Tax-exempt municipal bonds are issued by state governments, U.S. territories, cities, counties, and a wide range of special-purpose public bodies such as school districts, water authorities, transit agencies, and public hospital and airport authorities. Public authorities can also lend their tax-exempt borrowing power to private hospitals, universities, and affordable housing developers as conduit issuers, and certain nonprofit corporations can issue on behalf of a government. The federal exemption itself comes from Internal Revenue Code Section 103, which excludes interest on any state or local bond from gross income.1Office of the Law Revision Counsel. 26 US Code 103 – Interest on State and Local Bonds The outstanding market exceeds $4 trillion.
State Governments and U.S. Territories
Every state has sovereign authority to issue debt. States sell bonds for highways, university campuses, environmental cleanup, and other statewide projects, and because a state can pledge its full taxing power, state debt is often backed by what bond documents call the “full faith and credit” of the state.
U.S. territories sit in a distinctive position. Puerto Rico, Guam, the U.S. Virgin Islands, American Samoa, and the Commonwealth of the Northern Mariana Islands can all issue tax-exempt bonds in U.S. capital markets.2Internal Revenue Service. TEB International – U.S. Territories / Possessions Federal law makes Puerto Rico bonds exempt from taxation by the United States, any state, and any local government, regardless of where the bondholder lives, and similar provisions cover other territories.3Office of the Law Revision Counsel. 48 USC 745 – Tax Exempt Bonds That “triple tax-exempt” status is what draws investors in high-tax states who would otherwise owe state and local tax on out-of-state municipal interest.
Cities, Counties, and Other Local Governments
Local governments do not have inherent authority to issue bonds the way states do. Cities, counties, and towns get that power from a state constitution or state statute. Scope varies widely. Some states allow broad local borrowing, while others require voter approval or impose strict debt ceilings before a local government can sell bonds at all.
These issuers finance the most visible day-to-day infrastructure: fire stations, police vehicles, road repaving, parks, and municipal buildings. Most of their bonds are general obligation bonds backed by the local property tax base, meaning the government is committed to raise property taxes enough to cover debt service if revenue falls short.
One practical point for anyone evaluating a local issuer: a single property often sits inside overlapping jurisdictions that each carry their own debt. A homeowner might be inside a city, a county, and a school district, all of which have outstanding bonds supported by the same taxable property. Credit analysts look at direct debt plus a proportional share of overlapping obligations when they assess risk.
Special-Purpose Districts and Public Authorities
A large share of the municipal market comes from entities that are not general-purpose governments at all. School districts are among the most prolific issuers, selling bonds to build classrooms, gyms, and technology upgrades. Water and sewer authorities borrow to expand treatment capacity. Transportation agencies finance bridges, tunnels, and transit systems. Hospital districts, airport authorities, and public power utilities round out the list.
What these entities share is a narrow charter. They exist to perform one function, and their borrowing authority is limited to that function. Many rely on revenue bonds rather than general obligation bonds, repaying investors from user fees, tolls, or utility rates generated by the specific project the bond financed.4MSRB. Sources of Repayment A revenue bond gives you a claim only against the project’s income stream, not against any broader tax base.
Conduit Issuers and Nonprofits Acting on Behalf of a Government
Not every named issuer is the entity that actually uses the borrowed money. Public authorities frequently act as conduit issuers, lending their tax-exempt borrowing power to a private hospital, university, or affordable housing developer. The public authority’s name appears on the bond, but the private borrower is responsible for repayment, and the conduit issuer does not guarantee the debt.5MSRB. Municipal Bond Basics If the hospital goes bankrupt, the conduit authority has no obligation to step in.
Nonprofit corporations can also issue tax-exempt debt under a longstanding IRS framework. To qualify, the nonprofit must carry out an essentially public purpose, organize under the state’s nonprofit corporation law, and ensure that no private individual profits from the arrangement. The relevant state or local government has to approve both the nonprofit entity and the specific bonds, and the government must receive title to the financed property once the debt is retired.6Internal Revenue Service. Valid Issuer / Valid Debt These “on behalf of” bonds let a government deliver public infrastructure through a nonprofit intermediary without directly appearing as the borrower.
What Legally Qualifies an Issuer
Section 103 excludes interest on “any state or local bond” from gross income, and the qualifying language does the real work.1Office of the Law Revision Counsel. 26 US Code 103 – Interest on State and Local Bonds To meet it, an issuer has to be a state, a political subdivision of a state, or an entity acting on behalf of one.
Under Treasury regulations, a political subdivision is an entity that exercises recognized sovereign powers. The IRS looks for some combination of the authority to levy taxes, the power to take private property for public use, and the power to regulate public behavior. An entity lacking these powers risks having its bonds reclassified as taxable, which would mean investors suddenly owe federal income tax on interest they expected to receive tax-free.6Internal Revenue Service. Valid Issuer / Valid Debt When that happens, the issuer typically negotiates a settlement with the IRS.
The bonds themselves must also meet structural requirements. They must be issued in registered form, cannot be federally guaranteed, and the issuer must file an information return with the IRS no later than the 15th day of the second month after the quarter the bond was issued.7Office of the Law Revision Counsel. 26 USC 149 – Bonds Must Be Registered, Etc. Governmental issuers typically file Form 8038-G, which reports the size, interest rate, and term of the issue.8Internal Revenue Service. About Form 8038-G, Information Return for Tax-Exempt Governmental Obligations
Private Activity Bonds and the State Volume Cap
When more than 10 percent of a bond issue’s proceeds go toward private business use and more than 10 percent of the debt service is secured by or derived from payments related to that private use, the IRS treats the bonds as private activity bonds. A separate test triggers the same classification when those figures exceed 5 percent for private uses unrelated to the governmental purpose of the bond.9Office of the Law Revision Counsel. 26 USC 141 – Private Activity Bond; Qualified Bond
Private activity bonds are taxable by default, but Congress carved out exceptions for specific categories that serve a public purpose despite involving private parties. Qualified categories include exempt facilities such as airports and solid waste disposal plants, mortgage bonds for first-time homebuyers, student loan bonds, small manufacturing facility bonds, redevelopment bonds, and bonds issued for 501(c)(3) nonprofit organizations like hospitals and universities. Each category has its own eligibility rules.
To prevent unlimited private-sector access to tax-exempt borrowing, federal law caps the total volume of qualified private activity bonds each state can issue per year. The ceiling is the greater of a per-capita amount multiplied by the state’s population or a fixed dollar floor. For 2026, the per-capita multiplier is $135 and the minimum state ceiling is $397,625,000. Each state decides how to allocate its cap among local issuers, and unused cap can sometimes be carried forward.10Office of the Law Revision Counsel. 26 US Code 146 – Volume Cap
The volume cap is the boundary that keeps the issuer list from expanding indefinitely. A private company cannot directly issue tax-exempt bonds. It has to find a qualifying public issuer willing to allocate part of its state’s cap and structure the bonds under one of the qualified categories in Section 141.