a particular fund is bona fide is a determination for bond counsel and tax counsel.
How is the carryover amount measured at the depletion date?
Treasury Regulation §1.148-1(b) allows a reasonable carryover not to exceed the greater of the earnings on the fund for the immediately preceding bond year or one-twelfth of the principal and interest payments for that year.
Which issues can use the exclusion without the $100,000 test?
The statute says the $100,000 limit does not apply to non-PAB issues with an average maturity of at least 5 years and fixed interest rates. For the test itself, IRS Publication 5271 says an issue meets the $100,000 test when average annual debt service is not greater than $2,500,000.
Do the two debt service accounts carry the same horizon?
GFOA's guidance describes a typical horizon of about 6 months for the interest account and about 12 months for the principal account, and presents both as typical rather than as rules.
Sources
- 26 CFR 1.148-1, Definitions (sinking fund, bona fide debt service fund)
- 26 CFR 1.148-2, General arbitrage yield restriction rules
- 26 U.S. Code § 148, Arbitrage
- 26 U.S. Code § 103, Interest on State and Local Bonds
- IRS Publication 5271, Complying with Arbitrage Requirements
- MSRB Glossary of Municipal Securities Terms, 3rd ed. (Aug. 2013)
- GFOA, Investment and Management of Bond Proceeds
- TreasuryDirect, About SLGS
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.
