Tax Considerations

Tax-Exempt Status of Municipal Bonds

The tax-exempt status of municipal bond interest is one of the most important features distinguishing municipal bonds from other fixed-income securities. Under the Internal Revenue Code, interest earned on most municipal bonds is exempt from federal income tax. This tax advantage is the primary reason that municipal bonds can offer lower nominal yields than taxable bonds of comparable credit quality and maturity while still providing competitive after-tax returns for investors in higher tax brackets.

The rationale for the federal tax exemption is rooted in the principle of reciprocal immunity between the federal government and state/local governments. The federal government does not tax the interest on state and local debt obligations, just as state governments generally do not tax the interest on federal obligations. This arrangement is based on constitutional principles of federalism and has been upheld by the courts.

Tax-Equivalent Yield

The tax-equivalent yield (TEY) is a critical concept for comparing the attractiveness of tax-exempt municipal bonds to taxable alternatives. The TEY converts a tax-exempt yield to the taxable yield that would provide the same after-tax return. The formula is:

Tax-Equivalent Yield = Tax-Exempt Yield / (1 - Marginal Tax Rate)

The higher the investor's tax bracket, the more valuable the tax exemption becomes and the higher the tax-equivalent yield. This is why municipal bonds are most attractive to investors in the highest marginal tax brackets. Conversely, investors in lower tax brackets (or tax-exempt entities like pension funds) may find taxable bonds more attractive because they do not benefit as much from the tax exemption.

State and Local Tax Considerations

In addition to the federal tax exemption, many states exempt interest on bonds issued by in-state municipalities from state income tax. This provides a "double tax exemption" for state residents who invest in bonds issued by their own state or its political subdivisions. Some states (and certain municipalities like New York City) also exempt municipal bond interest from local income taxes, providing a "triple tax exemption."

However, most states tax interest earned on out-of-state municipal bonds. For example, a California resident who purchases a New York municipal bond will owe California state income tax on the interest, even though the interest is exempt from federal tax. This is why financial advisors often recommend that investors in high-tax states purchase bonds issued within their state of residence to maximize the tax benefit.

Alternative Minimum Tax (AMT)

The Alternative Minimum Tax is a parallel tax system designed to ensure that high-income taxpayers who claim many deductions and exclusions still pay a minimum level of tax. For the Series 52 exam, the key point is that interest on certain private activity bonds is a preference item for AMT purposes. This means that while the interest may be exempt from regular federal income tax, it must be added back to the taxpayer's income when calculating their AMT liability.

Private activity bonds subject to AMT include industrial development bonds, student loan bonds, and certain housing bonds. Not all municipal bond interest triggers AMT. Interest on GO bonds, essential service revenue bonds (water, sewer, electric), and certain other categories is not subject to AMT. The 501(c)(3) bonds used by non-profit hospitals and universities are also exempt from AMT.

The De Minimis Rule

The de minimis rule determines whether the discount on a municipal bond purchased in the secondary market at a price below par is treated as a capital gain (more favorable tax treatment) or as ordinary income (less favorable). This rule is one of the most frequently tested tax concepts on the Series 52 exam.

Under the de minimis rule, a market discount is considered "de minimis" (too small to matter for tax purposes) if the discount is less than one-quarter of one percent (0.25%) of the bond's par value multiplied by the number of complete years remaining to maturity. If the discount is de minimis, it is treated as a capital gain when the bond matures or is sold. If the discount exceeds the de minimis threshold, the portion of the discount from the original issue price to par is treated as ordinary income.

The formula is: De Minimis Amount = 0.25% x Par Value x Years to Maturity

Cost Basis, Premium Amortization, and Original Issue Discount

Premium Bonds

When an investor purchases a municipal bond at a premium (above par value), the tax treatment of the premium is an important consideration. For tax-exempt municipal bonds purchased at a premium, the investor is required to amortize the premium over the remaining life of the bond. This amortization reduces the investor's cost basis each year. The amortized premium cannot be deducted as a loss because the bond's interest is already tax-exempt.

For example, if an investor purchases a municipal bond at 105 ($1,050) with 10 years to maturity, the $50 premium is amortized over 10 years ($5 per year using straight-line). After one year, the adjusted cost basis is $1,045. At maturity, the cost basis equals par ($1,000), so there is no gain or loss. The key point is that the premium amortization for tax-exempt bonds is mandatory and reduces the cost basis but cannot be taken as a tax deduction.

Original Issue Discount (OID)

Bonds issued at a price below par value have an Original Issue Discount (OID). For municipal bonds, the OID is treated as tax-exempt interest that accrues over the life of the bond, increasing the investor's cost basis each year. When the bond matures at par, there is no taxable gain because the cost basis has been adjusted upward to par through the annual OID accrual.

The most extreme example of an OID bond is a zero-coupon bond, which pays no periodic interest and is issued at a deep discount from par. The entire return comes from the difference between the purchase price and the par value received at maturity. For tax-exempt zero-coupon municipal bonds, the annual OID accrual is treated as tax-exempt income that increases the cost basis.