Are Municipal Bonds Really Income Tax Free?
Overview Of Municipal Bonds
Municipal bonds (also known as “munis”) are attractive to many investors because the interest income is exempt from federal income tax and in many cases, state and local taxes as well. Also, munis often represent investments in state and local government projects that have an impact on our daily lives, including schools, highways, hospitals, housing, sewer systems, and other vital public projects.
Taxation of Municipal Bonds
At the outset, understood that the term “municipal bonds” is typically used to describe all tax-exempt bonds, whether or not they are issued by a municipality (as opposed to a state, county or other political subdivision). Although such bonds are referred to as “tax-exempt,” there are numerous federal and state tax consequences associated with the acquisition, ownership, and disposition of such obligations.
It is important to know that your particular tax situation should be considered when making any changes to your investments. I am addressing only beneficial owners who hold such bonds as capital assets and does not address special classes of beneficial owners such as dealers in securities or currencies, banks, life insurance companies. Persons holding such bonds as a hedge against interest rate or currency risks or as part of a straddle or conversion transaction, or beneficial owners whose functional currency is not the U.S. dollar.
Capital Gains and Losses
Even though the interest paid on a municipal bond is tax-exempt, a holder can recognize gain or loss that is subject to federal income tax on the sale of such a bond, just as in the case of a taxable bond. The amount of gain or loss is equal to the difference between
i. the sale price of the bond and
ii. The holder’s tax basis in the bond (the amount the holder paid for the bond initially, including any additions to such bases, such as OID as discussed in the following section).
Thus, if a holder purchased a $5,000 face amount municipal bond for $5,000 and then sold the bond for $5,200, the holder would have a capital gain of $200. Typically, the purchase and sale price of a municipal bond includes the dealer’s markup; however, in cases where a commission is charged, it should be taken into account by the holder in computing gain or loss.
Interest Rate Relationships.
The relationship to enforce bonds and general interest rates is important. If an enforce bond paying 5% is subject to an overall decrease in interest rates, the value ( the amount it could be sold for) would increase. The opposite is also true, if interest increase, the value of the enforce bonds would decrease.
If you have owned municipal bonds during the time interest rates declined, the value of your bonds could be much higher than their future maturity value.
As an example, a bond paying 5% purchased ten years ago for $10,000 with an overall 20-year maturity date. The value of that $10,000 bond in today’s market could be $13,000, not $10,000.
If making money on your investments is essential, taking profit before maturity might be a correct choice. Learning the current value of your enforce bonds is easy and at no cost.