Tax Treatment of Municipal Securities

Tax treatment drives the pricing and yield calculations for municipal bonds. Understanding exactly what is and is not tax-exempt is essential for the exam.

What Is the Federal Income Tax Status of Muni Interest?

• Interest on governmental purpose municipal bonds is exempt from federal income tax
• Interest on qualified private activity bonds is also exempt from regular federal income tax, but for most of them it is a tax preference item for the alternative minimum tax (AMT); 501(c)(3) bonds are the main exception
• Taxable municipal bonds (e.g., Build America Bonds, private activity bonds that are not qualified bonds) pay interest that is fully taxable at the federal level

What Is the State and Local Tax Status?

Exam Tip: Gotchas

• U.S. territory bonds (Puerto Rico, Guam, USVI) are triple tax-exempt for ALL investors regardless of state. This makes them uniquely attractive for tax-sensitive investors in any state.

How Are Premium Bonds Taxed?

• The premium must be amortized over the remaining life
• Amortization reduces cost basis annually
• The amortized premium is not deductible (because the income is tax-exempt)
• At maturity, cost basis = par; no capital gain or loss

Think of it this way: If you pay $1,050 for a $1,000 par bond with 10 years left, you amortize $5 per year. Each year your cost basis drops by $5. At maturity, your basis equals par ($1,000), so there is no gain or loss. And because the interest is tax-exempt, you cannot deduct the premium either.

Exam Tip: Gotchas

• Premium amortization on munis is NOT deductible. You cannot take a tax loss on amortizing a tax-exempt bond. The tax-free interest is the tradeoff.

How Are Market Discount Bonds Taxed?

• If a bond is purchased below par in the secondary market, the market discount is the difference between par and the purchase price
• At sale or maturity, the accrued market discount is taxed as ordinary income (not capital gain), unless the de minimis exception below applies
• The investor may elect to accrete the discount annually or recognize it all at disposition
• De minimis exception: if the market discount is less than 0.25% (1/4 point) of face value times the number of complete years remaining to maturity, the discount is small enough to be treated as a capital gain instead of ordinary income

Exam Tip: Gotchas

• The de minimis threshold is 0.25% of face value times the complete years to maturity. Below that tiny discount, the market discount rule doesn't apply and the gain is capital, not ordinary income. At or above it, the full discount is ordinary income.

How Is Original Issue Discount (OID) Taxed?

• For tax-exempt municipal OID bonds, the accretion is treated as tax-exempt interest income (not taxable)
• The bondholder's cost basis increases by the annual accretion amount
• If sold before maturity at a price above the accreted value, the excess is a capital gain

OID vs. market discount:

Exam Tip: Gotchas

• OID accretion on munis is tax-exempt; market discount accretion is taxable ordinary income unless it is de minimis. The key distinction is who created the discount: the issuer (OID, tax-exempt) vs. the market (market discount, taxable).

How Is Accrued Interest Taxed?

• Accrued interest received by the seller is tax-exempt (same as regular interest)
• Accrued interest paid by the buyer is treated as a return of tax-exempt income when the buyer receives the next coupon (not separately taxable)

When Does the Alternative Minimum Tax (AMT) Apply?

• The general private business tests require both more than 10% private business use of proceeds and more than 10% of debt service secured by, or paid from, private business property or payments. Private use alone does not establish both tests
• A separate private loan financing test can also make an issue a private activity bond
• A private activity bond must meet the requirements for a qualified bond to pay tax-exempt interest. An unqualified private activity bond pays federally taxable interest
• Interest on certain tax-exempt private activity bonds is a preference item for AMT. Newly issued qualified industrial development, airport, and student loan bonds are common examples
• Governmental bonds and qualified 501(c)(3) bonds (issued for nonprofits) are not AMT preference items. Exceptions also cover certain housing bonds, so private ownership alone does not establish AMT exposure
• AMT bonds may offer higher yields to compensate for the tax treatment
• The AMT only adds the interest back in the separate AMT calculation. The interest stays exempt from regular federal income tax, and an investor who owes no AMT keeps the full higher yield tax-free

Exam Tip: Gotchas

• Tax-exempt does not always mean AMT-exempt. Check the issue's tax status: certain qualified private activity bonds create an AMT preference item, while governmental and qualified nonprofit bonds do not.
• "Private activity" does not mean "AMT" by itself. A private activity bond that is not a qualified bond is fully taxable, so check that a question calls the bond tax-exempt before you treat AMT as the only issue.

What Are Bank-Qualified Bonds?

• Municipal bonds issued by small issuers (no more than $10 million in tax-exempt bonds per calendar year) may be designated as bank-qualified (or "qualified tax-exempt obligations")
• Banks that purchase bank-qualified bonds may deduct 80% of the carrying cost (interest expense) of funds used to buy the bonds
• This makes bank-qualified bonds attractive to commercial banks, increasing demand and lowering borrowing costs for the issuer

Exam Tip: Gotchas

• Bank-qualified threshold: $10 million per calendar year. The 80% carrying cost deduction applies only to banks, not individual investors.

Are Capital Gains on Municipal Bonds Tax-Exempt?

• If a bond is sold for more than its adjusted basis, the gain is a capital gain (taxable)
• Capital gains on municipal bonds are NOT tax-exempt (only the interest is exempt)
• Short-term capital gain (held 1 year or less): taxed as ordinary income
• Long-term capital gain (held more than 1 year): taxed at preferential capital gains rates

Exam Tip: Gotchas

• Municipal bond interest is tax-exempt, but capital gains are NOT. If you buy a muni at par (100) and later sell it at 105, the $50 per bond gain is a taxable capital gain.
• Market discount is taxed as ordinary income (not capital gains) unless it is below the de minimis threshold. This is a frequent exam trap.

What Should You Check on Exam Day?

• Federal exemption applies to interest, never to capital gains
• In-state bonds are triple tax-free; out-of-state bonds are federal-exempt but state-taxable; U.S. territory bonds are triple tax-exempt everywhere
• OID accretes tax-exempt; market discount accretes as taxable ordinary income, unless the discount is under the de minimis threshold, which is taxed as capital gain; premium amortization is not deductible because the underlying interest is already tax-free
• AMT applies only to private activity bonds, never to governmental or 501(c)(3) bonds
• Bank-qualified threshold is $10 million per calendar year; the 80% carrying-cost deduction benefits the bank, not the investor