Municipal Bonds And Taxes: What Investors Need To Know

June 10, 2013

Municipal bonds can be very attractive to investors because of munis beneficial tax treatment; this is a major benefit to investors since nontaxable bonds are tax exempt regardless of the investors tax bracket. Below we outline four key tax treatments of municipal bonds:

Tax-Exempt Bonds

In bond investing, municipal bonds are known for being tax-free, which makes them very attractive to investors. Unlike most investments, which require a tax to be paid on earnings, most municipal bonds are tax exempt to most investors.

Sold to help finance special projects, a municipal bond is eligible to be tax exempt for businesses, including manufacturing companies and nonprofit organizations. These organizations are permitted to sell tax-exempt bonds of up to $10 million dollars to fulfill all or some of their financial requirements. Bonds are not eligible to be tax exempt if they finance debt relief or venture and working capital.

For each specific bond, an official statement is issued that states the terms of the bond. Along with describing the terms, such as explaining when the bond can be redeemed and the benefits to the bondholder, the statement also explains the exact terms of the tax-free or taxable bond.

When comparing tax-exempt bonds with taxable bonds, investors look at the tax equivalent yield. This yield effectively compares the two bonds to see which bond would be the better investment. The tax equivalent yield is equal to the bonds tax-free municipal bond yield divided by one minus its tax rate.

Taxable Munis

Although most municipal bonds are tax exempt, there are some bonds that are an exception to the rule, and are subject to taxation. In some cases, the government will not subsidize the funding of a certain project if they dont believe the project will make a significant improvement benefiting the general public. These casesfor example, investor-led housing, local sports facilities or other private projectsrequire bondholders to pay tax on the interest that they earn. Overall, the number of taxable bonds has been increasing over the past few years.

AMT Bonds

Alternative minimum tax (AMT) is a system that the IRS uses in order to ensure that the minimum amount of the tax is always paid by investors. The system makes sure that investors pay their fair share of tax even with any deductions, credits or exemptions.

This system has become very controversial as it targets middle and upper class investors. Many investors are unhappy with AMT since they feel that the tax is unfair to those having children or living in high tax states.

These bonds are issued as private activity bonds, which are bonds used for private investment for projects that have some public benefit. This bond is often used since it cuts financing costs by avoiding federal tax.

State Tax Treatment

Depending on the particular state, income tax from bonds may or may not be subject to taxation. Individuals who are residents of Texas. Washington State, Florida. Nevada. Alaska. Wyoming. Texas or South Dakota are not required to pay income tax on their bond interest. Therefore, people from the aforementioned states are able to purchase bonds from any state and not pay state taxes on them.

Residents from the states who do not have state income tax are often indifferent to whether or not they are buying bonds from their state or another state. However, bonds from states with no income tax requirements tend to have higher yields to attract local residents into buying them. Local residents may not be interested in local bonds if they do not offer a high yield since they receive the same tax exemption benefit locally and country-wide.

In 2008, a U.S. Supreme Court case was brought up against Kentucky (Kentucky vs. Davis), accusing the state of discriminating against interstate commerce by making state-issued bonds tax-exempt, while taxing bonds issued in other states. The case against the state was unsuccessful with a vote of 7-2.

In most states, only interest from bonds that were issued in that state are exempt from taxes. Bonds issued from other states may be taxed.