What is Special Tax Bond?

A special tax bond is a type of municipal bond that is typically repaid with revenue from a tax levied against an existing activity or asset specifically for that purpose.

Key Takeaways

  • A special tax bond is a type of municipal bond typically repaid with tax revenue levied against an existing activity or asset.
  • A special tax bond is a hybrid security that combines features of a general obligation bond and a revenue bond.
  • Special tax bonds are repaid with either excise taxes or special assessment taxes, but not by ad valorem taxes.

Understanding Special Tax Bond

A municipal bond is issued by a state or local government to fund community projects such as highways, sewage systems, hospitals, parks, and public schools. A municipal bond backed by revenue generated by increasing a particular tax is referred to as a special tax 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. A special tax is usually imposed on the general population through designated taxes. After the tax payments are collected, they are used to make interest and principal repayments on the outstanding bonds.

Bondholders who purchase a special tax bond receive periodic interest from the issuer until the bond matures, at which time the principal will be repaid. Payment obligations are guaranteed from revenue derived from the increment of tax the issuer levies specifically for paying back its debt. Special tax bonds are repaid with either excise taxes or special assessment taxes, but not by ad valorem taxes.

The special tax may include taxes on gasoline, tobacco, hotel stays, road use, sales, 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 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.

Special Assessment Bond

A type of special tax bond is the special assessment bond, which is a bond which has its payment obligations guaranteed from revenue received from the increment of taxes on residents who 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. Because 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.