What Is a Private Activity Bond and How Does It Work?
Explore the intersection of public finance and private enterprise with a guide to the bonds that fund them, including their purpose and unique tax implications.
A private activity bond (PAB) is a municipal bond issued by a state or local government to finance a project owned or operated by a private entity. This financing structure creates a partnership where a government body helps a private user access lower-cost funding, justified by the project’s contribution to a public good. If the bond and project meet federal requirements, the interest paid to bondholders is exempt from federal income tax. This exemption allows the private entity to borrow at a lower interest rate than with conventional financing. The government issuer acts as a conduit, issuing the bonds without pledging its own credit for repayment, and the obligation to repay the debt rests with the private user.
The Two Defining Tests
For a municipal bond to be classified as a private activity bond, it must meet two criteria outlined in the Internal Revenue Code: the private business use test and the private security or payment test. If a bond issue satisfies both of these conditions, the Internal Revenue Service (IRS) designates it as a PAB, which determines its tax treatment.
The private business use test is met if more than 10% of the proceeds from the bond sale are used in the trade or business of a non-governmental entity, such as a private company. For example, if a city issues $20 million in bonds to construct a facility, and a private corporation’s lease and operation of a portion of it was financed with more than $2 million of the bond proceeds, this test is satisfied.
The private security or payment test is met if more than 10% of the bond’s principal or interest payments are secured by property used in a private business or are derived from payments related to that property. Continuing the example, if lease payments from the corporation are the source of funds used to pay back more than 10% of the debt service, this second test is also met.
A less common alternative is the private loan financing test. A bond issue meets this test if more than 5% of the bond proceeds, or $5 million (whichever is less), are used to make or finance loans to non-governmental persons. An issue is defined as a PAB if it meets either the combination of the two private business tests or this private loan test.
Qualified Projects and Facilities
For the interest on a private activity bond to be tax-exempt, the financed project must be a “qualified” activity as defined by federal tax law. Meeting the two-part test for being a PAB is not enough; the use of the funds must align with a list of project types Congress has determined provide a public benefit worthy of a federal tax subsidy.
Qualified projects often target public-use infrastructure, social goals, or economic development. These include:
- Exempt facilities such as airports, docks, mass commuting facilities, and water, sewage, or solid waste disposal plants.
- Qualified residential rental projects, often called multifamily housing bonds, which finance apartment complexes with units set aside for low-income tenants.
- Qualified mortgage bonds and qualified veterans’ mortgage bonds to help finance mortgages for first-time homebuyers or eligible veterans at below-market interest rates.
- Qualified small issue bonds for acquiring and constructing manufacturing facilities, with issue sizes generally capped at $10 million.
- Student loan bonds to provide funding for educational loans.
- Qualified redevelopment bonds used to revitalize blighted areas.
A significant category is qualified 501(c)(3) bonds, which are used to finance capital projects for non-profit organizations like hospitals, universities, and museums. These bonds are a common tool for these institutions to fund the construction of new buildings or expand their facilities. Unlike many other PABs, these bonds often have fewer restrictions.
Tax Treatment for Bondholders
The primary attraction for an investor purchasing a qualified private activity bond is that the interest income is exempt from federal income tax. This tax-exempt status allows issuers to offer lower interest rates compared to taxable bonds, reducing borrowing costs for the private entity using the funds.
A consideration for investors is the Alternative Minimum Tax (AMT), a separate tax calculation that runs parallel to the regular income tax system to ensure high-income individuals pay a minimum amount of tax. For AMT purposes, the tax-exempt interest from most private activity bonds is considered a “tax preference item.”
This means an investor must add the interest earned from these PABs back into their income when calculating their potential AMT liability. This addition increases their alternative minimum taxable income and could trigger the AMT or increase the amount owed. PABs subject to the AMT offer slightly higher yields than other tax-exempt bonds to compensate investors for this potential tax exposure.
Not all PABs are subject to this rule. Interest from qualified 501(c)(3) bonds, issued for non-profits like hospitals and private universities, is not a tax preference item for the AMT. Investors must review the official statement for any bond issue, which will disclose the bond’s tax status and its treatment under the AMT.
State Volume Cap Restrictions
The federal government limits the total amount of most types of tax-exempt private activity bonds that can be issued within a state each year. This annual limit is known as the state volume cap, a regulatory mechanism to control the supply of this federally subsidized financing.
The volume cap for each state is determined annually by the IRS using a formula based on the state’s population. For 2025, the amount is the greater of $130 per capita or $388,780,000. This structure provides smaller states with a substantial minimum allocation, and the state is responsible for allocating this bonding authority among eligible projects.
This allocation process is often competitive, as the demand for tax-exempt financing can exceed the state’s available cap. Each state develops its own procedures for distributing its volume cap, which may involve applications or discretionary awards by a state financing authority. Projects seeking PAB financing must secure an allocation from their state’s volume cap before the bonds can be issued.
Certain types of PABs are not subject to the state volume cap. The most notable exceptions are qualified 501(c)(3) bonds and bonds for certain government-owned facilities like airports and docks. By exempting these categories, federal law allows for unlimited tax-exempt financing for these specific public-purpose projects.