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Advising clients on municipal bonds.

Advising Clients ON Municipal Bonds

Frequently clients consult with their accountants for advice concerning investments in securities, using these professionals as sounding boards for many of their investment alternatives. Accountants are expected to point out the tax and non-tax factors the clients should consider before making the investment decisions.

Municipal bonds are one of the few remaining pure tax shelters following the modifications in the tax laws the past few years. The tax-free interest revenue at the federal level and attractive yields of municipal bonds may be the only major factors considered by potential investors prior to making investment decisions. (See Table 1. Other considerations which are often overlooked by individual taxpayers engaged in investment activity (not a trade or business) are presented below.

Table : Table 1 Yield Equivalents
Marginal Income Tax Rate 15% 28% 33%
Tax-Exempt Yield Taxable Yield Equivalents
 6.0% 7.0% 8.3% 9.0
 7.0% 8.2 9.7 10.5
 8.0 9.4 11.1 11.9
 9.0 10.6 12.5 13.4
 10.0 11.8 13.9 14.9

Tax-Exempt Yield

(1 - Marginal Income Tax Rate) = Taxable Yield Equivalent

(Taxable Yield) (1 - Marginal Income Tax Rate) = Tax-Exempt Yield Equivalent

Alternative Minimum Tax

The interest revenue received from municipal bonds must be included in the computation of the alternative minimum tax for taxpayers subject to it. These municipal bonds are classified as private activity or non-governmental purpose bonds which were issued after August 7, 1986. Thus, municipal bonds issued before this date are not subject to the 21% alternative minimum tax.

Credit Risk

The rating agencies of Standard & Poor's and Moody's grade municipal bonds regarding quality. A credit risk classification of "A" or better normally indicates that the municipal bond is a safe investment. (See Table 2.) However, one must remember that there is a trade-off between risk and return.

Table : Table 2 Credit Ratings
Credit Risk Moody's Standard & Poor's
Prime Aaa AAA
Excellent Aa AA
Upper Medium A-1, A A
Lower Medium Baa-1, Baa BBB
Speculative Ba BB
Very Speculative B, Caa B, CCC, CC
Standard & Poor's Ca, C D
Default Ca, C D

The ratings of A-1 and Baa-1 used by Moody's indicate those credit risks which are thought to be the higher quality credits in the respective categories.

Source: Public Securities Association, An Investor's Guide to Tax-Exempt

The payments of interest revenue and principal on municipal bonds may be secured by the full faith and credit of the issuer (general obligation bonds), a specified tax (special tax bonds) or income generated by the project (revenue bonds). In addition, several municipal bonds contain the special feature of backing by municipal bond insurance. This is another method of decreasing investment risk, since the insurer pays the principal and interest revenue if default occurs.

Maturity Dates

Generally, municipal bonds mature in 30 years from the original issue date. As an investor begins to build an impressive portfolio of municipal bonds, one objective is to spread-out the maturity dates over the years. The investor should avoid the situation of a high percentage of his or her bonds maturing in the same year.

Interest Payment Dates

Interest revenue from municipal bonds is usually payable semi-annually. An investor should strive to have interest revenue inflows each month of the year. This can be accomplished by holding as few as six municipal bonds. The bunching of interest income into a few months of the year while having no interest income in the other months should be avoided as the portfolio grows.

State Taxation of Interest


While the interest revenue from municipal bonds is exempt from the federal income tax (although the alternative minimum tax may apply), the interest revenue may be subject to state income tax. Alabama, for example, does not tax the state's own bonds, but does tax other states' bonds. Oklahoma taxes the state's own bonds, as well as other states' bonds. Yet, Nebraska does not tax municipal bond interest revenue at all. Investors need to research this before investing. (See Table 3.

Table : Table 3 State Taxation of Municipal Bond Interest for Individuals
State State's Own Bonds Other State's Bonds
Alabama X

Arizona X
Arkansas X
California X
Colorado X
Connecticut X
Delaware X
District of Columbia X(*)

Georgia X
Hawaii X
Idaho X
Illinois X X
Indiana X
Iowa X
Kansas X
Louisiana X
Maine X
Maryland X
Massachusetts X
Michigan X
Minnesota X
Mississippi X
Missouri X

Montana Nebraska Nevada
New Hampshire X
New Jersey X

New Mexico
New York X
North Carolina X
North Dakota X
Ohio X
Oklahoma X X
Oregon X
Pennsylvania X
Rhode Island X
South Carolina X

South Dakota

Tennessee X

Texas Utah
Vermont X(**)
Virginia X

West Virginia X
Wisconsin X X

(*) Taxable if purchased after 1991.
(**) Taxable only if long form is used.

(***) First $5,000 of interest exempt for taxpayers over 65.

Source : Commerce Clearing House, Inc., State Tax Guide.

Expenses of Producing Tax-Exempt


The tax laws prohibit a deduction for interest expense that is incurred regarding the investment in municipal bonds. Investment-related expenses incurred to produce municipal bond interest are also disallowed as deductible items. These include safekeeping expenses, investment advisory services and financial publications.

Effects of Taxation on Social

Security Benefits

Even though municipal bond interest may be wholly exempt from federal income tax, it may have to be taken into account when computing the taxable amount of Social Security benefits received. An individual taxpayer whose modified adjusted gross income plus one-half of the Social Security benefits received for the tax year exceeds the appropriate base amount must include a corresponding amount in gross income. The taxable amount is the lesser of one-half of the Social Security benefits, or one-half of the Social Security benefits exceeds the appropriate base amount. Thus, a taxpayer's adjusted gross income increased by the amount of tax-exempt interest received or accrued during the tax year produces the modified adjusted gross income. The base amounts are $32,000 for married filing jointly status or $25,00 for most other individual filers.

Premiums and Discounts

The purchase of a bond for an amount in excess of the bond's par value results in a bond premium. The premium on a municipal bond must be amortized each year by the bondholder. The amortization of premium reduces the investor's basis in the bonds. the purchaser's basis is his or her cost. Thus, basis minus the amortized premium equals adjusted basis. No tax deduction is permitted for the amount amortized each tax year. The purchase of a bond from an issuer for an amount less than the par value of the bond results in an original issue discount (OID). The bondholder must report a portion of the OID as interest income in each tax year the bond is held. Yet, municipal bonds are not subject to the current inclusion rules regarding OID. Municipal bond issued with OID still present another tax ramification. A holder's basis is increased by the amount of OID which the holder should have included in current gross income if the bond was not exempt. Thus, basis plus the "should be included OID" equals adjusted basis.

Sale or Call of Municipal


A bondholder may elect to sell a municipal bond in his or her portfolio prior to maturity. Many municipal bond issues permit the issuer to call all or some of the bonds before the maturity date. The sale or call of a municipal bond results in a taxable gain or loss for the investor disposing of the security. The taxpayer has a gain on the disposition to the extent the proceeds exceed the taxpayer's adjusted basis in the bond. When the amount realized on the disposition is less than the adjusted basis, a loss occurs. If the bond is classified as a capital asset in the hands of the taxpayer, a capital gain or loss results.


Accountants need to apprise their clients seeking advice about investing in municipal bonds of these considerations. This is not meant to be an exhaustive list. Depending on the situation, a practitioner may need to register as an investment advisor under applicable federal and state laws. Investors should always consult with their legal and financial advisors before purchasing securities.

Andrew D. Sharp is assistant professor of accounting at Spring Hill College in Mobile, Alabama. He received his BS from Spring Hill College, his MBA from Duke University and his PhD from the University of Misissippi. He has published articles in numerous academic and professional journals.
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Title Annotation:taxation of municipal bonds
Author:Sharp, Andrew D.
Publication:The National Public Accountant
Date:Sep 1, 1991
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