About Municipal Bonds
Taxation of Municipal Bonds
This article will discuss the federal and state tax consequences of owning “municipal bonds.” At the outset, it should be understood that the term “municipal bonds” is typically used to describe all tax-exempt bonds, whether or not they are actually issued by a municipality (as opposed to a state, county or other political subdivision). Although such bonds are commonly referred to as “tax-exempt,” there are numerous federal and state tax consequences associated with the acquisition, ownership, and disposition of such bonds. This article will provide an overview of such consequences.
Capital Gains and Losses
Even though the interest paid on a municipal bond is tax-exempt, a holder can recognize gain or loss that is subject to federal income tax on the sale of such a bond, just as in the case of a taxable bond. The amount of gain or loss is equal to the difference between
- the sale price of the bond and
- the holder's tax basis in the bond (the amount the holder paid for the bond originally, including any additions to such basis, such as OID as discussed in the following section).
Thus, if a holder purchased a $5,000 face amount municipal bond for $5,000 and then sold the bond for $5,200, the holder would have a capital gain of $200. Typically, the purchase and sale price of a municipal bond includes the dealer's markup; however in cases where a commission is charged, it should be taken into account by the holder in computing gain or loss.
There are currently two types of capital gains: long-term and short-term. A long-term gain requires that a bond be held for more than 12 months before it is sold; a short-term gain is the result of holding a bond for 12 months or less. The maximum tax rate on long-term capital gains is 15% (for bonds sold on or after May 6, 2003) and the maximum tax rate on short-term capital gains is 35% (which is also the maximum tax rate on ordinary income).
When a bond is sold, an investor may also recognize a capital loss if the sale proceeds (adjusted for selling costs) are less than the holder's tax basis. In such a case, capital losses are first applied against capital gains of the same type to reduce such gains. Thus, a long-term capital loss will first reduce long-term capital gains, and a short-term capital loss will first reduce short-term capital gains. Any excess long-term capital loss is used to offset short-term gain. Any excess short-term capital loss is used to offset long-term capital gain. Any capital losses remaining after offsetting all available capital gains can then be used to reduce ordinary income by up to $3,000 per year, with any losses in excess of that amount available to be carried forward indefinitely to reduce capital gains or ordinary income in future years under the same procedures.
Original Issue Discount
If a tax-exempt bond is originally issued at a price less than par (as distinguished from a subsequent sale of a previously-issued bond), the difference between the issue price of such bond and the amount payable at the maturity of the bond is considered “original issue discount” (OID).
For instance, if a $5,000 face amount bond (with a maturity of 10 years and a stated interest rate of 5%, payable semi-annually) is issued for $4,628, the bond is treated for federal tax purposes as issued with $372 of original issue discount ($5,000 minus $4,628). From the bondholder's perspective, OID is simply additional interest that the bondholder will receive on the bond, except that it is paid at maturity instead of annually throughout the life of the bond. In the case of a tax-exempt bond, such OID is treated as tax-exempt interest.
Although the OID is treated as tax-exempt to the holder, it will increase the holder's tax “basis” in the bond (over the life of the bond) for purposes of calculating gain or loss if the holder disposes of the bond prior to maturity. In the example above, the value of the bond on the day it is issued is $4,628; at maturity, the bond will be worth $5,000 (assuming it is not in default). If interest rates remain stable, the value of the bond will increase over time from $4,628 to $5,000. If the OID did not increase the holder's tax basis during the period the bond is outstanding, a sale of the bond for an amount in excess of $4,628 would produce taxable capital gain to the bondholder, even if the increase in value arose solely as a result of the accretion of OID.
In order to avoid this result, the Internal Revenue Code (the “Code") provides that the holder's basis will increase over time based on a “constant yield to maturity” (CYM) method. Because this CYM method is also utilized for other purposes related to tax-exempt bonds, including the treatment of premium and “market discount,” we will calculate the CYM on the above bond to demonstrate how the holder's basis is increased.
In order to determine the constant yield to maturity on a bond, it is necessary to determine a constant discount rate that must be applied to each and every payment on the bond (principal and interest) in order to produce an aggregate value (as of the issue date) that is equal to the issue price of the bond. Using the above example (a bond that will pay $125 semi-annually for 10 years, with a final principal payment of $5,000 at the end of such ten year period), the discount rate that must be applied to each of those payments to produce a value of $4,628 is 6.00%, compounded semi-annually.
Thus, even though the stated interest rate is 5%, the bond actually produces a yield to the bondholder of 6% due to its being issued at a discount. This 6% CYM will enter into the accretion of the holder's basis and such basis will increase each year by an amount equal to the excess of
- the accreted issue price at the beginning of each semi-annual period multiplied by the 3% yield (6% annual yield divided by 2 to reflect interest payments), over
- the amount of interest actually paid on the bond during such period.
For instance, assume the bondholder purchased the bond upon issuance on July 1, 2003. The holder's basis six months later on January 1, 2004 would be equal to the opening basis of $4,628 plus ($4,628 x 3% or $138.84) minus ($125 of interest), which will produce a basis of $4,641.84 as of January 1, 2004. Because this calculation is only necessary to determine the bondholder's basis, it need not be done by the bondholder until sale or other disposition of the bond and, if the holder holds the bond until maturity, it need never be done. The basis of a bond purchased at issuance and held to maturity will equal the principal amount of the bond at maturity.
In the case of a taxable bond, if the OID is less than one-fourth of one percent (1/4%) of the principal amount of the bond multiplied by the number of full years until the bond's maturity, the OID is treated as de minimis and is ignored. This rule does not apply in the case of a tax-exempt bond in order to ensure that the full amount of OID is treated as tax-exempt interest to the holder and that the holder does not have an “artificial” gain on the sale of the bond.
If a tax-exempt bond is purchased at a premium (i.e., at a price in excess of the face amount of the bond), whether at original issue or in the secondary market, the bond premium is amortized over the remaining term of the bond using the same constant yield to maturity method discussed above under “Original Issue Discount.” The amount of bond premium amortized each year is not deductible by the holder but instead reduces the holder's tax basis.
Amortizable bond premium can also result if a holder purchases a bond that was originally issued at a discount and the purchase price exceeds the issue price of the bond plus any accrued OID on the bond.
Market discount on a tax-exempt bond can arise if
- the bond is issued at par or at a premium and is later purchased in the secondary market at a price that is less than par or
- the bond is issued at a discount and is later purchased in the secondary market at a price that is less than the original issue price plus accrued original issue discount through the date of purchase.
Market discount, unlike OID, is not treated as tax-exempt interest to the holder when recognized because it arises as a result of market forces, not through the action of the issuer.
The effect of this rule is that a taxpayer who purchases a tax-exempt bond subsequent to its original issuance at a price less than its stated redemption price at maturity (or, if issued with OID, at a price less than its accreted value), either because interest rates have risen or the obligor's credit has declined since the bond was issued, and who thereafter recognizes gain on the disposition of such bond will have part or all of the “gain” treated as ordinary income.
For example, if a $5,000 tax-exempt bond (issued at par on January 1, 2003) with a 20-year maturity were purchased five years after its issuance (on January 1, 2008) at a price of $4,400, the market discount would be $600. If that bond were sold on January 1, 2013 at a price of $4,700, one-third (5 years of owning the bond divided by 15 years from purchase to maturity) of the market discount would have accrued. Thus, $200 (1/3 x $600) of market discount would have accrued and that portion of the holder's $300 gain would be treated as ordinary income. The remaining $100 of the holder's gain would be taxed as long-term capital gains.
In the above example, the market discount accrued ratably over the remaining term to maturity of the bond, i.e., on a straight-line basis. Alternatively, a holder can elect to accrue market discount using the same method that is used for OID (i.e., using a constant yield-to-maturity method).
If the market discount is below a certain “de minimis” amount, it is treated as zero. In the case of a tax-exempt bond, this is beneficial to the holder because, although the discount will be taxable when the bond matures, it will be taxed as capital gain instead of ordinary income. Market discount is treated as de minimis if it is less than one-fourth of one percent (1/4%) of the redemption amount of the bond (typically the par value) multiplied by the number of complete years until the bond matures, measured from the date it is acquired by the holder.
For example, if an individual acquires in the secondary market a $10,000 face amount bond (issued at par) on January 1, 2004 for a price of $9,800, and the bond matures on January 1, 2014, the $200 market discount is de minimis. This result occurs because the face amount of the bond $10,000 multiplied by 1/4 of one percent, multiplied by 10 years until maturity, equals $250. Thus, any market discount less than $250 is de minimis. If the purchase price had been exactly $9,750, the market discount would not have been de minimis and would have been treated as ordinary income upon maturity of the bond.
How would market discount be calculated in the case of a tax-exempt bond that was originally issued at a discount?
For example, the bond that was discussed in section 2 (Original Issue Discount) was issued at $4,628 on July 1, 2003, had a coupon rate of 5.00%, and a yield to maturity of 6.00%. On July 1, 2004, the original holder would have accrued $28.10 in original issue discount (calculated by multiplying the issue price by 3%, reducing that amount for the actual interest paid, and repeating the calculation for two semi-annual periods). Thus, the “adjusted issue price” would be $4,656.10 ($4,628, plus the accrued OID).
Assume the holder sells the bond for $4,456.10 ($200 less than the adjusted issue price). In that case, the new holder has $200 of market discount. The new holder will continue to accrue the tax-exempt OID at the same rate as the prior holder (and for this purpose should consult IRS Publication 1212 for the appropriate amount of OID that accrues each period). Those amounts of OID will equal, in the aggregate, $343.90 by the time the bond matures ($5,000 face amount minus the adjusted issue price of $4,656.10). When the second bondholder adds that amount to his cost basis of $4,456.10, he will have a final basis of $4,800 in the bond. If the second bondholder holds to maturity, he or she will thus recognize a gain of $200 ($5,000 proceeds on maturity minus $4,800 basis). Since this gain is wholly attributable to the market discount, the gain will be taxed as ordinary income.
What if the second holder sold the bond prior to maturity? In that case, he would have to determine his adjusted basis by starting with his cost basis ($4,456.10), and adding to that the amount of OID that has accrued (based on the original discount on the bond). If the holder would sell after two years, the amount of OID that would accrue in the above example would be $61.42 in those two years. Thus, the second holder's basis would increase to $4,517.52. If he sold the bond for $4,600, he would have a gain of $82.48. Part of that gain is attributable to the $200 market discount at the time he bought the bond. That market discount accrues on a straight-line basis at the rate of ($200 divided by 9 years) or $22.22 per year. Since he has held the bond for two years, $44.44 of his gain is ordinary income and the remaining $38.04 is long-term capital gain.
These calculations are very complex and holders who purchase bonds in the secondary market should consult with their brokers and tax advisors to ensure that they have adequate information to properly calculate their tax basis, the amount of original issue discount and market discount that accrues during the period they hold the bond, and the appropriate amount of gain on sale or maturity. In many cases, the information supplied on Form 1099 (in the case of a taxable bond) or through IRS Publication 1212 may be insufficient (or inaccurate) in the case of a secondary purchaser of bonds. This will be true with respect to both tax-exempt bonds and taxable bonds.
Accordingly, all secondary purchasers of bonds should ensure that they fully understand the information that is supplied to them on Forms-1099 (in the case of a taxable bond) or through Publication 1212 (for both taxable and tax-exempt bonds) so that they (or their tax advisors) can properly determine the tax consequences of holding or disposing of bonds after purchase in the secondary market.
The treatment of market discount as ordinary income applies to tax-exempt bonds purchased after April 30, 1993. Thus, if a holder bought a market discount bond in the secondary market prior to May 1, 1993, any gain realized on the eventual sale of such bond would be treated as capital gain, not ordinary income, whether or not the gain was attributable to accrued market discount.
Redemption of Bonds at a Premium
An issuer will sometimes be permitted under the terms of a bond to redeem the bond prior to its maturity date at a fixed price. Such a redemption is treated as a sale of the bond by the bondholder. Thus, the holder may recognize a capital gain or loss on such a sale. If the bond is redeemed at a price above the state face amount of the bond, it is considered to be redeemed at a “premium.”
For instance, assume a holder purchased at original issue a ten-year bond for $10,000 on January 1, 2003 and that the issuer was permitted to redeem the bond on January 1, 2008 for a payment of $10,300. If the issuer in fact chooses to redeem the bond at such time, the additional $300 paid by the issuer to the holder is considered a “premium” and will produce a $300 long-term capital gain to the holder.
Borrowing to Buy a Tax-Exempt Bond
Taxpayers may, in some instances, claim an interest deduction for debt that is incurred to purchase or carry investments. However, a taxpayer may not deduct interest on indebtedness incurred or continued to purchase or carry obligations that are exempt from federal income tax. Without this rule (the “interest disallowance rule"), taxpayers would realize a double tax benefit from using borrowed funds to purchase or carry tax-exempt bonds, since the interest expense would be deductible, while the interest income would escape federal tax.
The interest disallowance rule applies whenever a taxpayer uses borrowed funds to purchase or carry tax-exempt bonds. Thus, if
- borrowed funds are used for, and directly traceable to, the purchase of tax-exempt bonds, or
- tax-exempt bonds are used as collateral for indebtedness,
then no part of the interest paid or incurred on such indebtedness may be deducted. If borrowed funds are only partly or indirectly used to purchase or hold tax-exempt bonds, then the rule will disallow a deduction for that portion of the interest allocable to the tax-exempt bonds.
While the interest disallowance rule is broad in scope, it does not automatically deny an interest deduction whenever a taxpayer simultaneously maintains debt and earns tax-exempt income. For example, the rule generally will not apply if an individual, while holding tax-exempt bonds, takes out a mortgage to purchase a residence rather than selling the bonds to finance the purchase. In this circumstance, the personal purpose of the loan predominates, and the Service considers it unreasonable to deny the mortgage interest deduction.
Similarly, the interest disallowance rule will not apply with respect to bona fide business loans unless the indebtedness is determined to be in excess of reasonable business needs. For example, the interest disallowance rule generally will not apply if a taxpayer that owns tax-exempt bonds borrows funds to finance a major capital improvement. In addition, a taxpayer may invest the proceeds of bona fide business indebtedness directly in short-term tax-exempt bonds for a temporary period while the borrowed funds await their intended use.
The Internal Revenue Service has issued a Revenue Procedure (Rev. Proc. 72-18) that permits individual and corporate taxpayers to avoid the effect of this disallowance rule where the taxpayer's investment in tax-exempt bonds is insubstantial. In the case of an individual, investment in tax-exempt obligations is considered insubstantial if the average amount of tax-exempt obligations (valued at their adjusted basis) is less than or equal to two percent (2%) of the average adjusted basis of all portfolio investments of the taxpayer. In the case of a corporation, investment in tax-exempt obligations is considered insubstantial if the average basis of such investments is less than or equal to two percent (2%) of the corporation's total assets.
The interest disallowance rule also prevents a bank or other financial institution from deducting that portion of its interest expense that is allocable to tax-exempt interest. The disallowed portion is determined by applying a ratio of
- the taxpayer's average for the tax year of the adjusted bases of tax-exempt bonds acquired after August 7, 1986 to
- the average for the tax year of the adjusted bases of all assets of the taxpayer. However, a financial institution may deduct 80 percent of its interest expense allocable to “qualified tax-exempt obligations,” which are a special type of tax-exempt obligation issued by qualified small issuers that reasonably anticipate issuing no more than $10 million in tax-exempt obligations during the calendar year.
Reporting of Tax-Exempt Interest
Notwithstanding the exemption from taxes for interest on municipal bonds, taxpayers are still required to report such interest on their federal income tax returns pursuant to section 6012(d) of the Code. For taxpayers filing 2002 returns, such income is required to be reported on line 8b of Form 1040. The interest is reported for information purposes only and does not enter into the computation of any tax that is due, except as discussed below with respect to the Alternative Minimum Tax and the Taxation of Social Security Benefits.
Alternative Minimum Tax
The tax-exempt status of municipal bonds does not extend in all instances to the alternative minimum tax. The alternative minimum tax (“AMT”) is a separate tax calculation that must be performed by both individual and corporate taxpayers and the resulting tax is then compared to the regular tax. Whichever tax is higher is the one that must be paid.
The AMT is calculated by starting with regular income and then making certain adjustments to that income. The most common adjustments are the elimination of the personal exemption deduction, the elimination of a deduction for state and local taxes, and the inclusion in income of interest on “private activity” municipal bonds. In general, the bonds on which interest is taxable for AMT purposes are private activity bonds that were originally issued after August 7, 1986 except for
- qualified 501(c)(3) bonds, and
- certain refunding bonds.
Although the definition of “private activity bonds” is beyond the scope of this article, such bonds will typically include any municipal bond the proceeds of which are used to benefit, or finance a facility for the use of, a private business.
Once AMT income is calculated, a taxpayer is permitted to reduce that income by a so-called “exemption amount” before calculating the tax due. The exemption amount is $58,000 for married taxpayers filing jointly, $29,000 for married taxpayers filing separately, and $40,250 for individual taxpayers. However, these exemption amounts are reduced if AMT income exceeds a certain level.
In essence, for each $4 of income above that level, the exemption amount is reduced by $1. For instance, for married taxpayers filing jointly, the $49,000 exemption amount begins to be “phased out” if AMT income exceeds $150,000 and is completely eliminated once AMT income reaches $382,000.
Once the taxpayer's AMT income is calculated, and then reduced by the appropriate exemption amount (if any), that income is subject to tax at a rate of 26% on the first $175,000 of income ($87,500 for married individuals filing separately) and 28% on income above that level.
In general, investors in the 35% federal tax bracket will not encounter an AMT problem because their regular income tax will exceed their AMT. However, for investors in the 28% or 33% brackets, especially those with large capital gains that may result in the reduction or elimination of the exemption amount and those who live in states with high income taxes, the AMT may become a problem. An investor that is not otherwise subject to the AMT should take into account the effect of this provision in deciding whether, and to what extent, to purchase tax-exempt bonds that are subject to the AMT. Furthermore, an investor already subject to the AMT should take into account the additional AMT that would be owed as a result of the purchase of otherwise “tax-exempt” bonds.
Effect of Tax-Exempt Interest in Calculation of Social Security Benefits Subject to Taxation
Under some circumstances, a taxpayer who receives tax-exempt interest will have a greater portion of his or her social security benefits taxed than if they received no tax-exempt interest. Although this does not constitute a direct tax on the tax-exempt interest itself, it does increase the overall tax liability of the individual and should be taken into account in making the investment decision of whether or not to purchase the tax-exempt bond.
The calculation of the amount of social security benefits subject to tax is governed by section 86 of the Code and is fairly complex.
This article will only deal with married taxpayers, filing jointly, whose “provisional income” exceeds $44,000. “Provisional income” is defined as
- adjusted gross income (with some adjustments) plus
- tax-exempt interest plus
- one-half of social security benefits.
Assuming provisional income (as determined above) exceeds $44,000, a taxpayer must include in income the lesser of:
- 85% of the social security benefits received during the year, or
- the sum of
- the lesser of
- $6,000 or
- the “50% amount” (defined below) and
- 85% of the excess of provisional income over $44,000. The “50% amount” is defined as the lesser of
- 50% of the social security benefits received or
- 50% of the excess of provisional income over $32,000.
- the lesser of
For example, assume married taxpayers with $40,000 of ordinary income (such as dividends and interest), $12,000 of social security benefits, and $10,000 of tax-exempt interest.
- Provisional income is $40,000 + (1/2 of $12,000) + $10,000 or $56,000.
- The 50% amount is $6,000 (one-half of social security benefits) because that amount is less than one-half of the difference between $56,000 and $32,000.
- The amount included in income is the lesser of
- 85% of $12,000 or
- the sum of $6,000 and (85% of the difference between $56,000 and $44,000).
What would have been the result if they had not received any tax-exempt interest? Provisional income would be reduced to $46,000 and the amount calculated in (ii) in the third bullet paragraph would have been $7,700. Since $7,700 is less than $10,200, the taxpayers’ additional tax would be reduced to 15% x $7,700 or $1,155. Thus, the effect of receiving $10,000 in tax-exempt interest resulted in $375 additional tax, which is an effective rate of tax of 3.75% on the tax-exempt interest. This additional tax would have to be taken into account by the taxpayers when making their decision as to whether or not to purchase the tax-exempt bond.
Because of the complexity of such calculations, individuals subject to section 86 may wish to consult their own tax advisors to perform these calculations.
State Tax Treatment of Tax-Exempt Bonds
This article is not intended as a comprehensive guide to the state tax treatment of tax-exempt bonds. However, in general, most states do not tax individuals on the interest income arising from tax-exempt bonds issued by that state, its agencies, or its political subdivisions. However, the reverse is true with respect to bonds issued by out-of-state agencies or political subdivisions — virtually all states tax the interest resulting from such bonds. The effect of such disparate treatment is to increase the effective yield on a tax-exempt bond issued in one's own state versus an out-of-state bond. For instance, if an investor pays state tax at an effective 5% rate (after taking into account the federal deduction allowed for such state taxes) and the state taxes out-of-state bonds (but not in-state bonds), an in-state bond bearing a 6% interest rate is the equivalent of a 6.32% out-of-state bond.
The state tax exemption for interest on in-state bonds will not necessarily extend to capital gain resulting from the sale or disposition of such bonds (or ordinary income resulting from the application of the market discount rules). Thus, a holder who recognizes capital gain (or ordinary income resulting from market discount) may be required to pay state tax on such capital gain and should consult a tax advisor with respect to the state tax consequences of such a sale.
This article was prepared for the Securities Industry and Financial Markets Association by Michael G. Meissner, Esq.
Squire, Sanders & Dempsey L.L.P.
4900 Key Tower
127 Public Square
Cleveland, Ohio 44114-1304
© June, 2003.