The Handbook of Municipal Bonds

CHAPTER 34

The Tax Treatment of Municipal Bonds

Martin J. Mauro, Ph.D. Fixed-Income Strategist Merrill Lynch

 

Philip Fischer, Ph.D., J.D. Municipal Strategist Merrill Lynch

 

 

 

In this chapter, we focus on the tax treatment of municipal bonds. We begin with the federal tax treatment and then move to state and local tax treatment.

FEDERAL TAX TREATMENT OF MUNICIPAL BONDS

Interest received on a bond that is an essential public-purpose or qualified private-purpose obligation of a state or municipality is exempt from federal taxation. Essential public purpose means that the proceeds from the bond’s sale will be used almost exclusively to benefit the public, and not a private person or corporation. General obligation bonds, water and sewer bonds, municipally owned utility bonds, and highway and public building bonds all fit the definition. Interest income on some other types of bonds is also tax exempt, such as those issued by not-for-profit hospitals, schools, and revenue bonds for airports and convention centers.

Capital gains from municipal bonds are subject to federal taxation.

Alternative Minimum Tax (AMT) and Munis

The federal AMT was designed to prevent individuals or corporations from reducing their tax liability by taking an “excessive” amount of deductions, although its reach has expanded far beyond its original purpose. Individuals must pay the higher of the tax calculated under the regular system and under the individual AMT.

AMT income is broader than ordinary taxable ...