What is a Private-Purpose Bond?

A private-purpose bond is a municipal bond that allows over 10% of its proceeds to be used for private activities. When a municipal bond is issued and a significant portion of its proceeds is used for a project or activity run by a non-governmental entity, it is called a private-purpose bond. Usually, municipal bonds are issued by the state or a government agency to fund projects that will benefit residents of the municipality. If such a bond is issued and more than 10% goes into private activities it is a private-purpose bond.

How Does a Private-Purpose Bond Work?

Private-purpose bonds are subjected to different tax treatments than other municipal bonds. Most private-purpose bonds are fully taxable, with exception to those used for private activities in rural communities. Those are exempted from federal taxes as contained in the Tax Reform Act of 1986. A local government can issue a private-purpose bond when seeking to raise money for a private company. Especially if the project to be executed will increase the employment level in the area and also attract more business and investments.

Investing in Private-Purpose Bonds

Investors who choose to invest in private-purpose bonds often expect a tax exception on their dividends. Despite that most of these bonds are not subject to federal taxes, investors are required to pay taxes on interest payments received. It is important that investors check the offering statements of municipal bonds before they buy them. The offering statement will state whether the bonds are for a public purpose or private purpose and their tax treatment according to the Tax Reform Act of 1986. Hence, private-purpose bonds can either be taxable or non-taxable municipal bonds. Here are some key points to know about a private-purpose bond;

• A private-purpose bond is a municipal bond that uses more than 10% of its proceeds to fund non-public activities or private projects.
• Local governments issue private-purpose bonds when seeking to raise capital for a private company who've activities will benefit the local community in the long run.
• Private-purpose bonds differ from public-purpose funds whose proceeds are only used to fund government activities.
• Private Purpose Bonds are taxable municipal bonds, except if exempted by the Tax Reform Act of 1986.

The Broader Impact 

Prior to the passage of the Tax Reform Act of 1986, private purpose bonds were not only attractive to investors but also constantly issued by local governments or municipalities to fund private projects. The motivation behind the issuance of these bonds for the government is the expansion of business, the creation of more jobs and better opportunities for the local area. However, after the Tax Reform Act of 1986, private-purpose bonds became less attractive to investors given the full payment of tax.