A distinguishing characteristic of most municipal securities is that the interest paid on the securities is exempt from federal income tax. Municipal bonds often are referred to as tax-exempt bonds, although not all tax-exempt bonds are municipal securities. For interest on a municipal security to be exempt from the investor's gross income for federal income tax purposes, the issuer must meet a number of requirements in the federal income tax code and regulations. The official statement for new issues of municipal securities generally includes a statement on the cover and other detailed information with respect to the tax-exempt status of the issue. The official statement also typically includes the opinion of a law firm, usually referred to as “bond counsel,” addressing, among other things, the federal income tax exemption.
In some cases, interest on a municipal security is not tax-exempt. Taxable municipal securities can also be issued if the purpose of the issuer’s financing does not meet certain public purpose or public use tests under the federal tax rules. Some taxable municipal securities are issued under special programs such as the Build America Bonds program adopted as part of the American Recovery and Reinvestment Act of 2009.
In addition, a bond initially issued as a tax-exempt bond can become a taxable bond if the issuer fails to comply with certain federal tax law requirements, which can have significant adverse consequences to bondholders.
Alternative Minimum Tax (AMT) Bonds
Some municipal securities pay interest that is exempt from gross income under the ordinary federal income tax calculation but are nonetheless subject to the federal alternative minimum tax, or AMT. The official statement for such an issue normally will state that the securities are subject to the AMT.
In that case, some of the benefits of tax-exemption may not be available to taxpayers who are subject to the AMT. For taxpayers subject to the AMT, certain tax preference items otherwise not subject to taxation, including interest on some private activity bonds, are added to the gross income of the taxpayer for purposes of calculating federal income tax liability.
State Tax Treatment
A state may provide an exemption from state income tax for interest on municipal securities in certain cases. Specific provisions and conditions of such exemption vary from state to state and not all states provide an exemption. In many states, investments by state residents in securities issued by the state or any other municipal issuer within the state will be provided with an exemption, but not for investments in out-of-state bonds.
For more information, see the Internal Revenue Service Tax Code, Regulations and Official Guidance. Various other sections of the Internal Revenue Code also affect the tax treatment of municipal securities for federal income tax purposes and should be consulted.