Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Public-Purpose Bonds

What it is:

A public-purpose bond is a municipal bond that is used to fund projects that benefit the general public rather than private groups or individuals. Public-purpose bond contrast with private-purpose bonds, which use a significant amount their proceeds to fund private activities or benefit private parties.

How it works (Example):

Let's assume ABC Town wants to open a new public library but does not have the money to fund the construction. One option may be to issue municipal bonds. Because the bonds will fund a project that benefits the general public, the municipal bonds will probably be considered public-purpose bonds. Although determining what projects truly benefit the general public may be controversial, the threshold for deciding whether a municipal bond is private-purpose or public-purpose is usually whether private entities receive more than 10% of the proceeds and whether the project has broad social value.

The Tax Reform Act of 1986 created the distinctions between public-purpose and private-purpose bonds in an effort to limit the tremendous temptation municipalities faced to essentially act as commercial bands for private entities with projects that lacked substantial social benefit. The Act, which made the private-purpose bond a taxable investment, quelled much of this temptation. Toda, there are many kinds of public-purpose bonds (i.e., general obligation bonds, revenue bonds, tax anticipation notes, etc.), but overall, these bonds fund projects such as roads, libraries, and infrastructure systems.

Why it Matters:

One of the largest advantages of investing in municipal bonds is that the interest is usually exempt from federal taxes (and most state and local taxes if the investor lives in the state or municipality issuing the debt), but this exemption only applies to public-purpose bonds, and even then the IRS can apply the alternative minimum tax (AMT) to the interest income in certain circumstances. Thus, every municipal bond investor must take the time to read his bonds' offering statements, learn whether his bonds are public-purpose or private-purpose, and understand his individual tax situation.

Municipal bond offering statements must carry the opinion of a qualified tax attorney stating whether the interest on the bond is taxable or tax-exempt according to the Tax Reform Act of 1986 and other related laws. Municipal bond funds should also receive the same scrutiny, because if any of a fund's bonds are private-purpose, investors could be subject to taxes there as well.