CHICAGO — The Gary school district is warning that Indiana’s refusal to allow the district to levy a new tax for debt service payments will lead to teacher layoffs and other classroom cuts.

The district, officially called the Gary Community Schools Corp., appealed to the Indiana tax court over the recent decision by the state’s Department of Local Government Finance denying the school’s request for a new property tax levy to generate roughly $3 million a year to cover debt service payments for a 2004 bond issue.

The bonds, which were issued by the Gary Community School Building Corp., include a backup pledge that allows the district to raise property taxes without voter approval. But it is subject to approval by the DLGF, which reviews and approves all local government budgets and tax levies.

In rejecting the school’s request, the department said that the district has sufficient money in its general fund to cover ­payments. The district appealed, saying that continuing to make debt service payments out of its shrinking general fund, as it has done since 2004, would lead to operational cuts.

Shifting the obligations to a so-called exempt debt-service fund would allow the district to impose a tax levy and avoid cuts, according to Jimmy Shanahan of Shanahan & Shanahan LLP, the firm representing the district.

Bond default is not a concern, he said.

“The debt is going to be paid regardless, but if it’s from the general fund, we will have to make other cuts,” Shanahan said. “The bonds are safe — they’re going to be paid — but the question is, can we hurt the children less? [The DLGF] has taken a position beyond their authority and is being more aggressive than they’re allowed to be.”

Like the city, the Gary school system has spent the last few years watching its general fund shrink. Falling enrollment has meant a drop in state aid, and the district’s general fund has dropped 28% since 2004, school officials said, to $104.4 million this year from $145.2 million in 2004.

The $20.5 million first-mortgage debt issue in 2004 is secured by a 25-year lease held by the school district, which makes semiannual payments of about $2.8 million directly to the bond trustee.

The bonds featured an unlimited ad-valorem tax pledge and carried an underlying rating of AA-minus from Standard & Poor’s, based on support from the Indiana State Aid Intercept Program. That rating is currently AA-plus.

“The DLGF approved the lease and in approving the lease, they expressly stated that if we ever needed to levy a tax, we could,” said Shanahan.

The bonds were insured by Financial Guaranty Insurance Co. The issue included serial bonds that matured through 2017 and three sets of term bonds maturing in 2019, 2023, and 2029. They are refundable in 2017.

A piece of the debt with a 2019 maturity traded at 3.59% in early April, according to Thomson Reuters. Bonds with a 2023 maturity were trading at 4.25% as of April 11 and bonds with 2029 maturity were trading at 4.67% as of May 11.

The proceeds were used to build two new elementary schools.

ABN AMRO Financial Services Inc. was the underwriter. Ice Miller LLP was bond counsel. The Ice Miller attorney representing the district was James Shanahan, who in 2009 went on to launch Shanahan & Shanahan with nephew Jimmy Shanahan.

Gary is located in Lake County, one of only two counties — along with St. Joseph — that is exempt from a statewide cap on property taxes enacted in 2008.

The new law caps homeowner bills at 1% of the home’s assessed value, and residential property bills to 2%, and commercial property to 3%.

Voters last November approved a measure that enshrines the tax caps in the state constitution in 2012. The special exemptions for Lake and St. Joseph counties, however, do not expire until 2019.

Officials from the DLGF declined to comment because the case is in ­litigation.

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