Tax-Exempt Bond Investing


Tax Issue

 Taxpayers pay tax on the interest income earned on taxable investments. Often the interest income is left to reinvest in the interest-earning investment. Therefore, the taxpayer is paying tax on interest earned even if the earnings are not being withdrawn and used for living expenses.

Even if the taxpayer is withdrawing the interest earnings and using this for living expenses, the interest earnings are subject to income tax. Taxpayers may be foregoing tax-free income and also may be earning a lower net rate of return on the investment when the effect of taxes is computed on the income.


Applicable Tax Law

  • Interest earned on municipal bonds, bonds issues by state and local governments, are not subject to federal income tax. The term “state” includes the District of Columbia and any possession of the United States.
  • Municipal bonds may be issues as governmental bonds or nongovernmental bonds. Nongovernmental bonds are called private activity bonds.
  • Interest earned from qualified private activity bonds is not subject to federal income tax. Qualified private activity bonds are bonds issues by state and local governments, the proceeds of which are used by an entity other than the government issuing the bonds. Qualified bonds included those used for:

-Airports, docks, and wharves,

-Mass transit facilities,

-Water, sewage, and solid waste disposal facilities,

-Qualified mortgages and qualified veterans’ mortgages,

-Certain small issue manufacturing facilities, small issue fam properties, and redevelopment projects, and

-Qualified enterprise zone and empowerment zone facilities.

  • Although income tax free, interest earned from qualified private activity bonds is subject to alternative minimum tax (AMT).
  • Municipal bond income is not subject to state income taxes if the bondholder resides in the state the municipal bond is issued from.
  • Municipal bonds are subject to capital gains tax rates and capital loss rules for bonds that are sold at a price above or below the investment amount.
  • Municipal bonds are backed by the full faith and credit of the issuing municipality. In addition, some bonds are insured against loss by third-party insurers.


Tax Planning Strategies

 Taxpayers whose income is subject to high tax brackets should consider investing money in municipal bonds to obtain tax-free income. The income earned, whether withdrawn or reinvested, is not subject to federal income tax.


Bond or bond mutual fund. Taxpayers can invest in a single-issue bond or a collection of bonds through a bond mutual fund. Municipal bond funds can invest in bonds nationwide or within a particular state. Interest earned on municipal bond funds is distributed to the owners of the funds by way of tax-free dividends.


Tax-equivalent yield. The yield a taxpayer earns on tax-exempt bond interest is generally lower than taxable bond yields. However, when subtracting tax from the taxable yield investment, the net return may be less on the taxable bond than the tax-exempt bond could yield. For example, a taxpayer whose income is in the 33% tax bracket invests in a municipal bond yielding 4.0%. The taxpayer would need to earn 5.97% in a taxable bond to have the same yield as the municipal bond. For municipal bonds not subject to state income taxes, the equivalent yield of a taxable bond is even higher.


Possible Risks

  • Municipal bonds carry credit risk. The bonds themselves are backed by the full faith and credit of the issuing entity. However, municipalities can become bankrupt and the bond may not be paid back in full, or at all.
  • Municipal bonds carry an interest rate risk. If interest rates increase after a bond is purchased, the bond itself may lose value due to other investments paying higher rates of interest. If the bondholder sells the bond before maturity, the value received may be less than the bondholder paid for the bond.
  • Municipal bonds carry tax risk. If tax rates are lowered, the equivalent yield of a taxable investment is higher. This may cause an existing municipal bond to be valued lower because other investments can yield a higher return. Conversely, an increase in tax rates may cause a municipal bond to be a more attractive investment.
  • Municipal bond mutual funds may have an element of taxable income in the distributions. The funds can invest a portion of the investment in taxable money market funds that generate income to the fund and the income is then distributed to the shareholders as taxable income. In addition, a bond fund can buy and sell bonds within the fund itself, thereby generating a capital gain distribution when a profit is made on the sale of bonds within the fund.
  • Tax-free distributions from a municipal bond mutual fund reinvested in the same fund add to the basis of the investment and will be used to determine the eventual capital gain or loss when the taxpayer sells his or her shares.


Court Cases


Court Case: The state of Pennsylvania seized the taxpayers’ land through an eminent domain settlement. In the settlement, Pennsylvania made installment payments to the taxpayers over a period of years. Section 103 allows a taxpayer to exclude from gross income interest earned on the obligations of any state or its political subdivisions. The exclusion is limited to interest paid by a governmental entity on obligations issued under its borrowing authority. The taxpayers argued that interest paid on the installment payments were excludable from income because, in agreeing to the settlement, Pennsylvania was exercising its borrowing authority. The Tax Court ruled the interest payments were not excludable because Pennsylvania did not incur the obligation to pay the interest as an exercise of its borrowing authority.

The Circuit Court reversed the Tax Court decision. The State and the taxpayers negotiated a complete arm’s-length settlement of the State’s claims to the taxpayers’ property and because the taxpayers agreed to a lower variable interest rate for the purpose of extending credit to the State, the State’s obligation arose by voluntary bargaining. Since the State’s obligation to pay interest to the taxpayers under the installment agreement arose out of the voluntary bargaining, the State’s borrowing authority was implicated and, therefore, the interest was excludable under IRC section 103 by allowing the State to borrow money from the taxpayer at a lower rate of interest than it would have been required to pay in the condemnation proceedings. (DeNaples, 3rd Circuit Court of Appeals, March 19, 2012).