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 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

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)
• 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 per year 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% per year to maturity. Below that tiny discount, the market discount rule doesn't apply and the gain is capital, not ordinary income. 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. 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?

• 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.

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). 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 0.25%-per-year 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