Private Activity Bonds: An Introduction

Prepared for Members and Committees of Congress

The federal tax code classifies state and local bonds as either governmental bonds or private
activity bonds. Governmental bonds are for projects that benefit the general public, and private
activity bonds are for projects that primarily benefit private entities.
The federal tax code allows state and local governments to use tax-exempt bonds to finance
certain projects that would be considered private activities. The private activities that can be
financed with tax-exempt bonds are called “qualified private activities.” Congress uses an annual
state volume cap to limit the amount of tax-exempt bond financing generally and restricts the
types of qualified private activities that would qualify for tax-exempt financing to selected
projects defined in the tax code.
Although this report does not include a comprehensive economic analysis of tax-exempt private
activity bonds, it does provide some background on the reasons for the federal limitation on tax-
exempt bonds for private activities. In addition, this report explains the rules governing qualified
private activity bonds, describes the federal limitations on private activity bonds, lists the
qualified private activities, and reports each state’s private activity bond volume cap.
Since private activity bonds were defined in 1968, the number of eligible private activities has
been gradually increased from 12 activities to 21. The state volume capacity limit has increased
from $150 million and $50 per capita in 1986 to the greater of $262.095 million or $85 per capita
in 2008. Because of the $262.095 million floor, most small states (21 states and the District of
Columbia) are allowed to issue relatively more private activity bonds (based on the level of state
personal income) than larger states (29 states). Also, more recent additions to the list of qualified
activities have been exempt from a state-by-state cap and subject to a national aggregate cap.
For more on tax-exempt bonds generally, see CRS Report RL30638, Tax-Exempt Bonds: A
Description of State and Local Government Debt, by Steven Maguire. This report will be updated
as legislative events warrant.

Overview and Issues for Congress............................................................................................1
Overvi ew ....................................................................................................................... ...... 1
Issues for Congress.............................................................................................................2
Fundamentals of Private Activity Bonds...................................................................................3
Interest Rates on Tax-Exempt vs. Taxable Bonds...............................................................3
Technical Definition of Private Activity Bonds..................................................................5
What Are the Qualified Private Activities?.........................................................................6
IRS Review of Tax-Exempt Status.....................................................................................9
What Is the Private Activity Volume Cap?.........................................................................9
Allocation by Type of Activity..........................................................................................13
Other Restrictions on Private Activity Bonds...................................................................14
Conclusion and Further Reading.............................................................................................15
Table 1. Yield on Tax-Exempt and Corporate Bonds of Equivalent Risk, the Yield
Spread, and the Yield Ratio: 1980 to 2007...................................................................................4
Table 2. Qualified Private Activities..............................................................................................10
Table 3. Annual State Private Activity Bond Volume Cap, 2007 and 2008....................................11
Table 4. Private Activity Bond Volume by Type of Activity in 2004, 2005, and 2006.................13
Author Contact Information..........................................................................................................16

State and local governments issue debt for most large public capital projects such as new schools,
public buildings, and roads. On occasion, state and local governments will issue debt for projects
whose purpose is less public in nature, such as privately owned and operated multifamily
residential housing. Nevertheless, these projects are often afforded the same tax privilege as debt
issued for strictly government owned and operated projects. Congress limits the use of tax-
exempt bonds for private activities because of concern about the overuse of tax-exempt, private
activity bonds. The tax-exempt bonds issued for qualified private activities are limited by the type
of activity financed and the volume of debt used for such activities.
The federal tax code classifies state and local government bonds as either governmental bonds or
private activity bonds. Generally, the interest on state and local governmental bonds is exempt 1
from taxation whereas the interest on private activity bonds is not tax-exempt. However, the
federal tax code allows state and local governments to use tax-exempt bonds to finance certain 2
projects that would otherwise be classified as private activities. The private activities that can be 3
financed with tax-exempt bonds are called “qualified private activities.”
The current tax exemption for qualified private activities has evolved over time. Two events,
however, critically shaped the current treatment of private activity bonds. First, in 1968, Congress
passed the Revenue and Expenditure Control Act of 1968 (P.L. 90-364) which established the
basis for the current definition of private activity bonds. After persistent challenges to the right of
the federal government to restrict state and local government debt following the 1968 Act, the
Supreme Court agreed to hear a case in 1988 that changed the nature of the federal tax treatment
of state and local government debt. In that case, the state of South Carolina challenged the Tax
Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248). The 1982 Act required that state and 4
local government tax-exempt debt must be registered. The registration requirement was viewed
by the states, South Carolina in particular, as an unconstitutional intrusion on the ability of states
to issue debt. The Supreme Court held that the registration requirement for non-federal
government, though federally tax-exempt, debt was constitutional. In somewhat of a surprise to
observers at the time, the Court went beyond the registration ruling and also held the following:

1 The tax-exemption is provided for in 26 U.S.C. 103.
2 The Internal Revenue Service (IRS) uses a two part test to classify an activity as a private activity. This test will be
explained in more detail later in the report. Generally, activities are classified as “private” because private individuals
and businesses benefit directly from debt issued by the state or local government.
3 26 U.S.C. 141 describes requirements for qualified private activity bonds.
4 Before this act was passed, state and local government usually issued bearer bonds that paid principal and interest to
whomever presented the bond to the issuer (or the issuer’s agent, usually a bank). In contrast, a registered bond
includes the owners name on the bond and a change in ownership must be registered with the issuer (or the issuers
agent). For a full discussion of the impact of the South Carolina vs. Baker case on tax-exempt bonds, see Bruce Davie
and Dennis Zimmerman, “Tax-Exempt Bonds After the South Carolina Decision,” Tax Notes, vol. 39, no. 13, June 27,
1988, p. 1573.

The owners of state [and local] bonds have no constitutional entitlement not to pay taxes on
income they earn from the bonds, and states have no constitutional entitlement to issue bonds 5
paying lower interest rates than other issuers.
The ruling confirmed that Congress can restrict issuance of state and local tax-exempt debt and 6
could even rescind the tax-exemption altogether. Nevertheless, outright repeal of the tax-
exemption is unlikely. Instead, Congress has limited legislative action to modification of the
existing rules and definitions governing tax-exempt bonds for private activities. Generally,
Congress limits the amount of tax-exempt debt that can be used for private-activities and restricts
the type of private activities that can be financed with tax-exempt bonds. Congress can, and does,
encourage selected private activities by exempting the activity from the volume cap or by
allowing tax-exempt financing for the private activity.
As noted above, Congress uses two primary means to restrain the use state and local debt for
private activities: an annual state volume limit (or separate national aggregate limit) and
restrictions on the type of qualified private activities. The private activity bond volume limit,
which originated in the Deficit Reduction Act of 1984 (P.L. 98-369), was implemented because
“Congress was extremely concerned with the volume of tax-exempt bonds used to finance private 7
activities.” The limit and the list of qualified activities were both modified again under the Tax
Reform Act of 1986 (TRA 1986, P.L. 99-514). At the time of the TRA 1986 modifications, the
Joint Committee on Taxation identified the following specific concerns about tax-exempt bonds 8
issued for private activities:
• the bonds represent “an inefficient allocation of capital”;
• the bonds “increase the cost of financing traditional governmental activities”;
• the bonds allow “higher-income persons to avoid taxes by means of tax-exempt
investments”; and
• the bonds contribute to “mounting [federal] revenue losses.”
The inefficient allocation of capital arises from the economic fact that additional investment in
tax-favored private activities will necessarily come from investment in other public projects. For
example, if bonds issued for mass commuting facilities did not receive special tax treatment, the
bond funds could be used for other government projects such as schools or other public
The greater volume of tax-exempt private activity bonds then leads to the second Joint Committee
on Taxation concern, higher cost of financing traditional government activities. Investors have
limited resources, thus, when the supply of tax-exempt bond investments increases, issuers must

5 State of South Carolina vs. J.A. Baker, Secretary of the Treasury: Supreme Court of the United States, April 20, 1988.
485 U.S. 505.
6 Ibid.
7 U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction
Act of 1984, 98th Cong., 2nd sess. (Washington: GPO, 1984), p. 930.
8 U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Cong., 1st
sess. (Washington: GPO, 1987), p. 1151.

raise interest rates to lure them into investing in existing government activities. In economic
terms, issuers raising interest rates to attract investors is analogous to a retailer lowering prices to
attract customers.
The final two points are less important from an economic efficiency perspective but do cause
some to question the efficacy of using tax-exempt bonds to deliver a federal subsidy. Tax-exempt
interest is worth more to taxpayers in higher brackets, thus, the tax benefit flows to higher income
taxpayers, which leads to a less progressive income tax regime.
The revenue loss generated by tax-exempt bonds also expands the deficit (or shrinks the surplus).
A persistent budget deficit ultimately leads to generally higher interest rates as the government
competes with private entities for scarce investment dollars. Higher interest rates further increase
the cost of all debt financed state and local government projects.
Supporters of tax-exempt bonds for private activities counter that the benefit from tax-exempt
bonds exceeds both the explicit (the revenue loss) and implicit (the inefficient allocation of
capital) costs of the tax-exemption.
The debate surrounding use of tax-exempt bonds will continue well beyond the current Congress.
Proponents and opponents of tax-exempt bonds generally, and private activity bonds specifically,
both explore methods of modifying the rules for private activity bonds to advance their respective
positions. Because the rules and definitions for private activity bonds are complex, uncertainty
about the potential effects of the proposed modifications to those rules is common. This report
will not attempt to either justify or criticize the existence of or use of tax-exempt private activity 9
bonds. Instead, the report provides a brief review of bond fundamentals and a more detailed
examination of the rules and definitions surrounding private activity bonds to help clarify the
impact of the of those modifications.
Tax-exempt bonds for governmental purposes and for qualified private activities are special
because, unlike corporate bonds or U.S. Treasury bonds, the bond buyer does not have to include 10
the interest income from the bond in federal gross taxable income. The bond buyer is willing to
accept a lower interest rate because the interest income is not subject to federal income taxes. The
lower interest rate arising from the tax-exempt status subsidizes state and local investment in
capital projects. For example, if the taxable bond interest rate is 7.00%, the after-tax return for a
taxpayer in the 35% income tax bracket who buys a taxable bond is 4.55%. Thus, a tax-exempt
bond that offers a 4.55% interest rate would be just as attractive to the investor as the taxable
bond, all else equal. For more on tax-exempt bonds generally, see CRS Report RL30638, Tax-
Exempt Bonds: A Description of State and Local Government Debt, by Steven Maguire.

9 For a comprehensive economic assessment of private activity bonds, see Dennis Zimmerman, The Private Use of Tax-
Exempt Bonds: Controlling Public Subsidy of Private Activity (Washington, D.C.: The Urban Institute Press, 1991).
10 The discussion here does not address the effect of state taxes on the tax-exempt debt of other states. For example,
taxpayers in Virginia must pay Virginia income taxes on the tax-exempt (exempt from federal income taxes) debt of
other states. However, Virginia taxpayers do not have to pay income taxes on interest earned on Virginia bonds.

In 2007, the average high-grade corporate bond rate was 5.52% and the average high-grade 11
municipal (tax-exempt) bond rate was 4.42% (see Table 1). The actual interest rate spread, the
difference between the two interest rates, is smaller empirically than the earlier example because
many tax-exempt bond buyers are below the 35% marginal tax bracket. Individuals in income tax
brackets below 35% would require a higher tax-exempt bond interest rate because lower tax rates 12
mean less tax savings from tax-exempt bonds. The lower tax bracket taxpayers bid up the tax-
exempt bond interest rate closer to the taxable bond interest rate.
Table 1 reports the interest rate of corporate bonds and tax-exempt municipal bonds of like
maturity for 1980 through 2007. Bonds issued by state and local governments are usually called
“municipal bonds” by the investment community. Generally, the two rates move in tandem, with
the taxable corporate bond interest rate always higher than the tax-exempt municipal bond
interest rate.
Table 1. Yield on Tax-Exempt and Corporate Bonds of Equivalent Risk,
the Yield Spread, and the Yield Ratio: 1980 to 2007
Year High Grade Tax- Exempt Yield (%) AAA Corporate Yield(%) Yield Spread (%) Yield Ratio (tax-exempt/ corporate)
1980 8.51 11.94 3.43 0.71
1981 11.23 14.17 2.94 0.79
1982 11.57 13.79 2.22 0.84
1983 9.47 12.04 2.57 0.79
1984 10.15 12.71 2.56 0.80
1985 9.18 11.37 2.19 0.81
1986 7.38 9.02 1.64 0.82
1987 7.73 9.38 1.65 0.82
1988 7.76 9.71 1.95 0.80
1989 7.24 9.26 2.02 0.78
1990 7.25 9.32 2.07 0.78
1991 6.89 8.77 1.88 0.79
1992 6.41 8.14 1.73 0.79
1993 5.63 7.22 1.59 0.78
1994 6.19 7.96 1.77 0.78

11 Interest rate averages are composites of a variety of bond issues and provide a good benchmark for market interest
rates for municipal bonds.
12 For example, someone in the 10% income tax bracket would find tax-exempt bonds attractive only if the interest rate
were 6.37%. Or, looking at the problem from a different perspective, the marginal tax rate below which tax-exempt
bonds are not attractive is 16.58%. Thus, taxpayers in marginal tax brackets below this rate would not find tax-exempt
bonds attractive investments because the market interest rate on municipal bonds would be too low. Taxpayers in the
15% marginal tax bracket would receive a higher after-tax return though buying taxable bonds and paying taxes on the
interest income at the 15% rate.

Year High Grade Tax- Exempt Yield (%) AAA Corporate Yield(%) Yield Spread (%) Yield Ratio (tax-exempt/ corporate)
1995 5.95 7.59 1.64 0.78
1996 5.75 7.37 1.62 0.78
1997 5.55 7.26 1.71 0.76
1998 5.12 6.53 1.41 0.78
1999 5.43 7.04 1.61 0.77
2000 5.77 7.62 1.85 0.76
2001 5.19 7.08 1.89 0.73
2002 5.05 6.49 1.44 0.78
2003 4.73 5.67 0.94 0.83
2004 4.63 5.63 1.00 0.82
2005 4.29 5.24 0.95 0.82
2006 4.42 5.59 1.17 0.79
2007 4.42 5.52 1.10 0.80
Source: Council of Economic Advisors, Economic Report of the President, February 2008, Table B-73.
Unlike tax-exempt government purpose bonds, the interest income from tax-exempt private
activity bonds is included in the alternative minimum tax (AMT) base. The AMT is a tax that is
levied in parallel with the income tax and is intended to ensure that taxpayers with many
deductions and exemptions pay a minimum percentage of their gross income in taxes. Because
private activity bonds are included in the AMT the bonds usually carry a slightly higher interest 13
rate (approximately 50 basis points higher) than do tax-exempt government-purpose bonds, all 14
else equal. However, the private activity bond rate is still lower than the taxable bond rate. For
more on the AMT, see CRS Report RL30149, The Alternative Minimum Tax for Individuals, by
Steven Maguire.
Repealing the AMT or exempting some bonds issued for qualified private activities from the
AMT would increase investor demand for those bonds. The increased attractiveness of those
bonds would eventually lead to lower interest costs for the issuer of private activity bonds.
A private activity bond is one that primarily benefits or is used by a private entity. The tax code
defines private business (or private entity) use as “...use (directly or indirectly) in a trade or
business carried on by any person other than a governmental unit. For purposes of the preceding 15
sentence, use as a member of the general public shall not be taken into account.” Two conditions

13 50 basis points is equivalent to one-half of a percentage point or 0.50%.
14 Jacob Fine, “AMT Spreads on the Rise, The Bond Buyer, July 26, 2000, p. 1.
15 26 U.S.C. 141(b)(6)(A)

or tests are used to assess the status of a bond issue with regard to the private entity test.
Satisfying both conditions would mean the bonds are taxable private activity bonds. Bonds are 16
private activity bonds and not tax-exempt if both of the following conditions are met:
• [use test] more than 10% of the proceeds of the issue are to be used for any
private business use,... [and]
• [security test] if the payment on the principal of, or the interest on, more than
10% of the proceeds of such issue is (under the terms of such issue or any
underlying arrangement) directly or indirectly secured by any interest in
(1) property used or to be used for a private business use, or (2) payments in
respect to such property. Or [if the payment is] to be derived from payments
(whether or not to the issuer) in respect of property, or borrowed money, used or
to be used for a private business use.
If a bond issue passes both tests, the bonds are taxable and would carry a higher interest rate.
Nevertheless, bond issues that pass both tests can still qualify for tax-exempt financing if they are
identified in the tax code as qualified private activities. Thus, when those in the bond community
refer to tax-exempt private activity bonds, the more technically correct reference is tax-exempt,
qualified private activity bonds.
A number of qualified private activities are granted special status in the tax code (see Table 2).
These activities are called “qualified private activities” because they qualify for tax-exempt
financing even though they would likely “pass” the two part private activity test which would
otherwise disallow tax-exempt financing. The list of qualified private activities has gradually
expanded to 21 activities from the 12 that were originally defined by the Revenue and
Expenditure Control Act of 1968. The Tax Reform Act of 1986 kept most of the activities listed in
the 1968 Act and reorganized the private activity bond section of the federal tax code.
The 1968 Act legislated that the interest payments on industrial development bonds (IDBs, the
original private activity bonds) were to be included in taxable income. This was a shift from the
previous Internal Revenue Service (IRS) position, which held that the interest on these bonds was
not taxable income. The motivation behind the change offered in the 1968 Act was based “...on
the theory that industrial development bonds described in the proposed [IRS] regulations were not
‘obligations of a State or any political subdivision’ within the meaning of section 103 since the 17
primary obligor was a not a State or political subdivision.” The 1968 Act also (1) established the
basis for the current private use and private security tests; (2) created exceptions to the taxability
provision for small issuers; (3) and specified a group of private activities that would qualify for
tax-exempt bond financing.

16 26 U.S.C. 141(b)
17 U.S. Congress, Conference Committees, 1968, Revenue and Expenditure Control Act of 1968, conference report to
accompany H.R. 15414, House Report No. 1533, 90th Cong., 2nd sess. (Washington: GPO, 1968), p. 32.

The 1986 Act, which rewrote the Internal Revenue Code of 1954, renewed most of the previously
defined private activities identified in the 1968 Act. Notably, TRA 1986 added one private
activity, qualified hazardous waste facilities, and limited the exemption for some previously
acceptable private activities, including construction of sports facilities and privately owned (as
opposed to government owned) airports, docks, wharves, and mass-commuting facilities. In
Table 2, the activities that must be government owned to qualify for tax-exempt financing are
identified in italics. Before and after enactment of TRA 1986, there were several other additions
to the list of qualified private activities. The date of introduction for each qualified private activity
is included in the last column of Table 2.
In addition to private activities listed in Table 2, there are special zones where tax-exempt private
activity bonds can be issued for qualified economic development projects in that zone. The
Empowerment Zone / Enterprise Community (EZ) program has been implemented in rounds and
each round is subject to different debt rules. Round I EZ bonds are subject to the state volume cap 18
and each zone can have only $3 million of EZ bonds outstanding. There are also limits on the
amount of Round I EZ bonds any one borrower can have outstanding. An EZ borrower can have
an aggregate of $20 million outstanding for all EZ projects throughout the country.
Round II EZs (and all EZs established after December 31, 2001) are subject to designation
“lifetime” caps depending on the urban vs. rural designation and population for urban EZs. For
the lifetime of the EZ designation, rural EZs can issue up to $60 million; urban EZs with
population less than 100,000 can issue up to $130 million; and urban EZs with population greater
than 100,000 can issue up to $230 million. In contrast to Round I EZs, there are no limits on the 19
amount any one entity can borrow for Round II EZs.
The New York Liberty Zone (NYLZ) was established in the wake of the September 11, 2001 20
terrorist attacks upon New York City. The tax benefits created to foster economic revitalization
within the NYLZ included a “Liberty Bond” program. The program allows New York State (in
conjunction and coordination with New York City) to issue up to $8 billion of tax-exempt, private
activity bonds for qualified facilities in the NYLZ. Qualified facilities follow the exempt facility
rules within section 142 of the IRC. The original deadline to issue the bonds was January 1, 2005,
but was recently extended to January 1, 2010, by P.L. 108-311.
This legislation created a new type of tax-exempt private activity bond for the construction of rail
to highway (or highway to rail) transfer facilities. The national limit is $15 billion and the bonds

18 A special EZ for the District of Columbia allows up to $15 million of outstanding EZ bond debt.
19 See the following publication for more details on the EZ programs: U.S. Department of Housing and Urban
Development, Tax Incentive Guide for Businesses in the Renewal Communities, Empowerment Zones, and Enterprise
Communities: FY2003. The report is available at the Department of Housing and Urban Development website:
20 Section 301 of the Job Creation and Worker Assistance Act of 2002, P.L. 107-147, created the various NYLZ tax
benefits (26 U.S.C. 1400L). The tax-exempt bond component can be found in 26 U.S.C. 1400L(d).

are not subject to state volume caps for private activity bonds. The Secretary of Transportation
allocates the bond authority on a project-by-project basis.
The hurricanes that struck the gulf region in late summer 2005 prompted Congress to create a tax-
advantaged economic development zone intended to encourage investment and rebuilding in the
gulf region. The Gulf Opportunity Zone (GOZ) is comprised of the counties where the Federal
Emergency Management Agency (FEMA) declared the inhabitants to be eligible for individual
and public assistance. Based on proportion of state personal income, the Katrina-affected portion
of the GOZ represents approximately 73% of Louisiana’s economy, 69% of Mississippi’s, and 21

18% of Alabama’s.

Specifically, the “Gulf Opportunity Zone Act of 2005” (P.L. 109-35, GOZA 2005) contains two
provisions that would expand the amount of private activity bonds outstanding and language to
relax the eligibility rules for mortgage revenue bonds. The most significant is the provision to
increase the volume cap (see Table 3) for private activity bonds issued for Hurricane Katrina
recovery in Alabama, Louisiana, and Mississippi (identified as the Gulf Opportunity Zone, or
“GO Zone”). GOZA 2005 would add $2,500 per person in the federally declared Katrina disaster
areas in which the residents qualify for individual and public assistance. The increased volume
capacity would add approximately $2.2 billion for Alabama, $7.8 billion for Louisiana, and $4.8
billion for Mississippi in aggregate over the next five years. The legislation defines “qualified
project costs” that can be financed with the bond proceeds as (1) the cost of any qualified
residential rental project (26 sec. 142(d)) and (2) the cost of acquisition, construction,
reconstruction, and renovation of (i) non residential real property (including fixed improvements
associated with such property) and (ii) public utility property (26 sec. 168(i)(10)) in the GOZ.
The additional capacity would have to be issued before January 1, 2011. The provision is 22
estimated to cost $1.556 billion over the 2006-2015 budget window.
The second provision allows for advance refunding of certain tax-exempt bonds. Under GOZA
2005, governmental bonds issued by Alabama, Louisiana, and Mississippi may be advance
refunded an additional time and exempt facility private activity bonds for airports, docks, and
wharves once. Private activity bonds are otherwise not eligible for advance refunding. Following
is a brief description of advance refunding and how the GOZA 2005 provision confers a
significant tax benefit to the gulf states.
Refunding is the practice of issuing new bonds to buy back outstanding bonds to potentially
lower interest costs. Advance refunding is the practice of allowing the new bonds to be
outstanding for longer than 90 days. Advance refunding, thus, allows for the existence of two sets
of federally tax-exempt bond issues to be outstanding at the same time for a single project. GOZA

2005 allows the states of Alabama, Louisiana, and Mississippi to advance refund $1.125 billion,

$4.5 billion, and $2.25 billion, respectively. This provision was estimated to cost $741 million

21 See CRS Report RL33154, The Impact of Hurricane Katrina on the State Budgets of Alabama, Louisiana, and
Mississippi, by Steven Maguire.
22 The 10-year revenue loss estimates for GOZA 2005 are from the Joint Committee on Taxation, Estimated Revenue
Effects of H.R. 4440, the ‘Gulf Opportunity Tax Relief Act of 2005,’ as passed by the House of Representatives and the
Senate on Dec. 16, 2005, JCX-89-05, Dec. 20, 2005.

over the 2006-2015 budget window.23 For more on advance refunding, see CRS Report RL30638,
Tax-Exempt Bonds: A Description of State and Local Government Debt, by Steven Maguire.
The IRS often reviews the tax-exempt status of outstanding bonds issued for qualified private
activities. If the bonds that were originally issued as tax-exempt are found to no longer qualify
(meaning that they pass both the security and use tests) the interest on the bonds becomes taxable.
Technically, bond holders are the recipient of the tax benefit and are responsible for remitting
forgone taxes to the Treasury when a tax-exempt bond fails to qualify. A retroactive taxability
finding means all previous tax benefits to the bond holder would have to be returned to the
Treasury. A prospective taxability finding means all future interest payments would be taxable to
the bond holder. However, in most cases, the IRS will settle the apparent violation by requiring
that the issuer, not the bond holders, pay a monetary penalty and that the issuer change the 24
circumstances that led to the non-compliance finding.

The federal government has limited the amount of private activity bonds that states can issue to a
subset of the 21 activities listed in Table 2 and to EZ bonds. The third column of Table 2
identifies the 13 activities (of the 21) that are subject to an annual state volume cap. The annual
cap was increased from the greater of $50 per capita or $150 million in 2000, to the greater of $85
per capita or $262.095 million in 2008 (and is now adjusted for inflation). For small states, the
$262.095 million minimum provides a more generous volume cap than the per capita allocation.
Table 3 lists the volume cap amount in 2007 and 2008 for all states and territories and compares
the 2008 cap to state personal income in 2007.
Of the 13 activities subject to an annual volume cap, two are treated differently than the others,
and two others are subject to a separate cap. First, states are required to count only 25% of the
bonds issued for high-speed intercity rail facilities (26 U.S.C. 142(I)) against the annual cap. If
the facility is government owned and operated, no cap allocation is required. Second, bonds
issued for solid waste disposal facilities (26 U.S.C. 142(a)(6)) are not subject to the cap if the
facility is government owned and operated. Qualified public educational facilities (26 U.S.C.

142(k)), are subject to a separate annual cap which is the greater of $10 per capita or $5 million.

The two newest activities, bonds for green buildings (26 U.S.C. 142(l)) and highway-freight
transfer facilities (26 U.S.C. 142(m)), are subject to a separate cap. Green buildings are subject to
a $2 billion lifetime (not annual) cap and transfer facilities are subject to annual national caps
ranging from $130 million for 2005 rising to $2 billion from 2011 through 2015 (for a total of 26
$15 billion).

23 JCT, Dec. 20, 2005.
24 See the following IRS website for more information on tax-exempt bond rulings and findings:
25 26 U.S.C. 146.
26 For more on the transfer facility private activity bond program, see U.S. Department of Transportation,Applications
for Authority for Tax-Exempt Financing of Highway Projects and Rail-Truck Transfer Facilities,” 71 Federal Register
642, Jan. 5, 2006.

The total 2008 private-activity bond volume cap for all states and the District of Columbia is over
$28 billion. California is allowed to issue over one-tenth of total new volume in 2008 or $3.1
billion (see Table 3). However, as measured against total California personal income, the new
volume cap is considerably less than the national average. For every $100 of 2007 personal
income in California, approximately $0.20 of private activity debt can be issued in 2008 whereas 27
the U.S. average is $0.39. In contrast, North Dakota could issue up to $1.18 of private activity
debt for every $100 of personal income (see the last column of Table 3). The less populous states 28
are more likely to not use the entire annual cap amount for this reason.
Table 2. Qualified Private Activities
Internal Revenue Type of Private Activity (Italicized activities must be owned by the Subject to Year
Code Section issuing government to qualify) Volume Cap Established
Sec. 142 Exempt facility bonds
Sec. 142(c) Airports No 1968
Sec. 142(c) Docks and wharves No 1968
Sec. 142(c) Mass commuting facilities Yes 1981
Sec. 142(e) Water furnishing facilities Yes 1968
Sec. 142(a)(5) Sewage facilities Yes 1968
Sec. 142(a)(6) Solid waste disposal facilities Yes/Noa 1968
Sec. 142(d) Qualified residential rental projects Yes 1968
Sec. 142(f) Local electric energy or gas furnishing facility Yes 1968
Sec. 142(g) Local district heating and cooling facilities Yes 1982
Sec. 142(h) Qualified hazardous waste facilities Yes 1986
Sec. 142(I) High-speed intercity rail facilities Yesb 1988
Sec. 142(j) Environmental enhancements of hydroelectric No 1992
generating facilities
Sec. 142(k) Qualified public educational facilities Noc 2001
Sec. 142(l) Qualified green building and sustainable Noc 2005
design projects
Sec. 142(m) Qualified highway and surface freight Noc 2005
transfer facilities
Sec. 143 Mortgage revenue bonds
Sec. 143(a) Qualified mortgage bond Yes 1968
Sec. 143(b) Qualified veterans’ mortgage bond No 1968
Sec. 144(a) Qualified small issue bond Yes 1968
Sec. 144(b) Qualified student loan bond Yes 1976

27 The states were each given equal weight for the average calculation. The values in the last column of Table 3 were
summed then divided by 51.
28 For more on state use of the volume cap, see CRS Report RL34159, Private Activity Bonds: An Analysis of State
Use, 2001 to 2006, by Steven Maguire and Heather Durkin Negley.

Internal Revenue Type of Private Activity (Italicized activities must be owned by the Subject to Year
Code Section issuing government to qualify) Volume Cap Established
Sec. 144(c) Qualified redevelopment bond Yes 1968
Sec. 145 Qualified 501(c)(3) bond No 1968
a. Exempt from the cap if governmentally owned. Subject to the cap if privately owned.
b. 25% of the bond issue is included in the cap. If the facility is owned by a governmental unit, no cap allocation
is required. In addition, if the facility is not governmentally owned, to qualify for tax-exempt status, the
owner must elect not to claim any depreciation deductions or investment tax credits with respect to the
property financed with the bonds.
c. Educational facility bonds are subject to a separate cap: the greater of $10 per capita or $5 million. Green
building bonds are subject to a national aggregate amount of $2 billion through the expiration of the
program, scheduled for October 1, 2009. Highway bonds are subject to the following annual issuance limits:
$130 million in 2005; $750 million each year for 2006 through 2009; $1.87 billion in 2010; and $2 billion
each year for 2011 through 2015, zero thereafter.
Table 3. Annual State Private Activity Bond Volume Cap, 2007 and 2008
State 2007 Volume Cap ($ millions) 2008 Volume Cap ($ millions) 2007 Personal Income ($ millions) 2008 Cap per $100 of 2007 Personal Income
Alabamaa 390.9 393.4 149,959 $0.26
Alaska 256.2 262.1 27,580 $0.95
Arizona 524.1 538.8 209,361 $0.26
Arkansas 256.2 262.1 85,214 $0.31
California 3,099.0 3,107.0 1,519,547 $0.20
Colorado 404.0 413.2 199,525 $0.21
Connecticut 297.9 297.7 189,535 $0.16
Delaware 256.2 262.1 35,116 $0.75
District of 256.2 262.1 35,940
Columbia $0.73
Florida 1,538.0 1,551.0 701,647 $0.22
Georgia 795.9 811.3 319,339 $0.25
Hawaii 256.2 262.1 50,359 $0.52
Idaho 256.2 262.1 46,776 $0.56
Illinois 1,091.0 1,092.0 518,245 $0.21
Indiana 536.6 539.4 213,302 $0.25
Iowa 256.2 262.1 104,651 $0.25
Kansas 256.2 262.1 102,069 $0.26
Kentucky 357.5 360.5 131,956 $0.27
Louisianaa 364.5 364.9 149,214 $0.24
Maine 256.2 262.1 44,418 $0.59
Maryland 477.3 477.6 258,561 $0.18
Massachusetts 547.2 548.2 316,568 $0.17

State 2007 Volume Cap ($ millions) 2008 Volume Cap ($ millions) 2007 Personal Income ($ millions) 2008 Cap per $100 of 2007 Personal Income
Michigan 858.1 856.1 353,376 $0.24
Minnesota 439.2 441.8 213,282 $0.21
Mississippia 256.2 262.1 84,193 $0.31
Missouri 496.6 499.7 202,153 $0.25
Montana 256.2 262.1 31,090 $0.84
Nebraska 256.2 262.1 64,721 $0.41
Nevada 256.2 262.1 103,847 $0.25
New Hampshire 256.2 262.1 54,622 $0.48
New Jersey 741.6 738.3 427,297 $0.17
New Mexico 256.2 262.1 62,002 $0.42
New York 1,641.0 1,640.0 914,432 $0.18
North Carolina 752.8 770.2 304,781 $0.25
North Dakota 256.2 262.1 22,291 $1.18
Ohio 975.6 974.7 399,897 $0.24
Oklahoma 304.2 307.5 123,541 $0.25
Oregon 314.6 318.5 130,353 $0.24
Pennsylvania 1,057.0 1,057.0 482,245 $0.22
Rhode Island 256.2 262.1 41,745 $0.63
South Carolina 367.3 374.7 136,696 $0.27
South Dakota 256.2 262.1 26,996 $0.97
Tennessee 513.3 523.3 204,896 $0.26
Texas 1,998.0 2,032.0 888,926 $0.23
Utah 256.2 262.1 82,506 $0.32
Vermont 256.2 262.1 22,782 $1.15
Virginia 649.6 655.5 318,873 $0.21
Washington 543.6 549.8 261,415 $0.21
West Virginia 256.2 262.1 53,522 $0.49
Wisconsin 472.3 476.1 201,921 $0.24
Wyoming 256.2 262.1 22,600 $1.16
U.S. Total 28,186.2 28,476.3 11,645,883 $0.39
Sources: Personal income data are from the Bureau of Census, State Annual Personal Income, available at Bond volume cap information for 2007 and 2008 is from the Bond Buyer,
SourceMedia Inc., 2008.
a. Under the Gulf Opportunity Zone Act of 2005, P.L. 109-135, Alabama, Louisiana, and Mississippi, can issue
before Jan. 1, 2011, in aggregate, an additional (CRS estimated) $2.17 billion, $7.88 billion, and $4.92 billion,
This disparity arises from the two part volume capacity calculation which provides for a
minimum of $262.095 million, regardless of state population. In addition, states that have total

personal income below the national average would also have a relatively high debt allowance as
measured against personal income. The last column of Table 3 provides a comparative measure
of the state-by-state volume capacity based on 2007 personal income.
Each state independently determines the allocation of its volume capacity. Table 4 identifies the
total cap distribution for private activities in 2004, 2005, and 2006. The category names used by
the Bond Buyer newspaper, the source of the data, differ from the more detailed names for the
private activities used in the tax code and listed in Table 2. Nevertheless, the Bond Buyer data
roughly reflect the cap allocation preferences of the states and their subdivisions. Note that 46.5%
of the available volume capacity for 2006 was not used and carried forward to 2007 ($22,638
From 2005 to 2006, the amount of capacity dedicated to mortgage revenue bonds (MRBs)
increased significantly. In 2005, $6.5 billion was used for MRBs and in 2006 the amount climbed
to $10.1 billion, a 55% annual increase. In 2006, MRBs accounted for more than one-fifth of 29
bond volume capacity.
Unused volume capacity can be carried forward for up to three years, as long as the state
identifies the project for which the cap space is dedicated. Bond capacity that has not been used
after three years is then abandoned. Abandoned bond capacity was less than 2% of total available
capacity in 2004 and 2005, but rose to 2.9% in 2006.
Table 4. Private Activity Bond Volume by Type of Activity in 2004, 2005, and 2006
Issued in ($ millions) Private Activity
2004 2005 2006
Total Volume Capacity Available 43,088 49,142 48,675
New Volume Capacity 25,741 26,079 26,438
Carryover from previous years 17,347 23,063 23,277
Carry forward to next year 22,950 26,337 22,638
Single-family Mortgage Revenue 5,204 6,507 10,093
Multi-family Housing 5,007 5,562 6,252
Student Loans 4,723 5,124 4,018
Exempt Facilities 1,646 1,915 2,605
Industrial Development 797 1,000 1,195
Abandon Capacity 839 910 1,417
Housing not Classified 186 822 562

29 For more on MRBs, see CRS Report RS22841, Mortgage Revenue Bonds: Analysis of Sections 3021 and 3022 of the
Housing and Economic Recovery Act of 2008, by Mark P. Keightley and Erika Lunder.

Issued in ($ millions)
Private Activity
2004 2005 2006
Mortgage Credit Certificates 417 493 510
Other Activities 1,320 485 284
Portion of Available Capacity
Total Volume Capacity Available 100.0% 100.0% 100.0%
New Volume Capacity 59.7% 53.1% 54.3%
Carryover from previous years 40.3% 46.9% 47.8%
Carry forward to next year 53.3% 53.6% 46.5%
Single-family Mortgage Revenue 12.1% 13.2% 20.7%
Multi-family Housing 11.6% 11.3% 12.8%
Student Loans 11.0% 10.4% 8.3%
Exempt Facilities 3.8% 3.9% 5.4%
Industrial Development 1.9% 2.0% 2.5%
Abandon Capacity 1.9% 1.9% 2.9%
Housing not Classified 0.4% 1.7% 1.2%
Mortgage Credit Certificates 1.0% 1.0% 1.0%
Other Activities 3.1% 1.0% 0.6%
Source: “State Allocations and Use of Private Activity Bonds in 2004,” The Bond Buyer, May 2, 2005; “State
Allocations and Use of Private Activity Bonds in 2005,” The Bond Buyer, May 1, 2006; and “State Allocations of Private
Activity Bonds in 2006,” The Bond Buyer, June 27, 2007.
The use of private activity bonds is also limited by other technical restrictions. In general,
loosening the restrictions would allow issuers to reduce administrative and compliance costs.
However, the relaxed restrictions would exacerbate the concerns (i.e., the economically
inefficient allocation of capital) surrounding tax-exempt bonds that were discussed earlier in the
report. Following is a list of the more technical rules along with the section in the tax code where
the rule appears.

• The maturity of the bonds cannot be greater than 120% of the economic life of
the asset purchased with the bonds (26 U.S.C. 147(b));
• less than 25% of the bond proceeds can be used to acquire land (except for
qualified first-time farmers) (26 U.S.C. 147(c));
• proceeds of the bond issue cannot be used to purchase existing property unless
greater than 15% of the cost of acquiring the property is spent on rehabilitating
the property (26 U.S.C. 147(d));
• public approval of bonds, either through public hearing and notice or voter
referendum, is required for private activity bonds (26 U.S.C. 147(f)); and
• issuance costs cannot be any greater than 2% of the bond proceeds (3.5% for
mortgage bond issues of less than $20 million) (26 U.S.C. 147(g)).
• private activity bonds cannot be advance refunded.30
The history, tax laws, financial properties, and economic effects of tax-exempt bonds are all
exceedingly complex and continually evolving. This report is intended to clarify part of the tax-
exempt bond labyrinth. Nevertheless, the reader may wish to explore tax-exempt bonds in more
depth or from a more general, less technical perspective. The following reading list should equip
the reader with a good foundation for pursuit of either objective.
Bruce Davie and Dennis Zimmerman, “Tax-Exempt Bonds After the South Carolina Decision,”
Tax Notes, vol. 39, no. 13, June 27, 1988, p. 1573.
Peter Fortune, “Tax-Exempt Bonds Really Do Subsidize Municipal Capital!,” National Tax
Journal, vol. 51, no. 1, March 1998, p. 43.
Roger H. Gordon and Gilbert E. Metcalf, “Do Tax-Exempt Bonds Really Subsidize Municipal
Capital?,” National Tax Journal, vol. 44, no. 4, part 1, December 1991, p. 71.
George J. Marlin and Joe Mysak, The Guidebook to Municipal Bonds: The History, The Industry,
The Mechanics (New York: The American Banker/Bond Buyer, 1991).
David J. Ott and Allan H. Meltzer, Federal Tax Treatment of State and Local Securities
(Washington, D.C.: The Brookings Institution, 1963).
Judy Wesalo Temel, The Fundamentals of Municipal Bonds, 5th Edition (New York: John Wiley
and Sons, 2001).
Dennis Zimmerman, The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of
Private Activity (Washington, D.C.: The Urban Institute Press, 1991).

30 Current refunding is the practice of issuing bonds to replace existing bonds. Issuers typically do this to “lock-in
lower interest rates or more favorable borrowing terms. Current refunding is allowed as long as theold” bonds are
redeemed within 90 days of the issuance of the refunding bonds. Advance refunding is the practice of issuing new
bonds to replace existing bonds, but not immediately (within 90 days) retiring the old bonds. Thus, two sets of tax-
exempt bonds are outstanding for the same project.

Steven Maguire
Specialist in Public Finance, 7-7841