Municipal Bond

A municipal bond is a debt security issued by a state, its political subdivisions such as cities, counties and school districts, their agencies and authorities, or a US territory. The SEC's investor education describes the purposes as ranging from public infrastructure to day-to-day government needs to financing qualifying projects by private entities. Interest on such a bond is generally excluded from federal gross income under IRC 103(a), which states that "gross income does not include interest on any State or local bond." That exclusion is the entire reason the category exists as a distinct investment.

Municipal bonds divide by who actually stands behind the promise, which is the question that matters when something goes wrong. A general obligation bond is backed by the issuer's taxing power. A revenue bond is backed by the income of a specific project or source, such as tolls or utility charges, and not by taxes. A conduit bond is issued by a government on behalf of a private borrower such as a nonprofit hospital or college, where the private borrower agrees to repay the issuer, who then pays the bondholders. The word "municipal" on a conduit bond describes who issued the paper rather than who is obliged to find the money.

The exclusion in IRC 103(a) is stated as a rule with exceptions, and the exceptions are where the surprises live. Section 103(b) disapplies the exclusion entirely for three categories, of which one reaches ordinary buyers: a private activity bond that is not a qualified bond within the meaning of section 141. A bond of that kind is issued by a governmental unit and is fully taxable, so being called a municipal bond is not by itself evidence that the interest is exempt. The other two categories, arbitrage bonds under section 148 and bonds failing the registration requirements of section 149, are compliance failures rather than a category a retail buyer chooses.

A qualified private activity bond keeps its exclusion and can still be taxed, through the alternative minimum tax. IRC 57(a)(5) makes interest on a "specified private activity bond" an item of tax preference, defined as a section 141 private activity bond issued after 7 August 1986 whose interest is excluded under section 103. Several categories are carved out of that preference, including qualified 501(c)(3) bonds under section 145 and certain housing bonds. The practical consequence is not that the alternative minimum tax is likely for most households, but that a bond marketed as tax-exempt can produce taxable income for a particular buyer, and whether it does depends on that buyer's whole return rather than on anything printed on the bond. Funds holding such bonds report the preference portion of their distributions separately for exactly this reason.

Section 103 excludes interest and stops there. A municipal bond sold for more than it cost produces a capital gain, and that gain is taxable in the ordinary way. Nothing about the exclusion reaches it. A holder who sells at a profit after a strong period for bond prices has exempt income and a taxable gain from the same security.

The market discount rule is the one a buyer is most likely to walk into without knowing it. Buying a municipal bond in the secondary market for less than its face value creates market discount, and Publication 550 states the result in one sentence: "Market discount on a tax-exempt bond is not tax exempt." Under IRC 1276(a)(1), gain on the disposition of a market discount bond "shall be treated as ordinary income to the extent it does not exceed the accrued market discount," and the IRS instructs that the accrued amount be reported as interest income rather than as capital gain. A de minimis rule keeps small discounts out of it: under IRC 1278(a)(2)(C), if the market discount is less than one quarter of one percent of the stated redemption price multiplied by the number of complete years remaining, the discount is treated as zero. Above that threshold, part of what looks like a tax-free bargain becomes ordinary income taxed at the buyer's top rate.

One naming warning goes with that. Two different de minimis rules exist in bond taxation. The MSRB's glossary defines "de minimis discount" as a rule about original issue discount, meaning a bond issued below face value. The rule a secondary-market buyer needs is the market discount rule above. Reading the first while meaning the second is easy to do and produces the wrong answer.

Tax-exempt interest is not invisible to the rest of the tax return. It is added back in full when computing whether Social Security benefits are taxable, and again when computing the income figure Medicare uses to set premium surcharges. Both of those computations are covered on their own pages, and the point to carry here is simply that buying municipal bonds to hold reported income down does not hold those two figures down at all.

You buy at issue or in the secondary market, receive interest twice a year, and are repaid face value at maturity. The interest generally arrives free of federal income tax, and whether it is free of state income tax depends on where you live and who issued the bond, since a state that taxes income commonly exempts interest on its own bonds while taxing interest from other states'.

Comparing a tax-exempt yield with a taxable one. The MSRB gives the arithmetic: divide the tax-exempt yield by one minus your marginal tax rate to get the taxable equivalent yield, the rate a taxable bond would have to pay to leave you the same amount.

A hypothetical example with an invented yield. A municipal bond pays 3.0 percent and Devon's marginal federal rate is 24 percent. His taxable equivalent yield is 3.0% ÷ (1 − 0.24) = 3.0% ÷ 0.76 = about 3.95 percent. So a taxable bond of similar quality and maturity would need to pay more than 3.95 percent to beat the municipal bond for him. For someone in a lower bracket, say 12 percent, the same bond computes to 3.0% ÷ 0.88 = about 3.41 percent, a much lower bar for the taxable bond to clear. The exemption is worth more to the buyer with the higher rate, which is why the same bond is a good deal for one household and a poor one for another.

A hypothetical example of the de minimis threshold. Priya buys a municipal bond with a stated redemption price of $1,000 at maturity, with 10 complete years remaining. The threshold is 0.25% × $1,000 × 10 = $25.

If she pays $980, the discount is $20. That is below the $25 threshold, so it is treated as zero and the eventual gain is a capital gain.

If she pays $960, the discount is $40. That exceeds the threshold, so the accrued portion comes back as ordinary income when she sells or when the bond matures, not as a capital gain and not as exempt interest. Two purchases $20 apart, and a different character of income at the end.

Pros

• Interest is generally excluded from federal gross income, which raises the after-tax return most for holders with the highest marginal rates.
• A state that taxes income commonly exempts interest on its own bonds, so an in-state holding can escape both layers.
• General obligation bonds are backed by an issuer's taxing power, which is a different kind of backing from a company's earnings.
• The market is large and varied, so maturities and credit qualities can be matched to a purpose.
• The exemption applies to the interest without any election, filing or holding period on the holder's part.

Cons

• The exemption is worth little to a household in a low bracket, and a tax-exempt yield accepted without doing that comparison can simply be a lower return.
• A private activity bond that is not a qualified bond is fully taxable, and a qualified one can produce alternative minimum tax exposure.
• Capital gains are fully taxable, and secondary-market purchases below face value can convert part of the return into ordinary income.
• Tax-exempt interest still counts toward the Social Security and Medicare income tests, so it can raise a tax bill it never appears in.
• Holding municipal bonds inside a tax-deferred account wastes the exemption, since nothing in such an account is currently taxed anyway.
• Individual issues can be hard to price and to sell, and the trading cost is usually inside the price rather than charged separately.