The overall tax benefit with municipal debt is often enough to outweigh the higher yields offered on taxable debt, and this tax benefit increases as an investor’s tax bracket increases. However, there are certain situations with tax-free securities that can create a tax liability on full or partial investment incomes.

In this article, we’ll take a closer look at scenarios that can cause tax-exempt muni bond investors to incur taxes.

Here are a few scenarios that every muni investor should be aware of before making any investments in tax-free vehicles.

1. Transactions with out-of-state municipal securities

The most common mistake would be purchasing municipal securities issued by a municipality of a different state other than the one in which you reside. The income generated through these securities will still be free of any federal taxes, but they will be subject to the state tax of where you reside.

2. Sell holdings at a premium

The interest rate and bond prices are inversely correlated to each other; meaning, when one goes up the other goes down and vice versa. If an investor is holding a municipal security, which has a higher coupon than the current interest rates, he/she can sell that security in the secondary market at a higher value than its face value. This is called selling a security at a premium. While the coupon payments are tax exempt, the premium is considered capital gains and will be taxed at either the capital gains tax (15% tax rate if the security is held for over a year) or at the ordinary income tax rate (if the security was held under a year, it’s also known as short-term gains).

3. Purchase a security at a discount

A rising interest rate policy creates a discount environment, compared to the currently prevailing market rates, for securities with lower coupon rates. In the secondary market, when you buy a security at a discount from its original par value, the difference can be taxed at the ordinary income tax rates or at the capital gains tax rate. In order to determine the tax rate that applies to the discount, the IRS introduced “De Minimis Tax Rule” for the discounted securities.

This 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 “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. So, let’s take a look at how this is determined.

De Minimis Threshold = 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. 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.

Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors & do read due diligence on muni bonds to have a better understanding of the regulatory framework.

4. Implications for private activity bonds

Private activity bonds are typically issued by a municipality or state with conjunction of a private enterprise partnership, primarily for infrastructure like airports, etc. These bonds don’t provide federal tax exemption for investors who are subjected to alternative income tax.

5. Potential taxation on your social security income

Investors must carefully structure their portfolio to make sure that interest income from municipal securities doesn’t subject social security benefits to taxes. For instance, if the provisional income – combined adjusted gross income (AGI), tax-exempt interest, and 50% of social security benefits – exceeds the specified levels then it could be taxed.

Check here to know all you want to know about taxation of municipal bonds.

Apart from the scenarios mentioned above, municipal securities can add tremendous value to your overall portfolio and can bring significant tax savings in the long run. Given an opportunity, you should always capitalize on the following ways to benefit from the tax exemption of municipal bonds.

1. Mind your tax bracket

Taxable securities tend to have a higher yield than tax-exempt securities to make up for the lost income to taxes. For example: an individual, in a 35% tax bracket, can buy a corporate security paying a 7% taxable coupon. This is equivalent to a tax-exempt security paying a 4.55% coupon (7%*(1-35%)). The overall tax benefit, provided by municipal securities, increases with higher tax brackets.

2. Purchase in-state municipal securities

Investor will reap the benefit of federal and state tax exemption when he or she invests in municipal debt issued by his/her own state.

3. No impact on the AGI

The coupon payment by municipal debt securities does not increase your AGI, which provides an overall tax benefit to investors.

Check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.

When constructing a diversified investment portfolio, a good mix of municipal debt securities can not only lower your tax bill but also provide a stable stream of income, if managed properly.

As mentioned above, not all municipal securities are tax free and not every discounted bond can be bought to enhance your overall yield. Investors must stay cognizant of all the tax liabilities that can be incurred, even with tax-exempt municipal debt.

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