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| Municipal Bonds
Not Always Tax Exempt By Joseph B. Tancer, CPA
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .August 1995 |
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It is a well known fact that investors who are in high tax brackets can earn a greater after-tax yield by investing in tax-exempt municipal obligations. The math is simple: a taxpayer in the combined tax bracket of 45% will earn a better after-tax yield from a triple tax-free bond carrying an interest rate exceeding 55% of the rate of a taxable investment. (In some high-tax areas, where the combined federal state and local rates go over 50%, triple tax-free bonds are even more attractive.)
There are some important tax considerations, and even some "tax traps", that the investor must be mindful of when allocating funds for investment. Federal and state tax laws can get pretty tricky and if not well-informed, the municipal bond investor can be in for a big surprise: income from the bonds could be taxable. In such case, accepting a lower yield than that available on a regular taxable investment would have been the wrong move. What You Should Know About the Tax Law
Knowing the areas in the tax law which could cause taxability of the bonds is the starting point. Some laws make clear how income from any municipal bond is to be taxed. Examples of these are state and local taxation, capital gains rules and the Alternative Minimum Tax. From the date of purchase through the eventual disposition, an investor could determine the tax effect of his or her income. Other laws have "hidden" tax effects. Examples are taxation of social security benefits, accrued market discount rules and premium amortization rules. While ostensibly remaining tax-exempt, the income from municipal bonds can produce less obvious tax costs.
State and Local Taxation
Virtually all state and local taxing authorities follow these basic rules: interest income from obligations issued by government agencies within a state's boundaries is exempt from taxation by that state (or locality). Interest from other states' obligations is taxable. Furthermore, if a qualified bond fund invests in municipal obligations, its dividends will likely be treated as if the interest income from the underlying bonds were earned directly by the investor. Some states, including New York and New Jersey, extend tax-exempt treatment to obligations issued by Puerto Rico, Guam and the Virgin Islands. When comparing yields of different municipal bonds and bond funds, consider the effect on state and local taxation if the obligations are derived from states outside of your own.
Capital Gains
Even though interest from municipal bonds is generally tax-exempt, the capital gains (i.e., the excess of the proceeds received on sale over the adjusted purchase cost) is not. Under present tax law, the capital gains rate is equal to the ordinary tax rate if the bond is held for one year or less. If held more than one year, the highest Federal rate that will apply is 28%. Some states also allow preferential rates for long-term capital gains; others do not. Falling interest rates in the "fixed income" markets make bonds held in portfolio more attractive to investors, causing prices of the bonds to rise. Bondholders who choose to cash in by selling bonds should be aware that Federal and state and local taxes will be paid on the gains. (On the other hand, losses may be deductible, subject to limits imposed by the different taxing authorities).
Alternative Minimum Tax
The Alternative Minimum Tax ("AMT") is an often-overlooked method of calculating your taxes. If the calculation results in a higher tax than your regular tax method, then you must pay the tax calculated under the AMT. The AMT rate structure and base exemption amount are more generous than under the regular tax method, but more income can be subject to tax and fewer deductions are allowed under AMT rules. One item of income which is taxable under the AMT rules is interest income from most "private activity bonds" issued after August 7, 1986. "Private Activity Municipal Bonds" include tax-exempt bonds issued by state and local governments for private-use purposes. Examples are Industrial Development Bonds and Student Loan Bonds. Only those issued after August 7, 1986 are subject to AMT taxation. Furthermore, most bonds which are subject to AMT are identified as such..
Taxpayers who are subject to the AMT, or whose regular tax is only slightly higher than the AMT, should ordinarily avoid purchasing bonds "subject to AMT". Other taxpayers have an opportunity here, however. Since these bonds are unattractive to some investors, the yields are generally better. Taxpayers not subject to the AMT can, therefore, obtain a bargain by purchasing a bond "subject to AMT". Social Security Benefits
Under present Federal tax laws, social security benefits received are not taxable if "Provisional Income" for the year remains below certain dollar levels, depending on the recipient's filing status. Once exceeded, up to 50 percent of benefits are subject to tax until the next level is reached. Once "Provisional Income" exceeds that second level, up to 85 percent of the benefits can be taxed. The dollar levels, based on filing status, are as follows: * 50% 85% Unmarried Individuals $25,000 $34,000 Married Individuals, filing separately, living together during the year ** -0- -0- Other Married Individuals 32,000 44,000
NOTE: Married Individuals, filing separately, living together at any time during the year have no lower dollar amounts. Therefore, these individuals will generally be taxed on 85% of benefits received. "Provisional Income" is computed by making a few adjustments to "Adjusted Gross Income" as generally defined. The problem for retiree-investors is that municipal bond interest is included in the calculation of "Provisional Income". Put a different way, for the purposes of computing the taxability of social security benefits, tax-exempt bond interest is treated the same way as taxable interest income. Social security recipients whose "Provisional Income" is at, or slightly more than, either dollar level amount will not find tax-exempt bond interest as attractive as others. These individuals would likely invest in taxable instruments, where yields are higher, if cash-flow is important. If cash flow is not an issue, tax-deferred investments (e.g., annuities), the increase in value of which does not enter "Provisional Income", may be more attractive. Accrued Market Discount Rules
Bonds purchased at a price less than maturity value are considered purchased at a discount. There are two types of bond discounts: Original Issue Discount ("OID") and Market Discount. OID occurs where the issuer of the bond offers it at a price less than face value. Instead of receiving interest payments, the purchaser pays less for the bond and receives face value on maturity. Market Discount occurs when interest rates in the fixed income markets have risen since the issuance of the bond. Since the bond becomes less attractive, a seller needs to offer a discount to entice a buyer in the bond market.
Since both OID and Market Discount are really forms of additional interest which accrue to the buyer of discounted bonds, when the bonds are sold, not all of the gains are capital gains. Under current tax laws, OID accruing on municipal bonds is tax-exempt interest. So is Market Discount on municipal bonds purchased before May 1, 1993; but not on purchases after April 30, 1993. It makes no difference when the municipal bond was issued. If purchased after April 30, 1993, the investor must compute the Market Discount which accrued since the purchase date to the date of disposition. That accrued discount must be reported as taxable interest income on sale or maturity of the bond instead of capital gain. Alternatively, the purchaser may elect to report the interest income annually as it accrues. This election would also apply to all other market discount bonds that are acquired in that tax year and all future tax years. (This may make sense for someone whose income tax brackets were expected to rise in the year of sale or maturity. However, this is usually very difficult to predict.) Accrued Market Discount may be computed under either of two methods: the "ratable accrual method" (applying the fraction of days held over the total days if held to maturity) or the "constant interest method" (applying a complicated amortization rate which represents a truer return on investment). If the bond is sold soon after its purchase, the "constant interest method" will provide less taxable interest income (and more capital gain). If held longer, the "ratable accrual method" will provide less ordinary income. Municipal bond purchasers need to be aware of the potential for converting capital gain income to ordinary income. This certainly makes a bond carrying a large market discount less attractive to high-bracket investors. Municipal bonds issued with OID which also carry Market Discount present a special problem: purchasers need to separately calculate the two discounts, since only the latter is taxable. Premium Amortization Rules
Bond premium is the excess of the purchase price paid over the face value of the bond. Bond premium occurs when interest rates in the fixed income markets have fallen since the issuance of the bond. Since the bond becomes more attractive, a seller can charge a premium to a buyer.
Investors in taxable bonds may elect to amortize premiums paid over the holding period of the bond. This election provides an annual tax deduction which partially offsets the income being recognized as interest payments are received. Then the bondholder must reduce the tax basis in the bond by the amortization for future capital gain or loss. While amortization of premium on a taxable bond is not required, it is required when it comes to tax-exempt bonds. However, the amortization of premium on a tax-exempt bond is not tax deductible. Nevertheless, the amortization does reduce the tax basis for gain or loss. Premiums must be amortized using the "constant interest method". This method, explained earlier, is the only method available. For a bond having an early call date, the amortization period will end at the call date if the bond purchase was priced anticipating a call. The municipal bond purchaser must realize that any bond premium paid is just an additional after-tax cost of acquiring the particular bond. Only if the bond is sold prior to maturity will the purchaser be able to use part of the premium for tax purposes (the remaining unamortized cost). Furthermore, under these rules, if a municipal bond bought at premium is held to maturity (or to the call date, if applicable) where the holder receives only face value, there will be no loss on redemption (or call). What You Can Do
First, you must gain familiarity with the rules laid out in the previous sections. Second, it is important to sit down with your tax advisor to identify which rules could apply to you. Without this strategy, you could find that a simple investment decision was not that simple.
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