WASHINGTON - The Internal Revenue Service has begun notifying bondholders of the 61 6.25 million River Bay North black box bond issue that they owe back taxes on their interest earnings.
The bonds were issued as tax-exempt in late 1985 by the Duval County, Fla., Housing Finance Authority.
Herbert W. Kay, a citrus grower in Wauchula. Fla., said on Friday the IRS had informed him he owed more than $1,800 in back taxes on the interest earned during 1989, 1990, and 1991 from $25,000 of the River Bay North bonds.
Mr. Kay said he bought the bonds in December 1988 and sold them Wednesday after receiving the IRS notice. The trader who sold the bonds for Mr. Kay said he did not disclose that the IRS was trying to tax them. But the trader, who asked not to be identified, said such disclosure was unnecessary since it has been reported that similar deals are under IRS investigation.
Mr. Kay said he plans to pay the back taxes on the bonds, but will file an appeal with the IRS office in Tampa protesting the action and seeking a refund.
IRS officials in Jacksonville confirmed they have begun sending notices warning investors of questionable bond deals that they owe back taxes on the interest earned from bonds bought as tax-exempt.
"We're shaking up a few people, but we tend to be good at that," said one IRS agent who would not say how many or which issues had been targeted.
The River Bay North issue is one of a growing number of deals the IRS is singling out for enforcement action by taxing bondholders' interest earnings.
Mr. Kay, a longtime investor in municipal bonds, said on Friday that while he applauds the IRS enforcement action against "bad" bond issues, those actions should not be aimed at bondholders.
"The IRS should go after the people who got the profits from these bonds," he said. "I'm a just little sheep, but they're going to shear me.
He chided the bond industry for not doing more to protect bondholders.
"I think the industry ought to get their stuff together on this." he said. it should not be up to the individual buyer like myself." Mr. Kay said it is up to the bond firms "to go to the IRS and find out what's going on. It's nice for them to make their profits, but when trouble comes they scatter like a pack of wolves. "
Mr. Kay complained that the IRS notice was his first indication of a possible tax law problem with the bonds. Duval County Housing Finance Authority officials said they had put a notice in the March 26 issue of The Bond Buyer about the IRS warning that the River Bay North issue might not be tax-exempt.
But Mr. Kay, a Bond Buyer subscriber, said he never saw the notice.
Authority officials said they were not surprised at the IRS' action because the agency had investigated four of its bond issues and informed them in January that three of the issues might not be tax-exempt.
The three issues included the one underwritten by Matthews & Wright to finance the River Bay North apartments, and two others that have never appeared on the lists of deals under federal investigation - a $27 million black box issue sold by Birr Wilson & Co. in June 1987 to finance the Clairborne apartments and a $9.72 million loans-to-lenders issue sold by Matthews & Wright in March 1985 to finance the Reflections of Ponte Vedra apartments. The three projects were not built. The bond firms are no longer in the municipal market.
The IRS told the authority in April that the fourth issue, a $4.5 million Marsh Oaks bond issue, is subject to rebate requirements, but that no arbitrage appears to be due.
R.C. Pitts, the former executive director of the authority, and Richard Browdy, its current chairman, had maintained repeatedly that the authority had had no contact with the IRS regarding any of its bond issues. Mr. Browdy is with Browdy and Browdy Builders in Jacksonville.
But Nathan Krestul, who recently replaced Mr. Pitts, said the authority placed notices in The Bond Buyer stating that the IRS had determined the River Bay North and Clairborne issues might not be tax-exempt. The March 26 notices said the authority would try to negotiate closing agreements with the IRS. In such agreements, the issuer pays the IRS so that bondholders are not taxed.
No notice about the Reflections of Ponte Vedra bonds appeared because the IRS had already begun to tell some holders of those bonds they owed taxes, Mr. Krestul said. "We never had time on that one," he said.
The authority eventually decided against entering into closing agreements with the IRS for all three issues, Mr. Krestul said. "We felt like we had been taken advantage of. We were innocent parties, a conduit issuer," he said.
The IRS' determination of tax liability for each issue, according to papers that accompanied the letters, was roughly $2.4 million for River Bay North, $3.1 million for Clairborne, and $1.2 million for Reflections of Ponte Vedra.
The IRS told the authority that the River Bay North bonds might be taxable arbitrage bonds because the proceeds appeared to be used to acquire a guaranteed investment contract from Crown Life Insurance Co. that had a higher yield than the bonds. In many of the black box housing deals done in the mid-1980s, a mortgage note was supposed to be sold to investors to provide funds for credit enhancement.
But typically the mortgage note was not sold and the bond proceeds were used for credit enhancement instead of housing.
The IRS said also that the authority appeared to have violated Revenue Ruling 85-182 for River Bay North. That ruling says that an issuer must have reasonable expectations that the bonds will be used to construct a project. In addition, the bonds may be subject to rebate requirements, the IRS said.
The River Bay North deal was closed without cash on Dec. 31, 1985, and the bonds were not sold to public investors for cash until Oct. 31, 1986. The bonds are to remain outstanding until March 13, 2006.
The IRS told the authority that the Clairborne bonds might be taxable arbitrage bonds because the proceeds appeared to have been used to purchase a letter of credit from the Sumitomo Trust and Banking Co. whose yield exceeded the bond yield. The IRS said also it appeared the authority could not have reasonably expected the bonds would be used for housing. In addition, the IRS said, the bonds could be taxable private-activity bonds because 95% of the proceed's were not used for a qualified residential rental project."
The bonds were to remain outstanding until June 1, 1997, but were called by the trustee, Premier Bank, on Sept. 4 after Sumitomo declared a default under its credit agreement with the developer and directed the bank to accelerate payment.
The IRS told the authority that the Reflections of Ponte Vedra issue might not be tax-exempt because it appeared the issuer could not have reasonably expected the proceeds to be used for housing, and because at least 90% of the proceeds were not used for a qualified residential rental project. The lower 90% figure applied because the bonds were issued before more stringent tax laws were enacted.
The authority and its lawyers have disputed the IRS' findings on this issue and maintain the project would have been built had the developer not had problems getting sewage treatment service. The authority had asked the IRS on Sept. 1, 1987, to rule that the bonds would not be treated as arbitrage bonds because of project delays, but the IRS refused to do so. The bonds were redeemed in 1988.
The Marsh Oaks issue was closed without cash on Dec. 31, 1985, by Matthews & Wright and was not sold to investors for cash until Oct. 31, 1986. The bonds were treated as spent after they were issued and used to repay the developer's construction loan that financed the project, which was half built at that time.
The bond issue is currently in default and foreclosure proceedings have begun on the project. The project was completed and was 90% occupied, but did not generate enough revenues to pay debt service, the authority's lawyers said.