What is Special Assessment Bond?

Special assessment bonds are general obligation bonds, commonly issued to fund development projects, where the interest owed is paid by taxes levied solely on the beneficiaries of that project.

Key Takeaways

  • Special assessment bonds are general obligation bonds, commonly issued to fund development projects, where the interest owed is paid by taxes levied solely on the beneficiaries of that project.
  • Interest on special assessment bonds is exempt from federal taxes, and most state and local taxes.
  • Special assessment taxes cannot exceed the total cost of the project.

Understanding Special Assessment Bond

A municipal bond is issued by a state or local government to raise capital to fund projects such as highways, sewage systems, recreational parks, public schools and so on. When a municipal bond is issued to sponsor the improvement of properties in a specific area of a city, town, or county, the bond is referred to as a special assessment bond.

Investors that purchase a special assessment bond receive periodic interest from the issuer until the bond matures, at which time the principal will be repaid to bondholders. The payment obligations on the bond are guaranteed from revenue that is received from the portion of taxes levied on residents that directly benefit from the project. In other words, additional tax is imposed only on those who will benefit directly from the improvement to defray the payments on the bond issue. Special assessment taxes cannot exceed the total cost of the project.

For example, if a special assessment bond was issued to pay for sidewalks to be re-paved in a certain community, an additional tax would be levied on homeowners in the area benefiting from this project. Area homeowners get nicer walking paths, and will probably see the value of their property increase accordingly, but this comes at a price. Their property taxes will increase to pay the interest owed to the bondholders by the municipality. Since the interest on special assessment bonds is paid by taxes of the community that benefit from the development, it is not unusual for the members of the benefiting community to invest in the issue, thereby, offsetting the additional taxes that are levied in order to finance the bond.

The interest on a special assessment bond may be fixed or variable. The length of maturity will vary depending on how complex the project is, with the typical maturity range falling between one to 20 years. Furthermore, these bonds may or may not be backed by the full faith and credit of the municipal government. If it is not secured by a full faith and credit pledge, it is more risky than a general obligation bond of the same issuer.

Like most municipal bonds, the interest on special assessment bonds is exempt from federal taxes, and most state and local taxes if the investor lives in the state or municipality issuing the debt. The higher an investor's marginal tax rate, the more valuable the bond's tax exemption is and, thus, more desirable. Therefore, there is usually stronger demand for special assessment bonds in states with high tax rates. If a state or the federal government reduces tax rates, the bonds lose some of their advantage for high-tax-bracket individuals and, thus, become less desirable.