Series 7: 3.2.3.2.2. Taxable Municipal Bonds

3.2.3.2.2. Taxable Municipal Bonds

The Tax Reform Act of 1986 placed severe restrictions on qualifying for tax-exempt financing. The government would no longer subsidize activities that did not provide a significant benefit to the general public. The Tax Reform Act distinguished two kinds of revenue bonds: public purpose bonds and private activity bonds. A public purpose bond is one that finances projects that serve the local population in general. This type of bond kept its tax-exempt status at the federal level. A private activity bond (PAB) is a municipal bond that channels more than 10% of its proceeds into private hands or otherwise meets a complex set of criteria under the Internal Revenue Code. Bonds issued to refund debt or to bolster underfunded pension funds are also considered private activity bonds.

Under the Tax Reform Act, most PABs completely lost their exemption from federal taxes. These are called non-qualified PABs. There are also qualified PABs, which are partial exceptions to the general rule that PABs have no federal tax exemption. Typically, this is because the private activity supported by the PAB is viewed as especially valuable or essential, such as financing airports and docks, hazardous waste disposal, water and sewer service, or residential property. Qualified PABs are exempt for purposes of regular taxation but are not exempt for purposes of the alternative minimum tax. For this reason, they are sometimes called alternative minimum tax (AMT) bonds. The alternative minimum tax (which is discussed more in Chapter Four) imposes a minimum income tax on high-income taxpayers who receive significant savings from the use of certain tax deductions. Many of these deductions are effectively erased in applying the AMT. Taxable income becomes the greater of the alternative minimum tax and the regular federal income tax.

Build America Bonds (BABs) are public purpose municipal bonds issued as part of the American Recovery and Reinvestment