What Is a Private-Purpose Bond?

A private-purpose bond is a municipal bond that is issued to finance a project that benefits a non-governmental entity. By definition, if 10% or more of the benefit of the money raised benefits a private entity, it is a private-purpose bond.

Private-purpose bonds generally do not offer the same tax benefits of other municipal bonds. As such, they are sometimes known as private activity bonds.

The Basics of Private-Purpose Bonds

Generally, municipal bonds are issued in order to finance projects that benefit its residents. It might fund road improvements or finance a senior citizens center.

In some cases, the project may also benefit a private entity. For example, a city might construct a new football stadium. The city expects to benefit economically from the presence of the new stadium, as do the owners of the football franchise. That may make it a private-purpose bond.

The interest payments that investors receive from private-purpose bonds are taxable unless the bonds are specifically exempted.

Investing in Private-Purpose Bonds

The tax benefit is one of the biggest incentives to invest in municipal bonds. They are exempt from federal taxes, and usually from state and local taxes as well, if the investor is a resident of the state or municipality that issued the bond—that is, unless they are private-purpose bonds.

An investor considering buying municipal bonds should check the offering statement. By law, it must contain an opinion by a qualified tax attorney on whether the bonds are public-purpose or private-purpose as defined by the Tax Reform Act of 1986.

In addition, private-purpose bonds are sometimes referred to as taxable municipal bonds. That, of course, makes the difference quite plain without resorting to the fine print in the offering.

Key Takeaways

  • A private-purpose bond is a municipal bond that uses most of its funding to benefit private, non-public activities or private parties.
  • If more than 10% of its proceeds are earmarked for private, non-governmental activities, it is considered a private-purpose bond.
  • While public-purpose municipal bonds are tax-free, private-purpose bonds are not, making the private bonds less appealing to investors than other munis.

The Broader Impact

Before the Tax Reform Act of 1986, municipal bonds intended to spur private economic investment were more common. A depressed city, for example, might issue a bond to help underwrite the construction costs of new industrial development, in hopes of bringing a number of new jobs to town.

The loss of some or all of the tax advantages of a municipal bond made them less attractive to investors.