Many investors spurn out-of-state municipal bonds because they might have to pay state and local income tax on their interest.

But special amortization rules let you offset some taxable interest. That amps the appeal of those out-of-state munis. Here’s how it works:

When you buy bonds on the secondary market now, you’ll likely pay a premium of about $100 to $200 or more for a bond with a face value of $1,000. Buyers pay it to get relatively high yields amid today’s low interest rates.

Still, that premium gets unique tax treatment, which differs for taxable and tax-exempt bonds.

When you buy a muni at a premium, you must amortize that premium. That is, you reduce your basis over the bond’s remaining life.

Suppose you buy muni bonds maturing in seven years with a $25,000 face value. You pay, say, $29,200 to get the bonds’ relatively high yields.

Then you reduce your basis in the bonds from $29,200 to $25,000 over seven years. The annual amortization of the $4,200 premium is a bit less than $600 in the early years and a bit more close to maturity.

The new basis only goes on your tax return if you sell a bond before its maturity. The basis, adjusted for amortization, determines gain or loss. You can’t use this amortization for any tax deduction with a tax-exempt bond from your home state.

There can be a tax benefit if you buy munis from out of state, said PricewaterhouseCoopers tax expert Bill Fleming.

Offsetting The Premium

With an out-of-state muni, taxpayers generally owe income tax in their home state. But amortization of the premium can offset the tax.

Say you buy a seven-year out-of-state bond that pays 5% interest. In 2013, you’d get $1,250 in interest: 5% of $25,000 face value.

That interest is federally tax-exempt. With out-of-state munis, the interest would be subject to state and perhaps local income tax.

But the bond amortization can be deducted against the interest income. Here, you can shelter from state and local taxes $600 (the amount amortized) of the $1,250 in annual interest.

With any type of muni, you’d redeem at face value at maturity. You cannot claim a capital loss, even though you paid $29,200 for bonds you redeemed for $25,000.

The $4,200 premium is what you pay for seven years of high tax-exempt interest, in this example.

In this case, the premium is worth it. You get $1,250 tax-exempt interest annually, totaling $8,750 after seven years.