DEFINITION of Special Tax Bond

A special tax bond is a type of municipal bond that is repaid with revenues derived from taxation of a particular activity or asset. These bonds are repaid with either excise taxes or special assessment taxes, but not by ad valorem taxes.

BREAKING DOWN Special Tax Bond

A municipal bond is issued by a state or local government to raise capital to fund projects, such as highways, sewage systems, hospitals, recreational parks, public schools, etc. that are beneficial to the community. A municipal bond that is backed by revenues generated by increasing a particular tax is referred to as a special tax bond.

Investors that purchase a special tax 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 gotten from the increment of tax that the issuer levies specifically for fulfilling its debt obligations. The tax is usually imposed on the general population through designated taxes depending on the city or state. After the tax payments are collected, they are used to make interest payments and principal repayments on the outstanding bonds.

Special taxes may include taxes on gasoline, tobacco, hotel stays, road use, sales, business license, etc. Ad valorem taxes are usually not considered for these types of bonds. Revenue from special taxation must be used for no other purpose but to pay holders of the bond used to finance the specific project. The bond indenture or resolution may include guidelines on how the tax proceeds are to be used for the duration of the bond’s life.

For example, say a special tax bond is issued by a city to fund the building of a new hospital wing dedicated to the treatment of cancer. Investors who purchase this bond expect to receive interest income in return for lending the city their money. The city guarantees the interest payments by levying an excise tax on cigarettes at the point of sale. The revenue from the tax is used to pay the debt to bondholders.

A type of special tax bond is the special assessment bond – a bond which has its payment obligations guaranteed from revenue that is gotten from the increment of taxes on residents that directly benefit from the project. In other words, those who will benefit directly from the property improvement are levied an additional tax to help with the interest payments on the bond issue. An example of a project for which a special assessment bond may be issued is the building of a new freeway. People who live in nearby areas of the proposed freeway would be subject to an increased property tax based on their likelihood of using the new road. Since the interest on special assessment bonds is paid by taxes of the community that benefit from the development, it is not unusual for members of the benefiting community to invest in the issue, thereby, offsetting the additional taxes that are levied in order to finance the bond.

A special tax bond is a hybrid security that combines features of a general obligation bond and a revenue bond. As a revenue bond, the special tax bond services its debt from special taxation funds. As a general obligation bond, it is secured by the full faith and credit of the municipal issuer.