Private Activity Bonds

Summary

A private activity bond is a municipal bond which is either used entirely or partially for private purposes and is given federal tax-exempt status. General types of private activity bonds are:

• an exempt facility bond
• a qualified mortgage bond
• a qualified veterans mortgage bond
• a qualified small issue bond
• a qualified student loan bond
• a qualified redevelopment bond
• a qualified 501(c)(3) bond

Private activity bonds must meet the test of qualification outlined within federal tax law to obtain tax-exempt status. To qualify as a private activity, tax-exempt bond, the debt must fit into one of the seven categories above, meet volume cap requirements, and satisfy several other requirements outlined of the statutes.

Advantages

• Tax-exempt bonds offer private entities lower interest rates than they would otherwise be able to obtain.
• A government can use private-activity bonds to give economic incentives to targeted activities or geographic areas.
• Some economists believe that the incentive given by tax-exempt status through private- activity bonds creates positive economic effects beyond the specific project or program that is being financed.

Disadvantages

• The purpose of private-activity bonds must be defined specifically and must be used according to the limitations of the state and federal statutes.
• The numerous and strict limitations on private activity bonds make them inflexible. Changes in their purpose may make them taxable.
• Volume caps limit the availability of private activity bonds. Each state's cap is determined by a formula computed as the greater of either $50 per capita or $150 million.
• Expedient financing is difficult due to the annual application and approval process.

Private Activity Bonds

Private activity bonds are used either entirely or partially for private purposes and are given federal tax-exempt status. Section 141 of the Internal Revenue Code qualifies a bond as tax- exempt if it meets the private business test and falls within one of the seven categories.

The Private Business Test

A bond issue is categorized as a private-activity, tax-exempt bond if it meets the following criteria:

• the "private business use test" - more than ten percent of the proceeds of the issue are to be used in the trade or business of any person other than a governmental unit; and
• the "private security or payment test" - more than ten percent of the payment of principal or interest on the issue is, directly or indirectly, secured by property used in a trade or business, or derived from payments related to property used in a trade or business; or,
• the "private loan financing test" - the amount of the proceeds of the issue to be used to make or finance loans to persons other than governmental units exceeds the lesser of five percent of such proceeds, or $5,000,000.

Federal Private Activity Bond Categories

Federal law outlines the following categorical definitions for private activity bonds:

• an exempt facility bond is used to finance certain types of facilities; (These facilities include government owned airports, docks and wharves; mass commuting facilities; facilities for the furnishing of water, sewage treatment, or solid waste disposal; qualified residential rental projects; facilities for local furnishing of electric energy or gas; local district heating or cooling facilities; qualified hazardous waste facilities; and high-speed intercity rail- facilities. )
• a qualified mortgage bond is used to finance multifamily and single-family housing;
• a qualified veterans mortgage bond is used to assist veterans in financing housing;
• a qualified small issue bond, also called an Industrial Development Bond (IDB), is used for manufacturing facilities with capital less than $10 million looking three years back or three years forward;
• a qualified student loan bond is used to finance student loan programs;
• a qualified redevelopment bond is issued for use in areas that the government designates as distressed areas or enterprise zones; and
• a qualified 501(c)(3) bond is used to finance facilities for non-profit corporations.

The 1986 Tax Reform Act

The 1986 Tax Reform Act placed substantial limitations on the use of private activity bonds. A unified volume cap was enacted which restricts the amount of private activity debt issued within a state to the greater of either $50 per capita or $150 million. The cap was put in place for all private activity bonds except for veterans mortgage bonds; qualified 501(c)(3) bonds; exempt facilities bonds for airports, docks and wharves; and 75 percent of high-speed intercity rail facilities.

In addition, bondholders must not be substantial users of the facility. Qualification also depends on the issue's average maturity not being longer than 120 percent of the economic life of the facility. A limit of 25 percent of a tax-exempt, private-activity bond issue may be used to purchase land for nonfarming purposes. The tax code places a similar set of restrictions and exceptions on the acquisition of existing property.

Application Process

In order to finance a project through tax-exempt private activity bonds, the issuer must first apply to the State of Minnesota.