IRS Wants to End Mello-Roos Bonds’ Tax-Exempt Status : Real estate: A public hearing is set on the agency’s proposal. It would affect bonds in California and three other states.

In a move that could slow residential development statewide and increase building costs in fast-growing areas, federal tax authorities have proposed eliminating 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 on property taxes imposed by Proposition 13. The bonds have been used extensively in fast-growing areas such as southern Orange County, the Inland Empire and suburban Sacramento to finance new fire stations, libraries and schools during the late 1980s.

Since the law creating them took effect 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 the tax exemption for the interest earned on Mello-Roos bonds purchased in the future.

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.

An IRS spokesman said the agency would not discuss the proposal 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,” said Robert G. Goldman, a tax lawyer at Latham & Watkins in Los Angeles.

Under the proposal, he said, Mello-Roos financing for many projects, like 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 of Kaufman & Broad Corp. in Los Angeles, the state’s largest home builder.

Despite their utility as a financing mechanism, the bonds have also acquired a stigma. Builders who have weathered a long recession that devastated the real estate industry are finding prospective home buyers 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.”

Typically, the bonds are issued by a school district or government agency, with a developer’s land 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 on 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. Should the federal tax exemption be stripped, cities and other bond sellers would be forced to increase the yield on the bonds.