How Exempt Are Tax-Exempt Bonds?

The CPA Journal, April 1994 | Go to article overview

How Exempt Are Tax-Exempt Bonds?


The demand for municipal bonds should increase as a result of higher marginal income tax rates. However, owners of tax-exempt bonds should be aware of various provisions that cause tax-exempt interest income to increase tax liabilities.

Interest received on debt obligations issued by states or their political subdivisions or a U.S. possession is generally excludabe from gross income. Individuals are, however, required to report the gross amount of their tax-exempt interest income on their Federal income tax returns.

Many Social Security recipients are required to pay Federal income taxes on up to one-half of their Social Security benefits. If one-half of the Social Security benefits received for the year plus "modified adjusted gross income" exceeds a) $25,000 for a single, head of household, qualifying widow(er), or married separate filing status, or b) $32,000 or a married couple filing jointly, then that excess is included in taxable income, up to one-half of the amount of benefits received.

In 1994, if comparable income exceeds $34,000 for singles, $44,000 for married filing jointly or for married filing separately, recipients will pay tax on 85%, of their benefits.

Generally, all income received from home state municipal bonds is exempt from taxation. (Illinois, Iowa, Oklahoma, and Wisconsin tax interest income on their own municipal debt securities). The income received from out-of-state municipals is usually taxable on resident tax returns. (The District of Columbia, Indiana, North Dakota, and Utah do not tax any interest income from municipal debt securities.) Interest on bonds issued by a U.S. possession or territory (e.g., Puerto Rico) is exempt from taxation on both the Federal and all state income tax returns. Expenses attributable to out-of-state municipals (e.g., bond premium amortization, custody fees) are deductible on state returns when the interest is taxable.

When a municipal bond is purchased for an amount (not including accrued interest) in excess of the amount payable at maturity or an earlier call date, the excess ("premium") must be amortized without any allowable deduction, since it is actually an offset to the tax-exempt income. This amortization reduces the bond's tax basis, so that no capital loss results when the bond matures (or is called). …

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