Local governments regularly need to purchase vehicles and other relatively small capital assets. Common examples include police cruisers, fire trucks, sanitation vehicles, radios, technology systems, heavy equipment, and sometimes land or facility improvements. These projects often cost more than can be paid from current revenues, but they are not large enough to justify issuing bonds
In these situations, local governments may look for financing. They may contact a bank, work directly with a vendor, or consider financing programs designed for government borrowers. A vehicle dealer, equipment manufacturer, or contractor, for example, may offer to let the government pay for an asset over several years instead of paying the full price upfront.
Not all of these options comply with North Carolina law. Some lenders understand the legal requirements for local government borrowing and structure their agreements accordingly. Others offer standard commercial loans, lines of credit, or vendor payment plans that are common in the private sector but do not meet those requirements. Because of this, local officials need to understand the legal framework before entering into a financing agreement.
A local government must have legal authority to borrow. For most purchases of vehicles, equipment, land, and smaller construction or renovation projects, that authority comes from installment financing under G.S. 160A-20. This statute allows a local government to acquire a capital asset now and pay for it over time. Although it is often used for smaller purchases, it can also be used for larger projects such as schools, jails, and other public facilities. In fact, installment financing may be used to fund any capital project that the local government has authority to undertake.
To be valid, an installment financing must meet specific statutory requirements. The discussion that follows explains when installment financing applies, how these transactions must be structured, why certain common arrangements such as unsecured loans, vendor title-retention agreements, and lines of credit do not comply, and what steps are required to complete a lawful financing. It also includes a few example financings to illustrate how these requirements apply in practice.
Important Note. Many of these smaller borrowings are arranged directly between a local government and a bank or vendor. Some do not require Local Government Commission approval. Even relatively small transactions, however, can involve complex legal and tax considerations. Installment financings require specific contractual provisions, compliance with statutory procedures, and attention to federal and state tax law. Local officials should consider consulting with a bond attorney, financial advisor, and/or Local Government Commission staff, and doing so early in the process, to ensure the transaction is structured correctly and to avoid problems later.
Is it a Borrowing?
A local government is borrowing when it gets money now to pay for a capital asset and repays that money over time, or when it gets the capital asset now and pays for it over time beyond a commercially standard invoice period.
It does not matter what the agreement is called. It might be labeled a lease, financing agreement, installment purchase, subscription, or something else. It also does not matter whether there is a stated interest rate or whether a bank is involved. If the government receives a capital asset today and commits to making payments over time, it is borrowing.
Common examples include:
- A town buying police vehicles and paying the vendor over several years
- A county financing sanitation trucks through a bank
- A city buying land and paying for it in installments
- A municipality borrowing from a private individual to renovate a building
Some arrangements are less obvious. A contract may be framed as a software or service agreement but include equipment or other capital items bundled into the price. If the government receives that equipment upfront and pays over time, the transaction is still a borrowing, even if part of the contract is for services like maintenance or support.
If any part of the agreement involves paying for a capital asset over time, it should be treated as a borrowing. By contrast, service contracts and true leases are not borrowings, even if the payments are made over time.
Installment Financing Overview
An installment financing allows a local government to purchase property or finance improvements and pay for them over time. Instead of paying the full cost upfront, the government makes scheduled payments over several years.
Under G.S. 160A-20, counties, municipalities, and several other types of local governments may enter into installment contracts secured by some or all of the property being financed. (See G.S. 160A-20(h) for the list of local government entities authorized to use this borrowing method.)
Except when borrowing directly from the state or federal government, installment financing is the only way a county or municipality may borrow money without issuing bonds.
What Can Be Financed
The statute allows installment financing in two main situations.
Purchasing real or personal property
A local government may purchase or refinance the purchase of real property or personal property through an installment contract that creates a security interest in the property being acquired. This includes assets such as vehicles, equipment, land, or buildings.
Financing improvements to real property
A local government may also finance or refinance the construction or repair of fixtures or improvements on real property. In these cases, the lender’s security interest may attach to the improvements themselves, the real property where the improvements are located, or both.
This authority allows installment financing to be used for projects such as new construction, building renovations, facility expansions, or infrastructure repairs or improvements.
Required Structure of an Installment Financing
Every installment financing follows the same basic legal structure. The local government holds an ownership interest in the asset or assets being financed, and the lender, vendor, or other creditor receives a security interest in some or all of that property to secure repayment of the financing obligation.
This requirement is critical. A creditor cannot obtain a security interest in property unless the borrower has an ownership interest in that property. For that reason, the local government holds legal title to the financed asset(s) or improvement(s) in order to grant the required security interest.
Common Financing Structures That Do Not Comply with the Installment Financing Statute
Banks and vendors sometimes propose financing arrangements that are common in private transactions but do not comply with North Carolina’s installment financing statute. The most common examples are described below.
Title Retention by a Vendor or Lender
In some financing arrangements, the vendor or lender retains legal title to the asset until the purchase price is fully paid. This approach is sometimes described as a lease-purchase or conditional sales arrangement.
This structure does not comply with the installment financing statute.
Because the local government must grant a security interest in the financed property, the government must have an ownership interest in the asset at the beginning of the transaction. If the vendor or lender retains title, the government has no ownership interest and therefore cannot grant the required security interest.
Instead, when a vendor or lender allows the government to pay the purchase price over time, the government must receive title to the asset when it is delivered. This applies to all capital projects, including vehicle purchases. The vendor or lender must then take a security interest in the property to secure repayment.
Unsecured Loans
Another issue arises when a bank or other lender proposes an unsecured loan. From the lender’s perspective, this may appear to be the simplest structure because the lender provides funds and relies on the borrower’s general creditworthiness for repayment.
But installment financing requires the borrowing to be secured by all or a portion of the asset or assets being financed. The lender must receive a security interest in that property. An unsecured loan does not meet this requirement.
Lines of Credit
Lenders sometimes offer local governments a line of credit to finance capital purchases or project costs. In this arrangement, the lender commits up to a stated maximum amount, and the borrower may request drawdowns over time as costs arise. The borrower does not have to identify all of the specific assets or projects to be financed when the credit arrangement is established.
This structure does not comply with the installment financing statute.
Installment financing must be tied to identifiable property, and the creditor must hold a security interest in some or all of that property. A revolving credit facility does not meet these requirements because the borrowing is not connected to specific assets when the credit line is created.
A local government may finance multiple projects through a single installment financing, but the assets being financed must be identified at the outset of the transaction. Funds may still be drawn down over time as project costs are incurred, but those drawdowns must relate to the specific assets identified in the financing documents.
Required and Prohibited Contract Provisions
Installment financing contracts must include certain provisions and must avoid others. Some of these requirements come directly from G.S. 160A-20, while others arise from the North Carolina Constitution and the Local Government Budget and Fiscal Control Act.
Non-appropriation Clause
Every installment financing agreement must include a non-appropriation clause. This clause provides that the local government’s obligation to make payments under the contract is subject to the governing board appropriating funds each fiscal year.
The requirement arises from the interaction between the North Carolina Constitution and the Local Government Budget and Fiscal Control Act.
North Carolina Constitution, specifically Article V, Section 4, requires voter approval before a local government may pledge its full faith and credit (taxing power) to secure debt. Installment financing is structured to avoid creating that type of pledge.
At the same time, G.S. 159-13(b)(15) requires governing boards to appropriate funds in future fiscal years to satisfy obligations that come due under multi-year contracts unless the contract expressly reserves the board’s right not to appropriate funds in future budgets.
Without a non-appropriation clause, this statutory requirement would commit future governing boards to make the installment payments. That type of commitment could function as a limited pledge of the government’s taxing power, which would require voter approval under the constitution.
For that reason, installment financing agreements must expressly preserve the governing board’s authority not to appropriate funds in a future fiscal year. If funds are not appropriated, the contract terminates and the lender’s remedies are limited to the collateral securing the financing.
North Carolina courts have recognized this structure. In Wayne County Citizens Ass’n v. Wayne County Bd. of Comm’rs, 328 N.C. 24, 399 S.E.2d 311 (1991), the North Carolina Supreme Court explained that installment financings do not create constitutionally restricted debt because the governing board retains the authority not to appropriate funds in future fiscal years.
Typical non-appropriation language is similar to the following:
The obligations of the [Local Government] to make installment payments under this Contract in any fiscal year are subject to and contingent upon the appropriation of funds for that purpose by the governing board of the [Local Government]. If sufficient funds are not appropriated for the payment of installment payments due in any fiscal year, this Contract shall terminate at the end of the last fiscal year for which funds were appropriated.
In practice, the governing board appropriates funds for the installment payments each year through the annual budget ordinance.
Limitation on Creditor Remedies
Every installment financing agreement must include a no-deficiency-judgment provision that limits the creditor’s remedies to the collateral securing the financing.
Under G.S. 160A-20(f), the creditor’s remedies are limited to enforcing the security interest in the financed property. If the local government fails to make the required payments, the lender may repossess or foreclose on the collateral. The lender may not obtain a deficiency judgment against the local government for any remaining unpaid balance.
The statute also provides that the taxing power of a local government may not be pledged directly or indirectly to secure the financing.
Installment financing agreements must include language similar to the following:
The remedies of the Secured Party upon a default under this Contract shall be limited to enforcement of the security interest granted in the financed property. No deficiency judgment may be rendered against the [Local Government] for any unpaid amounts due under this Contract, and the taxing power of the [Local Government] is not and may not be pledged directly or indirectly to secure the obligations arising under this Contract.
This limitation is central to the statutory structure. Installment financing is permitted without voter approval because the lender’s remedies are limited to the pledged asset(s) rather than the general credit of the local government.
No Nonsubstitution Clause
Installment financing contracts may not include a nonsubstitution clause. A nonsubstitution clause typically attempts to prevent the borrower from replacing the financed asset or from continuing to provide the same service if the financing agreement terminates. These provisions sometimes appear in private leasing arrangements.
Under G.S. 160A-20(d), however, installment financing contracts may not restrict the right of a local government to:
- continue to provide a service or activity, or
- replace or provide a substitute for the property or project financed under the contract.
This prohibition ensures that local governments retain the flexibility to continue providing public services even if a financing agreement terminates.
Procedural Requirements
Installment financings must also follow certain procedural steps.
Public hearing requirement
If the financing involves real property, the governing board must hold a public hearing before entering into the installment financing contract.
This requirement applies to:
- land purchases
- construction projects (including roads, utility pipes, etc.)
- renovations, repairs, or improvements to buildings and other infrastructure
Financings involving only personal property, such as vehicles or equipment, do not require a public hearing.
Notice of the hearing must be published at least 10 days before the hearing. The hearing is on the financing agreement, so there must be a draft of that agreement available so that the public can weigh in on its terms.
Local Government Commission Approval
Some installment financings require approval from the Local Government Commission (LGC).
LGC approval is required if the financing exceeds certain statutory oversight thresholds or if it involves the construction or repair of fixtures or improvements to real property, unless the financing qualifies for a statutory exemption. G.S. 160A-20(e); G.S. 159-148. The flowchart linked here provides guidance on when LGC approval is required. (Note that different thresholds apply for units on the Unit Assistance List (UAL).) For more information on LGC approval of borrowings and other contracts, see Local Government Commission (LGC) Approval of Bonds, Installment Financings, Leases, and Other Contracts Involving Capital Assets (Including Recent Changes Related to Local Governments on the Unit Assistance List).
When reviewing a proposed installment financing, the Commission evaluates whether:
- the project is necessary or expedient
- installment financing is preferable to issuing bonds
- the proposed costs are reasonable
- the local government demonstrates sound debt management practices
- any tax increase required to support the financing would not be excessive
- the local government is not in default on existing debt
LGC staff typically work with local governments before a formal application is submitted to ensure the proposed financing meets statutory requirements. Local governments should contact the LGC as soon as they begin considering borrowing to fund a capital project.
Federal Tax Treatment
Many installment financings are structured so that the interest paid to the lender is tax-exempt under federal and state law. This means the lender does not have to pay federal or state income tax on the interest it receives from the financing. Because the lender’s interest earnings are tax-exempt, the lender is usually willing to offer a lower interest rate to the local government.
This sometimes causes confusion for local officials. The tax-exempt status applies to the interest paid on the borrowing, not to the local government itself. The rule simply allows the lender to exclude the interest it receives from federal and state income tax if the financing meets certain federal requirements.
Many installment financings entered into by local governments qualify for this tax-exempt treatment because the borrowed funds are used to finance governmental capital assets.
To qualify for tax-exempt treatment, several federal tax rules must be satisfied. In general:
- The funds must be used for governmental purposes. The project being financed must serve a public governmental function, such as purchasing police vehicles, building a municipal fire station, purchasing public parkland, constructing a public works facility, or installing county water lines. (These are only a few examples to illustrate.)
- The project must comply with federal limits on private business use. In general, a project financed with a tax-exempt loan cannot provide too much use or benefit to private businesses or private organizations. Federal tax law establishes specific thresholds and tests to determine when private involvement becomes too great. Limited private use is permitted, but if the project exceeds those thresholds, the financing may not qualify for tax-exempt treatment.
- The financing must comply with federal arbitrage rules. These rules limit the ability to borrow money at a tax-exempt rate and invest the proceeds at a higher return. In general, borrowed funds should be spent within certain time periods, and excess investment earnings may have to be rebated to the federal government.
Banks frequently require local governments to complete federal information reporting forms when a financing closes. These forms are filed with the Internal Revenue Service to document the tax-exempt status of the obligation. For smaller financings, lenders typically request IRS Form 8038-GC. For larger financings, they may require Form 8038-G.
Local governments sometimes also incur project costs before the financing closes. For example, a town may purchase equipment or begin construction using available funds and later reimburse itself from the loan proceeds. Federal tax rules allow this type of reimbursement, but only if the governing board adopts a reimbursement resolution before the loan is executed stating that the government intends to reimburse those earlier costs from the financing proceeds. (There are certain timing requirements related to when the resolution must be adopted.)
Because these federal tax rules can be complex, local governments should consult bond counsel when structuring an installment financing that is intended to be tax-exempt. These professionals can help ensure that the transaction is structured properly, that required federal forms are completed, and that the financing continues to comply with federal tax rules after the transaction closes.
Accounts and Escrow Arrangements
G.S. 160-20(c) allows local governments to establish certain accounts to facilitate installment financing transactions. These accounts help manage the flow of funds during the life of the financing and may provide additional security for the lender.
One common example is an escrow. In some transactions, the lender advances all or a portion of the financing proceeds before the local government needs the funds to pay project costs. The proceeds may be deposited into an escrow account and invested until they are disbursed. Funds are then released from the account as invoices are submitted.
For example, a county financing the construction of a new EMS station may receive the full amount of the financing at closing. The proceeds are placed in an escrow account and invested. As the contractor submits invoices for construction work, the escrow agent releases funds to pay those costs. Similarly, a town purchasing several fire trucks may deposit the financing proceeds into an escrow account and draw from that account as each vehicle is delivered and invoiced.
The statute also allows the creation of other accounts that support the repayment structure of the financing. These accounts may include:
- Debt service payment accounts. These accounts hold funds that will be used to make upcoming installment payments. A local government may deposit revenues into the account periodically during the year so that sufficient funds are available when each payment comes due.
- Debt service reserve accounts. These accounts hold a reserve amount that provides additional protection for the lender. If the local government fails to make a scheduled payment, funds in the reserve account may be used to make the payment.
For example, a lender financing a fleet of sanitation trucks might require the local government to maintain a reserve equal to one year of installment payments. The reserve account remains in place for the life of the financing and may only be used if the government fails to make a scheduled payment.
A lender may be granted a security interest in these accounts in addition to the financed property. This means the lender’s collateral may include both the asset being financed and certain related accounts that hold proceeds or repayment funds.
Local governments should use caution when investing borrowed funds that are held in escrow or other accounts. As stated above, federal tax law restricts the ability to earn investment returns on borrowed funds that exceed the interest cost of the borrowing. These arbitrage rules apply to most tax-exempt financings and may require the local government to limit investments or rebate excess earnings to the federal government. Finance officers should work with bond counsel or financial advisors to ensure that investment of installment financing proceeds complies with federal tax requirements.
How These Rules Apply in Practice
The rules above can feel abstract. In practice, the key questions are straightforward: What is being financed? How is the contract structured? And what steps must be completed before the agreement is signed?
The examples below walk through three common transactions and show both the required contract structure and the process requirements, including when Local Government Commission approval is triggered.
Example 1: Bank Financing for a Drainage Project
A city undertakes a drainage improvement project in a flood-prone area with a total cost of $850,000. The city proposes to finance the project through a bank over 5 years at an interest rate of 3.50%, with annual payments of approximately $185,000.
The bank initially proposes a standard unsecured loan. That is not allowed under the statute.
How the contract must be structured
- The contract must clearly describe the project and the property serving as collateral.
- The financing must be secured by the drainage improvements, the underlying land, or both.
- The city must have an ownership interest in the property or improvements in order to grant that security interest.
- The agreement must include a non-appropriation clause.
- The agreement must include a no-deficiency-judgment provision, limiting the bank’s remedies to the pledged property.
- The agreement cannot include a nonsubstitution clause.
- The city may establish an escrow account to hold and disburse proceeds as construction costs are incurred.
Process requirements
- A public hearing is required because the project involves improvements to real property.
- LGC approval is required because the financing involves construction or repairs to real property.
Example 2: Vehicle Purchase from a Vendor
A town purchases four police vehicles from a dealer at a total cost of $240,000. The dealer agrees to allow the town to pay over 4 years at an interest rate of 4.00%, with annual payments of approximately $66,118.
How the contract must be structured
- This is a borrowing and must be structured as an installment financing under G.S. 160A-20.
- The town must take title to the vehicles when they are delivered. The dealer cannot retain title until the final payment is made.
- The dealer must receive a security interest in the vehicles to secure repayment.
- The agreement must include a non-appropriation clause.
- The agreement must include a no-deficiency-judgment provision, limiting the dealer’s remedies to the vehicles.
- The agreement cannot include a nonsubstitution clause.
Process requirements
- No public hearing is required because the financing involves only personal property.
- LGC approval is not required unless the local government is on the Unit Assistance List.
Example 3: Mixed Services and Capital Agreement (Software + Equipment)
A county enters into a three-year agreement with a technology vendor for software, maintenance, and support. The agreement also includes the delivery of servers and networking equipment that will be owned by the county, valued at $1,000,000.
The vendor proposes a single agreement with a bundled annual payment of $399,000 for 3 years and no separation between equipment costs and service costs or grant of a security interest in specific assets. The vendor would retain control over the equipment until fully paid. This structure treats the arrangement as a service contract. However, because the county is receiving equipment now and paying over time, the equipment portion is a borrowing and must comply with G.S. 160A-20.
How the contract must be restructured
- The agreement must be revised to separate and properly structure the equipment component as an installment financing.
- The county must take title to the equipment at delivery.
- The vendor or financing party must receive a security interest in the equipment.
- Capital (equipment): $1,000,000 financed over 3 years at 4.25% (~$364,000/year); Services: $35,000 per year.
- The agreement must include a non-appropriation clause covering the installment payments.
- The agreement must include a no-deficiency-judgment provision, limiting remedies to the equipment.
- The agreement cannot include a nonsubstitution clause.
Process requirements
- LGC approval is not required because although the total financed cost is over $1 million, the repayment period is less than 5 years.
- No public hearing is required because this is personal property.
