Private Activity Bonds (PAB) Explanation and Tax Treatment

What Is a Private Activity Bond (PAB)?

Private Activity Bonds are bonds issued by or on behalf of a State or Local Government for the purpose of providing special financial benefits for qualified projects. If the bonds meet specific criteria the interest earned may be tax-exempt. The financing is most often for projects of a private user, and the government generally does not pledge its credit. Private activity bonds are sometimes referred to as conduit bonds.

Understanding Private Activity Bonds (PABs)

Private activity bonds are municipal bonds that are used to attract private investment for projects that have some public benefit; however, there are strict rules as to which projects qualify. Qualified projects that may be financed by private activity bonds include funding and refinancing student loans, airports, private universities, hospitals, affordable rental housing, mortgage provision for first-time lower-income borrowers, etc.

In no event may the proceeds of a private activity bond be used to finance an airplane, certain health club facilities, a gambling facility, stadium, golf course, oil refinery, or a liquor store. This type of bond results in reduced financing costs because of the exception of federal tax.

States and cities, through private activity bonds, are able to borrow on behalf of private companies and nonprofits, lowering borrowing costs for entities that might otherwise turn to corporate bonds or bank loans. Private activity bonds are issued to attract businesses and labor to a region in order to derive a public benefit, which would qualify the bond for tax-exempt status. These bonds pay taxable interest unless specifically exempted by the federal government.

Special Considerations

Under Section 103(a) of the Internal Revenue Code (IRC), interest on private activity bonds is not excluded from gross income unless the bond is a qualified bond. Interest from private activity bonds became subject to the Alternative Minimum Tax (AMT) after the Tax Reform Act of 1986, with the exception of the hospital and non-profit college bonds. All things equal, yields on private activity bonds are higher due to this tax treatment.

According to Section 141 of the IRC, a municipal bond will be deemed a private activity bond if more than 10% of the proceeds from the bond issue are used for any private business, and the principal and interest payment on more than 10% of the sale proceeds of the issue is secured by a private business property. Secondly, a municipal bond will be classified as a private activity bond if the amount of proceeds of the issue used to make loans to non-governmental borrowers exceeds 5% of the proceeds or $15 million, whichever is lesser.