Municipal bonds, or munis, have proved to be a great vehicle for states and municipalities that can receive financing at a low cost, and for investors who can find better after-tax returns for their bond portfolios. Despite these advantages, however, investors must be aware of certain issues surrounding the munis they purchase, lest they be surprised by a tax bill from their "tax-free" investments.

Tutorial: The Basics Of Bonds

Municipal Bonds can be Subject to Capital Gains Tax
When buying muni bonds on the secondary market, investors must be aware that bonds purchased at a discount (less than par value), will be taxed upon redemption at the capital gains rate. Note that this tax does not apply to the coupon payments, but only the principal of the bond.

For example:
The table below shows three different bonds, all maturing in two years and all of which give the buyer a return of 4% if purchased at their net present value price.

Bond Required Rate of Return Coupon Rate Cash Flow at End of Year 1 (Coupon) Cash Flow at End of Year 2 (Coupon+ Principal) Net Present Value
Par 4% 4% $4 $104 $100
Premium 4% 6% $6 $106 $103.77
Discount 4% 2% $2 $102 $96.22

The difference between the net present value and the principal payment at maturity is taxed at a capital gains rate of 15%. In this case, the discount bond (from above) will be worth less to the buyer, as shown below.

Bond Required Rate of Return Coupon Rate Cash Flow at End of Year 1 (Coupon) Cash Flow at End of Year 2 (Coupon + Principal - Tax) Net Present Value
Discount (Not Taxed) 4% 2% $2 $102 $96.22
Discount (Capital Gains Tax of 15%) 4% 2% $2 $101.34 (Tax=$100 - $95.62 x 0.15) $95.62

Without knowing that the gain is subject to capital gains tax, an investor could end up paying $96.22 for a bond that is only worth $95.62. So, when looking at a muni bond offered for sale on the secondary market, the investor must look at the price of the bond, not just the yield to maturity, to determine whether tax consequences will affect the return. (To learn more, see Where can I get bond market quotes?)

The bad news is, while discount bonds are taxed, bonds purchased at a premium do not work in a similar manner; they cannot offset capital gains by providing capital losses.This tax rule runs contrary to that of most investments, including other types of bonds, because the IRS treats tax-free instruments differently than their taxable cousins. Thus, when analyzing yields for muni bonds offered on the secondary market, for par or premium bonds the yield-to-maturity figure is usually sufficient to determine an expected return, but for discount bonds, one must also factor in the negative tax implications that can arise from capital gains.

The "De Minimis" Rule
One of the most confusing concepts related to muni bonds is the de minimis tax rule.This nugget of tax law states that if you purchase a bond at a discount and the discount is equal to or greater than a quarter point per year until maturity, then the gain you realize at redemption of the bond (par value minus purchase price) will be taxed as ordinary income, not as capital gains. For those in the top tax bracket this could mean the difference between paying 15 and 35% on the gain.

For example:
Let's take the discount bond from the previous example. Because it is a two-year bond, we can calculate that purchasing it for $99.50 or less will mean falling into the de minimis rule and being taxed at the ordinary income tax rate.

Par Value - (Amount Allowable * Years to Maturity) = De Minimis Cutoff
$100 - (0.25 * 2) = $99.50

Since the net present value for this bond is well below $99.50, we need to calculate the tax consequences when the gain on principal is taxed as ordinary income.

Bond Required Rate of Return Coupon Rate Cash Flow at End of Year 1 (Coupon) Cash Flow at End of Year 2 (Coupon + Principal - Tax) Net Present Value
Cap. Gains Tax (15%) 4% 2% $2 $101.34 $95.62
Ordinary Income Tax (35%) 4% 2% $2 $100.47 (Tax = $100 - $95.62 x 0.35) $94.42

While an investor might pay $95.62 if only accounting for capital gains tax, the true value is much lower - only $94.42. At the time of purchase, the buyer must recognize whether the bond is subject to de minimis, otherwise, the after-tax return could be substantially less than expected.

Some Municipal Bonds are Federally Taxable
The federal government does not tax most activities of states and municipalities, giving most muni bonds tax-exempt status, but some activities do not fall under this tax exemption. Thus, coupon payments for muni bonds sold to fund those activities are federally taxed. One common example is a bond issued to fund a state's pension plan obligation. When this type of bond is for sale, brokers selling the bond should readily know whether it is taxable.

Another, more harrowing example of taxable munis, is those that are issued as tax free, then later become taxable if and when the IRS determines the proceeds are being used for purposes that do not fall under tax-exempt status. This is very rare, but when it happens, it leaves a lot of very unhappy investors; their coupon payments are taxed as ordinary income and, if they choose to sell the bond, the price they receive will be lower because buyers would require a higher yield on a taxable bond.

Generally, taxable munis are still exempt from state and local taxes, so investors in states with high income taxes may find that they get a better after-tax return than with other fixed income investments that are fully taxable at all levels, such as corporate bonds or certificates of deposit.

The Alternative Minimum Tax
Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax (AMT). If you are unsure of whether a specific muni is subject to AMT, be sure to consult the broker before purchasing it. An example of the type of muni that is subject to AMT is that used for a particular municipal improvement that is not backed by the credit of a state or municipality, but rather that of a corporation (such as an airline backing an airport improvement bond).

The Bottom Line
While munis are an attractive investment for many due to the tax savings, it is vital that you understand potential tax liabilities surrounding a purchase. If not, you might be surprised with an unexpected tax bill. To learn more, read The Basics Of Municipal Bonds and Weighing The Tax Benefits Of Municipal Securities.

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