IRS Takes Aim at Mello-Roos Bond Status : Finances: The agency wants to eliminate tax break for investors who buy the bonds, a move that could slow residential development. It would not affect homeowners’ deduction.

In a move that could slow residential development statewide and increase building costs in fast-growing areas, federal tax authorities have proposed to eliminate the tax exemption for investors who buy California’s Mello-Roos bonds.

The bonds--sold by municipalities, used by developers and repaid by home buyers--are designed to get around the restrictions of Proposition 13’s property tax limit. Since the law became effective in 1982, more than $5 billion in Mello-Roos bonds have been sold essentially as tax-free municipal bonds.

But the Internal Revenue Service, concerned that the public money being raised is enriching private enterprise, is threatening to change current regulations to do away with tax exemption for investors who purchase Mello-Roos bonds in the future.

“We’re at the point where the construction industry is turning up, and many projects are in a vulnerable state,” said Dean Misczynski, director of the State Library’s research bureau who drafted the Mello-Roos law. “The uncertainty created if it is adopted could affect home building in the state.”

The IRS will hold a public hearing June 8 in Washington on its proposed rule, which also would strip the tax-exempt status from similar bonds issued in Minnesota, Arizona and Florida. The proposal sets up criteria for determining which bonds can be taxed and which can remain tax-exempt. It would mark the agency’s first comprehensive revision of these regulations since 1986, industry experts said.

An IRS spokesman said the agency wouldn’t comment during the public comment period.

The state’s home builders and the National Assn. of Bond Lawyers have begun lobbying tax officials to leave the regulation unchanged.

The proposed rule is “a straitjacket that gives cities no flexibility,” Robert G. Goldman, a tax lawyer at Latham & Watkins in Los Angeles, said. Under the proposal, he said, Mello-Roos financing for many projects, such as freeway interchanges, would lose their tax-exempt status.

“It’s possible that a development that’s on the fence isn’t going to get done if this change becomes real,” said Cory F. Cohen, vice president for Kaufman & Broad Corp. in Los Angeles, the state’s largest home builder.

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The use of Mello-Roos bonds has waned, along with the economy.

Nearly $1 billion in Mello-Roos bonds were issued in 1990, but with less building recently, only $662 million were sold last year, according to the California Debt Advisory Commission, a state agency that tracks bonds.

Despite their utility as a financing mechanism, the bonds also have gained a stigma. Builders who have weathered a long recession that has devastated the real estate industry are facing a buying public increasingly reluctant to pay higher property taxes in Mello-Roos developments. Billboards advertising new tracts in the Santa Clarita Valley, for instance, boast “No Mello-Roos.”

The bonds have been used extensively in fast-growing areas such as South County, the Inland Empire and suburban Sacramento to finance new fire stations, libraries and schools during the late 1980s.

Typically, the bonds are issued by a school district or government agency, and a developer’s land is pledged as collateral. Payments initially made by developers are passed on to individuals as the property is sold. Mello-Roos fees show up as an extra levy in property tax bills of businesses and homeowners within specially created districts.

The IRS is not proposing to eliminate the tax deduction that homeowners get in Mello-Roos areas. It is proposing to tax investors on the interest earned on the bonds they buy.

Should the federal tax exemption be stripped, cities and other bond sellers would be forced to increase the yield on the bonds by as much as two percentage points to compete with rates offered on corporate, or high-yield, notes, said Stephen B. Ward, chief investment officer of Charles Schwab Investment Management in San Francisco.

In addition, builders would have higher overhead costs, and prospective home buyers would face higher annual levies. Both consequences would hurt home sales, Kaufman & Broad’s Cohen said.

Misczynski believes that the IRS wants to generate income as well, but he said that the revenue it stands to gain under the proposed rule will be small because developers will use some of the rule’s exceptions to get around it.

Even uncertainty prompted by the IRS proposal is likely to affect construction, said Robert Rivinius, director of the state Building Industry Assn. trade group in Sacramento.

“If I were working on a project,” he said, “I would speed up use of Mello-Roos bonds.”