Many fixed-income investors gravitate towards municipal debt as an investment option because of the tax-free income; for some, this single benefit is enough to relinquish the potential for higher coupons on other alternatives like corporate debt or equity investments.
These alternatives may produce higher yields; however, the overall tax benefit with municipal debt is often enough to outweigh the higher yields offered on taxable debt. Most importantly, this tax benefit increases as an investor’s tax bracket increases.
On the contrary, an investor purchasing municipal debt solely for its tax-free income benefit must be aware of situations where income from municipal debt holdings can be treated like normal interest income, creating a tax liability and cutting into the overall return of the security.
In this article, we will take a closer look at some of these situations and how investors can thoroughly assess their investment options before making any investment decisions.
Click here to know more about the process of conducting muni bond due diligence.
When Your Muni Bonds Are Taxed
Here are some of the situations that might lead to an event where your muni bond holdings can be taxed in some form or the other.
Muni debt purchased at a discount
Before we talk about the De-Minimis Tax rule and its applicability, it’s important to understand the price appreciation of fixed-income instruments purchased at a discount. Typically, investors are aware of the inverse correlation between an instrument’s market value and interest rate fluctuations and it can be easily understood with the following example.
Suppose you purchased an AAA-rated bond in 2015 that was issued by a municipality with a 5% coupon, 10-year maturity and $1,000 face value. In 2018, you’d likely sell this bond in the secondary market. However, the prevailing interest rates have gone above 2015 levels. Upon assessing the market, you realize new debt with the 7-year maturity with the same credit quality is being issued at 6%. Now, any new investor will have two choices: either invest money into a new bond paying 6% or purchase your 5% coupon bond below the face value (less than $1,000) to increase the yield. The same concept applies in the declining interest rate environment: if the new debt was being issued at 4% then you would be able to sell your 5% bond above its face value (premium).
The De-Minimis rule determines whether the price appreciation of securities, initially purchased at a discount, will be taxed at an ordinary income tax or at a capital gains tax rate. Under this rule, if the discounted amount is less than the De Minimis Threshold then the whole discounted amount is taxed at the ordinary income tax rate. On the contrary, if it’s more than the De Minimis Threshold then the capital gains tax rate is applied. Let’s take a look at how this is determined.
De Minimis Threshold = Lower of Par or Current Original Issue Discount – (0.25 X full years to maturity)
For example: A security with 5 years to maturity and $1,000 par value will have a De Minimis Threshold of $998.75, which is calculated below:
$1,000 – (0.25 X 5) = $998.75
If this security is bought under $998.75 then the total discount will be subject to the ordinary tax rate, or else the discount would be treated to the capital gains tax rate.
Click here to know more about the De Minimis Rule.
Muni debt sold at a premium
Just as a bond purchased at a discount and held until maturity can create a taxable event, a bond sold at a premium will create a taxable event. While the coupon payments are tax-exempt, the premium is considered capital gains and its subject to either capital gains tax rate or the ordinary income tax rate.
Muni debt purchased out-of-state
Municipal debt is often known for its triple tax exemptions – federal, state and local taxes. However, this doesn’t necessarily apply to debt instruments issued by a municipality of a different state other than the one in which you reside. Typically, these instruments will still provide you with a federal tax exemption benefit, but the coupon income can be subject to your own state’s income taxes.
Use our Screener to choose muni bonds from a specific state.
Muni debt subject to AMT
Alternative Minimum Tax (AMT) scenario can create a tax liability for muni bond investors that are subject to this provision. This means that the income generated from the municipal debt instruments can be treated like regular income and potentially taxed. Investors must be aware of scenarios where debt is issued to either build or improve an asset for the municipality but the debt may not be backed by the local or state government. For example, private activity bonds are typically issued for a municipality or state with the conjunction of private enterprise partnerships, primarily for infrastructure like airports, etc. These bonds don’t provide a federal tax exemption for investors who are subjected to AMT.
The Bottom Line
Investors must be cognizant of the aforementioned scenarios and their implications before making any investment decisions to purchase municipal debt. It’s important to weigh your options regarding taxable and tax-free options; where tax-free provides a tax benefit, taxable investment instruments will likely to offer better yields to make up for the tax-free benefit.
Although these scenarios may not be applicable to your individual investor profile, it’s imperative to consult with a tax-advisor and investment counselor before making any investment decisions.
Learn more about the implications of using muni bonds in your IRA here.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.