Tax Treatment of Municipal Securities

This final section brings together the tax rules that apply to municipal bonds. Tax treatment is one of the most frequently tested areas for munis on the Series 7, so understanding these distinctions matters.

Federal Income Tax Status

• Interest on most municipal bonds is exempt from federal income tax
• This is the primary advantage of municipal securities and the reason they carry lower nominal yields than comparable taxable bonds
• The tax exemption applies to interest only; capital gains on munis are still taxable

State and Local Tax Status

Exam Tip: Gotchas

• U.S. territory bonds are the only munis that are triple tax-exempt regardless of where the investor lives. The exam may present an investor in any state holding a Puerto Rico bond and ask about tax status. The answer is always triple-exempt.

Securities Bought at a Premium in the Secondary Market

• The premium on a tax-exempt muni must be amortized (mandatory)
• The amortized premium is not tax-deductible
• At maturity: cost basis = par, so there is no capital loss
• If sold before maturity: gain/loss is calculated against the amortized cost basis (not the original purchase price)

Exam Tip: Gotchas

• Premium amortization on tax-exempt munis is mandatory AND not deductible. This is a double hit: you must reduce your cost basis each year, but you get no tax deduction for doing so. At maturity, your basis equals par, so there is no capital loss to claim.

Securities Bought at a Discount in the Secondary Market

• Market discount (amount below par, or below the accreted original issue discount (OID) value) is taxed as ordinary income upon sale or maturity
• The investor may choose to accrete market discount annually (paying tax each year) or defer recognition until sale or maturity

The De Minimis Rule

If the discount is small enough, it gets favorable treatment:

• De minimis threshold = 0.25% (1/4 point) per year remaining to maturity x face value
• If the discount is less than the de minimis threshold, it is treated as a capital gain (lower tax rate) rather than ordinary income
• If the discount exceeds the de minimis threshold, the entire discount is ordinary income

Example: A $1,000 bond with 10 years to maturity:

De minimis threshold = 0.25% x $1,000 x 10 years = $25

• Bought at $980 (discount = $20, below $25 threshold) → capital gain treatment
• Bought at $960 (discount = $40, above $25 threshold) → ordinary income treatment

Exam Tip: Gotchas

• De minimis threshold: if the discount exceeds the threshold, the ENTIRE discount is ordinary income (not just the amount above the threshold). A common wrong answer is that only the excess is taxed as ordinary income.

Original Issue Discount (OID) Bonds

Think of it this way: OID is a discount that existed from day one (the issuer set the price below par), so the IRS treats the accretion like interest you are earning. Market discount happens because prices moved in the secondary market, so the IRS treats that gain as ordinary income you owe taxes on.

• OID = par value - original issue price
• OID on tax-exempt bonds is accreted annually and treated as tax-free interest (same exemption as coupon interest)
• The accreted OID increases the cost basis each year
• If sold before maturity above the accreted basis → capital gain
• If sold before maturity below the accreted basis → capital loss

Exam Tip: Gotchas

• OID accretion on tax-exempt munis = tax-free. This is the opposite of market discount, which is taxable as ordinary income. Both increase cost basis, but OID accretion is treated like tax-exempt interest while market discount is ordinary income.

Accrued Interest Tax Treatment

• Tax-exempt accrued interest paid by the buyer at purchase is recovered tax-free when the next coupon is received
• The buyer's first coupon includes the accrued interest paid at purchase; only the portion earned during the buyer's holding period is considered income (which is tax-exempt for munis)

Alternative Minimum Tax (AMT)

Interest on certain private activity municipal bonds is subject to the federal alternative minimum tax (AMT).

• Private activity bonds finance projects that primarily benefit private entities
• Bonds subject to AMT typically offer higher yields to compensate investors
• Investors subject to AMT should factor this into yield comparisons

Exam Tip: Gotchas

• Private activity bonds are subject to AMT; essential purpose bonds are NOT. If a question asks which muni bonds may trigger AMT, look for bonds financing private projects (stadiums, industrial parks, private housing). Bonds for public schools, roads, and government buildings are exempt from AMT.

Taxable Municipal Bonds

Some municipal bonds are fully taxable at the federal level:

• Build America Bonds (BABs): taxable munis created under the 2009 Recovery Act that provided issuers with a federal subsidy
• Taxable munis offer higher yields than tax-exempt munis to compensate for the loss of tax exemption
• These bonds appeal to investors in lower tax brackets or tax-exempt accounts (IRAs, pension funds) where the tax exemption has no value

Bank-Qualified Bonds

Bank-qualified bonds (also called qualified tax-exempt obligations) are a special designation for small issuers:

Exam Tip: Gotchas

• Bank-qualified bonds benefit the BANK, not the individual investor. The bank can deduct 80% of carrying costs, which makes small municipal issuers' bonds attractive to banks and lowers the issuer's borrowing costs. The exam may ask who benefits from bank qualification: the answer is the bank (and indirectly the issuer through lower rates).

Tax Treatment Summary Table