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.
Federal Income Tax Status
- Interest on governmental purpose municipal bonds is exempt from federal income tax
- Interest on private activity bonds subject to the alternative minimum tax (AMT) is a tax preference item
- Taxable municipal bonds (e.g., Build America Bonds, certain private activity bonds) pay interest that is fully taxable at the federal level
State and Local Tax Status
| Scenario | Tax Treatment |
|---|---|
| Bond from investor's home state | Typically triple tax-free (federal + state + local) |
| Bond from another state | Federal exempt, but subject to investor's state income tax |
| U.S. territory bonds (Puerto Rico, Guam, USVI) | Triple tax-exempt for investors in all states |
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.
Premium Bonds (Purchased in Secondary Market)
- 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.
Market Discount Bonds (Purchased in Secondary Market)
- 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)
- The investor may elect to accrete the discount annually or recognize it all at disposition
Original Issue Discount (OID)
- 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:
| OID (Issued Below Par) | Market Discount (Bought Below Par in Secondary Market) | |
|---|---|---|
| Tax treatment of accretion | Tax-exempt interest | Taxable ordinary income |
| Cost basis | Increases annually | May increase if electing annual accretion |
| Who created the discount | The issuer (sold below par at issuance) | The market (price fell after issuance) |
Exam Tip: Gotchas
- OID accretion on munis is tax-exempt; market discount accretion is taxable ordinary income. The key distinction is who created the discount: the issuer (OID, tax-exempt) vs. the market (market discount, taxable).
Accrued Interest
- 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)
Alternative Minimum Tax (AMT)
- Interest on private activity bonds (bonds where more than 10% of proceeds benefit a private entity) is a preference item for AMT
- Governmental bonds and 501(c)(3) bonds (issued for nonprofits) are NOT subject to AMT
- Private activity bonds include: industrial development revenue bonds, certain airport bonds, student loan bonds, housing bonds
- AMT bonds carry higher yields to compensate for the tax treatment
Exam Tip: Gotchas
- AMT applies to private activity bonds, NOT to governmental bonds or 501(c)(3) bonds. If the exam asks which muni bonds are subject to AMT, only private activity bonds qualify.
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.
Capital Gains on Municipal Bonds
- 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 90 and sell at 95, the $50 per bond gain is a taxable capital gain.
- Market discount is taxed as ordinary income (not capital gains). This is a frequent exam trap.