Lease revenue bonds work by routing a government’s building project through a separate issuing entity: that entity sells bonds to investors, uses the proceeds to build or acquire a facility, and leases the facility back to the government. The government’s annual lease payments cover principal and interest on the bonds, and when the last payment is made, title transfers to the government for a nominal price. Because the obligation is framed as a year-by-year lease rather than long-term debt, the structure typically sidesteps the voter-approval and debt-limit rules that apply to general obligation bonds.
The Parties and What Each One Does
Four roles carry the deal. The lessee is the government that needs the facility, such as a city, county, school district, or state agency. The lessor is a separate legal entity created to hold title and issue the debt, usually a public building authority, joint powers authority, parking authority, or a nonprofit corporation organized specifically for the financing.1Association for Governmental Leasing & Finance. An Introduction to Municipal Lease Financing: Answers to Frequently Asked Questions The separation is not a formality. The bonds are obligations of the lessor, not of the government, and that firewall is what lets the structure work legally.
Bondholders are the investors who buy the debt and collect interest over its life. Because the bonds qualify as state or local bonds under federal tax law, the interest is generally excluded from federal gross income.2Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds That tax treatment lets the issuer offer lower interest rates than a taxable bond would require, which directly lowers the cost of the project.
A trustee, usually a commercial bank or trust company with fiduciary powers, sits between the lessor and the bondholders. The trustee holds bond proceeds in designated accounts, manages the flow of funds under the trust indenture, and distributes lease payments to bondholders on schedule.3National Association of Bond Lawyers. Trustee If payments fail, the trustee enforces bondholder rights under the indenture.
The Lease-Purchase Agreement
The controlling document is the lease-purchase agreement. Under it, the lessor keeps legal title to the property while the lessee gets exclusive use for the term of the lease, a possessory interest that lasts as long as payments continue.4University of Tennessee County Technical Assistance Service. Bundle of Rights Theory Lease payments are sized to cover full debt service on the bonds, including principal, interest, and trustee fees. The lessee also maintains the property and carries insurance during the term.
When the last bond payment clears, title transfers to the lessee for a nominal price, often one dollar by quitclaim deed. Economically the transaction is a purchase paid in installments; legally it is a lease that ends in a conveyance.
Non-Appropriation: Why It Isn’t Debt
The clause that keeps a lease revenue bond off the government’s books as long-term debt is the non-appropriation clause. Because the governing body must approve the lease payment each fiscal year, the obligation is not absolute. The government retains a legal right to walk away by not budgeting the payment.5Association for Governmental Leasing & Finance. AGLF 2022 – Muni Leasing Basics Presentation That annual opt-out is what prevents the lease from being classified as multi-year debt subject to constitutional debt limits.
Non-appropriation is not a default. If the government declines to appropriate, the lease terminates and the lessor (or trustee acting for bondholders) takes back the property. The government owes no damages for breach; it simply loses the facility.5Association for Governmental Leasing & Finance. AGLF 2022 – Muni Leasing Basics Presentation For bondholders, this is the central risk of the structure. Their security is the property itself and the political unlikelihood that a government would abandon a courthouse or fire station it uses every day.
Abatement If the Facility Becomes Unusable
A companion clause handles physical disaster. If a fire, natural disaster, or other event makes the property uninhabitable, the lessee’s rent obligation abates, pausing or reducing proportionally until the facility is restored.6Legal Information Institute. Abatement Clause If insurance proceeds fall short of what rebuilding costs, there can be a gap when no lease revenue flows to service the debt. That exposure is one reason lease revenue bonds typically carry lower credit ratings than general obligation bonds backed by the government’s full taxing power.
Capitalized Interest During Construction
A lease revenue bond funds a facility that does not yet exist, which creates a timing problem. Bondholders expect interest payments right away, but the government has no building to occupy and no reason to start paying rent. The fix is capitalized interest. A portion of the bond proceeds is set aside at issuance to cover interest during construction. Once the facility is complete and the government takes occupancy, budgeted lease payments replace the capitalized interest fund as the source of debt service.
Where the Lease Payments Come From
Most deals rely on one of two funding models. The more common approach uses appropriated general fund revenue: the government’s annual budget includes the lease payment alongside other operating costs, and the legislative body votes to approve it each year. Credit quality then tracks the government’s overall fiscal health and its continued willingness to appropriate.
The second approach dedicates a specific revenue stream to the lease payment, such as parking fees for a garage, utility charges for a water treatment plant, or similar user-generated income. Those revenues are legally pledged and flow through restricted accounts so they cannot be diverted until the lease obligation is satisfied. A dedicated-revenue deal can be stronger or weaker than a general-fund deal depending on how stable and sufficient the pledged stream is.
Debt Service Reserve Fund
Most issues include a debt service reserve fund, a cushion held by the trustee against missed payments. If the lessee pays late or the revenue stream dips, the trustee draws from the reserve to keep bondholders whole. Federal tax law caps the reserve at the least of three amounts: 10 percent of the bond’s principal amount, the highest single year of principal and interest payments, or 125 percent of the average annual debt service.7eCFR. 26 CFR 1.148-2 – General Arbitrage Yield Restriction Rules The cap exists because reserve funds invested above the bond’s yield create arbitrage profit, which the federal government restricts to preserve the subsidy of tax-exempt financing.
Tax-Exempt Status and Its Limits
The tax exemption that makes the low interest rate possible depends on the issuer following two sets of rules for the life of the bonds. Both can revoke the exemption retroactively if breached.
Private Business Use
Bonds become “private activity bonds,” and lose their tax exemption, if more than 10 percent of the proceeds are used for private business purposes and more than 10 percent of debt service is secured by or derived from payments related to that private use. A stricter 5 percent test applies to private business use that is completely unrelated to any governmental purpose.8Office of the Law Revision Counsel. 26 USC 141 – Private Activity Bond; Qualified Bond In practice this means watching what happens inside the building. Leasing space to a private coffee shop in a government office, letting a private company run a parking garage, or allowing a for-profit hospital to use a publicly financed medical facility can each count toward the limits.
The IRS provides safe harbor rules for management contracts. The key requirements are that the private manager receive reasonable, fixed compensation rather than a share of net profits, that the government retain control over budgets, capital spending, and the rates charged for using the facility, and that the contract term not exceed 30 years or 80 percent of the property’s expected useful life.9Internal Revenue Service. Revenue Procedure 2017-13
Arbitrage Rebate
When bond proceeds are invested before being spent on construction, they often earn more than the yield on the bonds. Federal law requires the issuer to calculate and pay that excess back to the U.S. Treasury as the arbitrage rebate.10eCFR. 26 CFR 1.148-3 – General Arbitrage Rebate Rules
The first rebate installment is due no later than 60 days after the fifth anniversary of the bond’s issue date, and subsequent installments follow on five-year intervals. Each installment must equal at least 90 percent of the cumulative rebate owed as of that date, and a final payment covering 100 percent is due when the bonds are fully retired. Missing a deadline turns the bonds into arbitrage bonds and strips the tax exemption unless the IRS accepts a penalty payment. For bonds that are not private activity bonds, the penalty is 50 percent of the unpaid rebate plus interest.10eCFR. 26 CFR 1.148-3 – General Arbitrage Rebate Rules
Continuing Disclosure
SEC Rule 15c2-12 requires the issuer to enter into a continuing disclosure agreement before an underwriter can sell the bonds. Under that agreement the issuer files annual financial information and audited financial statements with the Municipal Securities Rulemaking Board’s EMMA system. The issuer also files notice of specific material events, including payment delinquencies, rating changes, draws on the debt service reserve fund, adverse tax opinions, and property substitutions, within ten business days of the event.11eCFR. 17 CFR 240.15c2-12 – Municipal Securities Disclosure Late or missed filings can shut the issuer out of future bond sales, because underwriters must check an issuer’s disclosure record before participating in a new offering.