WASHINGTON -- The interest earnings of bondholders will not be taxed under a tentative agreement reached between Hemet, Calif., and the Internal Revenue Service that will settle tax law violations in connection with two black box bond issues, a city official and other sources said this week.

Under the proposed agreement, participants in the $23.86 million Fountains and Willows multifamily housing black box deals would pay $1.1 million to compensate the IRS for lost taxes on the bonds. In return, the IRS will refrain from taxing the bondholders or taking any enforcement action against the city, sources said.

Steven Temple, Hemet's director of finance, would not confirm the settlement amount, but said the participants in the deals rather than the city would be making the payments to the IRS.

"The city will not be a financial contributor," Temple said.

The city's housing authority issued the multifamily housing bonds in May 1986 and lent the proceeds to a developer to finance construction of the Fountains and Willows apartment projects. The Fountains bond issue was $17.8 million and the Willows issue was $6.06 million.

But the bond proceeds were locked into long-term guaranteed investment contracts and the projects were never built. The arbitrage earnings were never rebated to the federal government even though federal rebate requirements for such bonds took effect on Jan. 1, 1986.

The guaranteed investment contracts and the bonds are still outstanding and are not scheduled to be redeemed until April 1996, according to the bond documents.

Temple said participants in the deals that will contribute to the settlement amount include Miller & Schroeder Financial Inc. in Minneapolis, the lead underwriter; First Bank in Minneapolis [formerly The First National Bank of Saint Paul], another underwriter; James Warren Beebe, a retired lawyer in Los Angeles who was bond counsel; Stubbeman, McRae, Sealy, Laughlin & Browder in Houston and Bankston Wright & Greenhill in Austin law firms that served as counsel to the underwriters; and NationsBank of Texas in Houston [formerly InterFirst Bank Houston], the trustee for the issues.

Other participants in the deals that are no longer in business or could not be located include Hanover West Inc. in Aurora, Calif., another underwriter, and Southwest Capital Investment Corp., which served as mortgage broker, Temple said.

Cambridge Credit Corp. II. in Newport Beach, Calif., was the letter of credit provider and state Mutual Life Assurance Co. in Boston was the guaranteed investment contract provider, Temple said.

The IRS notified the city last March that the bonds violated the tax laws, Temple said. The IRS said, among other things, that the bond proceeds were not used for a governmental purpose and that the two issues could be considered taxable private-activity bonds that violated arbitrage rebate requirements, sources said.

The city and Abe Grossman, the Los Angeles-based developer that was to build the projects, approached the IRS about a possible settlement.

"The Internal Revenue Service surprised us," Temple said. "They did not want to declare the bonds taxable. That was their last option."

During negotiations, the IRS and the city considered the possibility of negotiating with the GIC provider to collapse the GIC, Temple said.

In the current market, the GICs of many black box deals are more valuable than the bonds they are securing because the rates the GICs are paying are higher than the current market rates for the bonds.

In the case of the Hemet deals, the liquidation of the GIC would have provided enough money to both redeem the bonds in full and compensate the IRS for back taxes, Temple said.

But the city and participants in the deals ultimately decided against the idea because they were concerned that bondholders would be upset about the early redemption of the bonds.

"The bondholders would have gained significantly, but they would have lost three years of tax-exempt interest,' Temple said.

The IRS and the participants began negotiating a closing agreement and reached a tentative agreement on July 29, Temple said. The agreement must now be formally approved by all parties and could be completed in September, he said.

In many of the black box deals done in mid-1980s, so named because of their complexity and the difficulty tracing cash flows, the bond proceeds were supposed to be used for the project and the proceeds from the sale of participation interests in the mortgage note were supposed to be used for credit enhancement. But in many cases, as with the Hemet deals, third-party investors were never found for the mortgage note and the bond proceeds were used to acquire a guaranteed investment contract that backed a letter of credit that paid debt service on the bonds.

Temple said the Fountains and Willows deals, which he and others thought were legitimate, have been a real eye opener for him and will make him much more cautious in future tax-exempt financings.

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