How to tell if a Municipal Bond is Tax Free?April 3rd, 2012 by David Waring
Disclaimer: Many municipal bonds can provide income that is free of federal, state, and local income taxes. However, there are municipal bonds that are not free from certain types of income taxes, and tax laws are complicated and occasionally change. With this in mind, please consult your tax professional before acting on any of the information provided.
In this series we will examine all the different tax considerations for municipal bond investors starting with how to tell if a municipal bond is tax free.
Every bond has a CUSIP number as a unique identifier. Its the bond market’s equivalent to a stock ticker symbol. If you are buying municipal bonds through a financial adviser, they should be able to provide the CUSIP numbers of the bonds they are recommending. If they cannot, you should change advisers. If you are going about things on your own you can use this tool from Fidelity to look up CUSIP numbers.
Once you have the CUSIP number, go to the MRSB website where you can access the original offering statement for the bond. On the first page, most often at the very top of the offering statement, will be the opinion of the bond counsel.
Example of a Municipal Bond’s Opinion of the Bond Counsel.
There are 3 critical pieces of information Contained in the Opinion of Bond Counsel
1) Is interest on the bond federally tax-free (excluding AMT)?
In this example, the interest paid by the municipal bond bond is tax-free as the opinion has the following line: “excluded from gross income for federal income tax purposes”
2) Is interest on the bond excluded from calculations of the Alternative Minimum Tax (AMT)?
There are many municipal bonds whose interest income is excluded from the normal federal income tax, but not from the calculations of AMT. Typically, these bonds are for financing a for-profit project, such as a sports stadium or privately owned housing project.
The above offering statement includes the line: “not treated as a preference item for calculating the alternative minimum income tax”.
In this example, the bond’s interest will not be included in income calculations for AMT, and a preference item would be included in the calculation of AMT.
3) Is interest on the bond subject to state or local income taxes?
In this example, the interest on the bonds is free of state and local income taxes, as the offering statement includes the following line:
“exempt from personal income taxes from the State of New York and its political subdivisions”
For a resident of New York City, which also pays a local city income tax, the interest from the bond in this example would be triple tax-free: No Federal, State, or local income taxes.
**In most cases, in order to receive the the state and local tax benefits of a municipal bond, you have to reside in the same state in which the bond you’re are buying was issued. A resident of California for example, would receive no state or local tax benefits from owning a municipal bond issued in New York State. With this in mind, the above only applies if you live in the same state where the municipal bond you are purchasing was issued.
Are there municipal bonds that are not free of federal income taxes?
Yes. Build America Bonds, which were issued as part of the stimulus package, are not federally tax-free. Because of this, they normally pay a higher rate of interest than municipal bonds of a similar credit quality, that are free from federal taxes.
If you do not buy a municipal bond when it is originally issued and hold it to maturity, then you will likely generate both a capital gain or loss on the bond and/or interest that is taxable. This will be the topic of the next article in this series.