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Tax aspects of municipal bonds.

Municipal bonds are one of the most popular ways to shelter income from taxes because the interest they pay is tax-exempt on the federal level. (Some states and cities also exempt interest on bonds issued within the state or city.) In the past, most municipal bonds were held by large institutional investors. Today, approximately 70% are held by individuals. This makes it essential for CPAs who provide financial planning services to be familiar with the tax consequences of municipal bonds and when it is appropriate to recommend them.

Because municipal bond interest is tax-exempt, yields are lower than those on comparable taxable bonds. To determine whether a particular investor would benefit from investing in municipal bonds, CPAs must convert the tax-free return to an equivalent taxable yield, as described in the sidebar on page 52.

In addition to yield considerations, this article provides an overview of municipal bond investments that includes the risk factors and tax consequences.

ARE THEY RISK FREE?

Investors should evaluate municipal bond risks, including credit risk, interest rate risk and--in some cases--call risk.

Credit risk. This is the possibility the bond's issuer will not make interest or principal payments. Municipal bond defaults have received considerable attention because of the troubles in Orange County, California. An easy way for CPAs to help clients evaluate a bond's credit risk is to refer to Moody's or Standard & Poor's credit ratings. The highest ratings are Aaa or AAA respectively, with lower ratings indicating decreased credit quality. Securities with ratings of A or above from either service generally are considered investment-quality bonds.

Although the most commonly cited default rate for municipal bonds is 0.5%, evidence suggests default rates vary widely. A recent study found the default rate among bonds with an A rating was 1.15%; among BBB-rated bonds it was 1.4% and among unrated bonds, 3.07%. Defaults also tend to occur less frequently with general obligation bonds (backed by the issuer's full faith and taxing authority) than with revenue bonds (backed only by a specific project's revenues).

Investors can minimize their exposure to credit risk by investing only in rated bonds. They also should decide whether the higher yield offered by lower-rated bonds is worth the increased risk. Diversifying by holding bonds of several different issuers (avoiding a single region or state) also can reduce credit risk by lowering a single default's impact on the portfolio. Insured or prerefunded bonds also limit credit risk. (Private insurance guarantees principal and interest payments on insured bonds; prerefunded bonds are secured by a securities portfolio held by the issuer.)

Interest rate risk. This is the risk that changes in market interest rates will have a negative impact on a bond's value. Rising interest rates have a negative impact on municipal bond prices, falling rates have a positive effect. The longer the tune to maturity, the greater the impact. Accordingly, investors can reduce interest rate risk by investing in bonds with short- and intermediate-term maturities and holding them to maturity since they will receive the face amount at that time regardless of interest rate changes. Interest rate risk can be further mitigated by staggering bond maturities so a portion of the portfolio matures each year. The proceeds then can be reinvested at the prevailing rate so at least a portion is always invested at current rates.

Call risk. Municipal bonds are issued with provisions that allow the issuer to call (redeem) the bonds at specified prices after a certain period. Bonds are most often called during periods of falling interest rates--when the issuer can issue new bonds at a lower rate--leaving investors to reinvest at the lower prevailing rate. To mitigate call risk, investors can either avoid bonds with call provisions or buy those unlikely to be called--those with a stated interest rate considerably below the current market rate.

THE TAX MAZE

All taxpayers report municipal bond interest on their federal income tax return. For most, it does not affect their ultimate tax liability. The sidebar on page 55 describes some exceptions. But owning municipal bonds also can lead to other--often complex--tax consequences.

When a municipal bond is called, redeemed or sold in tile secondary market, the result is a taxable transaction for the investor. Specifically, he or she recognizes a gain or loss for the difference between the net proceeds (not including amounts received for accrued interest) and the bond's basis. Tile investor's basis depends on whether the bond was purchased at par, at a premium or at a discount.

Bonds purchased at par. An investor's basis equals the face amount of the bond. Consequently, there is no gain or loss if the bond is held to maturity. If the bond is sold before it matures, the investor recognizes a capital gain or loss for the difference between the net proceeds and the face amount.

Bonds purchased at a premium.

The investor must amortize the premium and reduce his or her basis by the amortized amount. For bonds issued on or after September 28, 1985, the constant interest method must be used. (Before that date, the straight line method could be used.) For noncallable bonds, the premium is amortized over the bond's life. For callable bonds, the excess of the purchase price over the call price is amortized through the call date (the earliest price and date are used if there is more than one). If the bond is not called, the investor then amortizes the difference between the call price and the face amount (or next lower call amount) through the maturity date (or call date). The rules for premium amortization are such that no gain or loss results when a bond purchased at a premium is held to maturity or to the specified call date.

If the bond is sold before the call date or maturity, the investor recognizes a capital gain or loss for the difference between the net proceeds and the adjusted basis in the bond. The examples in exhibit 1, which appears on page 53, illustrate the amortization of bond premium.

Bonds purchased at a discount.

When an investor buys a bond for less than its face amount, the discount can be characterized as original issue discount (OID), market discount or some combination. Because they are treated differently for tax purposes, it is necessary to separate OID from market discount. This process is relatively easy for bonds originally issued to the investor (the entire discount is OID) and for bonds originally issued at par or at a premium (the entire discount is market discount). However, the process becomes more difficult for bonds originally issued at a discount.

When a bond is issued at a discount (an OID bond), the difference between the face amount and the purchase price is OID. OID is amortized over the life of the bond using the constant interest method (for bonds issued after September 3, 1982 and acquired after March 1, 1984) or the straight line method (for all other bonds). The revised issue price (RIP) of an OID bond is the difference between the bond's face amount and the unamortized OID. When an investor buys an OID bond for less than the RIP, the difference between the face amount and the RIP is OID and the difference between the RIP and the purchase price is market discount. When the purchase price equals or exceeds the RIP, the entire discount is OID.

Once the OID and market discount have been.determined, the OID is amortized (using the previously described method) and added to the bond's basis. Any market discount is accrued ratably over the bond's remaining life but is not added to its basis. (Investors alternatively can elect to accrue market discount using the constant interest method.) For bonds purchased at a market discount after April 30, 1993, the gain realized on sale or redemption is ordinary income to the extent of the accrued market discount; any remaining gain is capital gain. (For bonds purchased before May 1, 1993, the entire difference between the net proceeds and the investor's basis results in a capital gain or loss.) The examples in exhibit 2, page 54, illustrate the calculation and tax consequences of OID and market discount.

MORE TO THINK ABOUT

Other tax-related issues are of concern to municipal bond investors.

Bonds purchased between interest dates. When this occurs, the purchaser pays the seller the interest accrued through the sale date. When he or she receives the interest payment it is exempt from federal income taxes. However, CPAs should make certain the accrued interest paid to the seller is not reported on the investor's return when calculating the tax due on Social Security benefits or for alternative minimum tax purposes.

Tax-deferred accounts. With rare exceptions municipal bonds are not good investments for individual retirement accounts, Keoghs or other arrangements in which taxes are deferred until funds are withdrawn. Because income is not subject to tax until that time, it is advisable to invest in higher-yielding taxable bonds.

Borrowing to purchase or carry tax-exempt securities. Interest paid on loans to acquire or continue an investment in municipal bonds is not tax-deductible if there is a direct or indirect relationship between borrowing and owning the investment. A direct relationship exists when loan proceeds are used to acquire municipal bonds, such as purchasing them on margin. An indirect relationship is presumed when funds are borrowed when the taxpayer owns tax-exempt securities. The Internal Revenue Service assumes the money was borrowed so the taxpayer could continue to own (carry) those securities, even if the tax-payer can provide evidence the funds were used to make taxable investments. Investors may be able to rebut the IRS presumption by providing a convincing nontax reason for holding the tax-exempt securities.

TAX REFORM?

Some investors may be avoiding municipal bonds because of the potential for significant tax reform. However, tax-exempt bonds remain an attractive alternative for high-bracket taxpayers. It is unlikely tax reform will lead to a tax on municipal bond interest because of the impact on municipalities' borrowing costs. If reform exempts other sources of investment income from tax, the impact on municipal bonds would be similar to a significant rise in interest rates. By maintaining a Iaddered portfolio of bonds with short to intermediate maturities, investors can enjoy current tax advantages while limiting the uncertain impact of future legislation.

The Municipal Bond Market

* Of 52,000 issuers of municipal securities, 71% have less than $10 million in bonds outstanding.

* Among the 1 million different municipal securities issues, an average of only 180 trade actively in the secondary market at any given time.

Source: Municipal Finance Journal

Computing Equivalent Taxable Yields

To compare municipal and taxable bonds, the yield on a municipal bond can be converted to an equivalent taxable yield. This is done by dividing the tax-exempt yield by the difference between 1.00 and the investor's marginal tax rate (1.00-MTR). The table at right shows the equivalent taxable yields for the five current federal tax rates.

If a bond also is exempt from state or local income taxes, the marginal tax rate should be adjusted to reflect those rates--after taking into account the deductibility of such taxes on the federal tax return. For example, if an investor's marginal federal tax rate is 39.6% and the combined state and local tax rate is 17%, the combined federal, state and local marginal rate is 49.87%. (The deduction for state and local taxes reduces the effective rate for those taxes to 10.27%.)

For investors who must reduce their itemized deductions or personal exemptions because adjusted gross income exceeds a certain threshold, the actual federal marginal tax rates are higher than those included in the table, resulting in a higher equivalent yield.
 Marginal tax rate


 15% 28% 31% 36% 39.6%
 5.0% 5.88% 6.94% 7.25% 7.81% 8.28%
Tax-exempt 5.5% 6.47% 7.64% 7.97% 8.59% 9.11%
 yields 6.0% 7.06% 8.33% 8.70% 9.38% 9.93%
 6.5% 7.65% 9.03% 9.42% 10.16% 10.76%






EXECUTIVE SUMMARY

* MUNICIPAL BONDS ARE AN EXCELLENT vehicle for sheltering investment income from federal (and often state and local) taxes. CPAs can help clients compare tile yields on comparable taxable bonds before they decide to invest in municipal securities.

* THERE ARE THREE PRIMARY RISKS associated with municipal bonds. Credit risk can be reduced by avoiding unrated bonds, by investing in insured or prerefunded bonds or by diversifying purchases across several issuers. Interest rate risk can be reduced by investing in bonds with short- and intermediate-term maturities and by staggering maturities. Call risk can be eliminated by avoiding callable bonds.

* WHEN A MUNICIPAL BOND IS SOLD, called or redeemed, the investor recognizes a gain or loss on the difference between the net proceeds and his or her basis in the bonds. The investor's basis depends on whether the bond was purchased at par, at a premium or at a discount. For discount bonds, the basis also depends on whether the bonds were originally issued at a discount.

* THE GAIN OR LOSS ON THE SALE OR redemption of a municipal bond generally is taxed as a capital gain or loss. However, the gain on the sale or redemption of market discount bonds acquired after April 30, 1993 is taxed as ordinary income to the extent of the accrued market discount.

VAN E. JOHNSON, CPA, PhD, is assistant professor of accounting at Northern Illinois University, DeKalb. LINDA M. JOHNSON, CPA, PhD, is associate professor or accounting at Northern Illinois University.

Exhibit 1: Amortization of Bond Premium

Example 1: Straight line method.

On January 1, 1993, Cindy Morgan pays $104,500 for $100,000 of noncallable 30-year municipal bonds originally issued on January 1, 1969. The stated interest rate is 6% with interest payable in January and July. Morgan sells the bond on January 1, 1995, for $100,200.

Analysis: Morgan amortizes the $4,500 premium over the remaining six-year life of the bond. Since the bond was issued before September 28, 1985, she can use the straight line method. Each January 1 and July 1, $375 of the premium ($4,500-12 interest periods) is amortized and subtracted from Morgan's basis. On January 1, 1995, her basis is $103,000 and she recognizes a $2,800 capital loss ($100,200 [divided by] $103,000).

Example 2: Constant interest method.

Assume the same facts except the bonds Morgan purchases were originally issued on January 1, 1988.

Analysis: Since the bonds were issued after September 27, 1985, Morgan must use the constant interest method to amortize the $4,500 premium over the remaining 25-year life of the bonds. On January 1, 1995, her basis is $103,973.79 (assuming the bonds were issued to yield 5.5%). Morgan recognizes a $3,773.79 long-term capital loss ($100,200-$103,973.79).

Example 3: Callable bonds.

Or, January 1, 1989, Tom Leonard pays $104,500 for $100,000 of callable 30-year municipal bonds. The stated interest rate is 6% with interest payable on January 1 and July 1. The bonds were originally issued on January 1, 1969, and are callable on January 1, 1995, at 103.

Analysis: Leonard amortizes the $1,500 of the premium in excess of the call price over the six years to the call date. On January 1, 1995, his basis is $103,000. (Since the bonds were issued before September 28, 1985, the straight line method can be used.) If the bonds are called, Leonard will receive $103,000 and no gain or loss will result. If the bonds are not called, he will amortize the rest of the $3,000 premium over the remaining life of the bonds.

Exhibit 2: Bonds Purchased at a Discount

Example 1: Original issue discount bonds purchased at an acquisition premium.

On January 1, 1990, Alice Shaw purchased $100,000 of 20-year municipal bonds for $98,000. They were originally issued on January 1, 1980, for $94,000. The bonds pay interest on January 1 and July 1. Shaw sells the bonds on January 1, 1995 for $99,500.

Analysis: The original investor amortized the $6,000 of original issue discount over 20 years using the straight line method. Every January 1 and July 1, $150 of OID was amortized and added to the original investor's basis. As of January 1, 1990, $3,000 ($150x20 periods) of the $6,000 OID had been amortized. The revised issue price (RIP) on January 1, 1990, is $97,000 ($100,000 less $3,000 unamortized OID).

Since the amount Shaw paid for the bonds exceeds the RIP, the entire $2,000 discount is OID to her. Each period she continues to amortize $150 of OID (the original schedule applies). However, Shaw can increase her basis in the bonds only by two-thirds of this amount ($2,000 discount-S3,000 unamortized OID). On January 1, 1995, Shaw's basis in the bonds is $99,000 and she recognizes a $500 long-term capital gain.

Example 2: OID bonds purchased at market discount.

Assume the same facts as above except Shaw purchased the bonds on January 1, 1990, for $96,000.

Analysis: On January 1, 1990, Shaw's basis in the bonds is $96,000--the purchase price. Of the $4,000 discount from face value, the difference between the $100,000 face amount and the $97,000 RIP represents OID and the difference between the RIP and the purchase price ($1,000) is market discount.

As OID continues to accrue at $150 each period, the amortized amounts are added to Shaw's basis. The market discount accrues ratable over the bond's remaining life ($1,000 [divided by] 20 periods = $50); however, the amounts are not added to Shaw's basis.

On January 1, 1995, Shaw's basis in the bonds is $97,500 and she recognizes a $2,000 gain of which $500 is taxed as ordinary income and $1,500 is taxed as long-term capital gain. (Since the bonds were purchased after April 30, 1993, the gain is taxed as ordinary income to the extent of accrued market discount. Had Shaw purchased the bonds before May 1, 1993, the entire gain would have been taxed as a long-term gain.)

Paying "Tax" on Municipal Bond Interest

Social Security recipients must include municipal bond interest in the income calculation to determine if any portion of these benefits is subject to federal income tax. For these taxpayers, even a dollar of municipal bond interest may increase their tax liability. (Taxable interest does the same thing, with the added "penalty" of having to pay a regular tax on that income.) CPAs can help Social Security recipients calculate their estimated income tax liability and decide if they are better off investing in taxable versus tax-exempt securities.

Investors subject to the alternative minimum tax should be aware that the interest on so-called private activity bonds issued after August 7, 1986, is a preference item for purposes of calculating AMT. Since investors subject to AMT pay either a 26% or 28% tax rate on such interest, the tax advantage of investing in private activity bonds is reduced or eliminated. Accordingly, CPAs may wish to advise investors subject to AMT to avoid such bonds and invest in regular municipal bonds or even in taxable investments.

CASE STUDY

Helping Clients Balance Risk and Return

When it comes to advising clients on investment matters, Lori A. Dodson, CPA, PFS, CFP, admits that some of the things that work for her won't work for most CPA firms. At least part of the reason is because Lori A. Dodson Financial Advisory Services in Nashville, Tennessee, is registered as an investment adviser with the Securities and Exchange Commission. "CPAs don't want to be as specific as I am with their clients unless they are registered," Dodson cautioned. (See "To Register or Not, That's the Question," J of A, June95, page 47.)

But Dodson does not accept commissions or sell investment products. "I have a broad range of clients. But one thing they all have in common is that they know about fee-only financial planning versus paying commissions--and what they want is to pay only a fee."

Dodson takes an educational approach to moving clients toward their investment goals. She first helps them with asset allocation--the broad planning--and then with investment strategy and selection of specific securities that will help them achieve their objectives.

Inevitably some clients who come to her have investments that are too risky. "My experience is most clients who have risky securities in their portfolios know they are risky and are a bit chagrined they let themselves get into that position. They want to get risings straightened out and take more control; they don't want portfolios that were put together randomly."

On the heels of record returns in stock and bond markets, what concerns Dodson's clients most right now? "There is a feeling you might miss the boat by not participating to some extent in equities." Dodson's clients have lost the enthusiasm they might have had for more conservative investments such as certificates of deposit three or four years ago. "Back then I didn't have older clients telling me 'I don't like CD's."'

Dodson has no difficulty getting clients to describe what they want. For every client she offers investment advisory services to--separately or as part of a financial plan--she prepares a written investment policy statement setting out the asset allocation and particular techniques she'll use to achieve certain specified goals. The document outlines how much risk the client will assume, how great a one-year loss is tolerable and what average annual return is sought over the client's investment horizon.

Dodson bases the document on client interviews and questionnaires that gauge attitudes about risk tolerance and similar factors. "It forces clients to stop and think," she said. "It's hard sometimes to be honest with ourselves." Dodson doesn't see a lot of huge risk takers, but said she also doesn't see a lot of people who won't take any risk. "I see people mostly in the middle. They want to optimize their return relative to their risk."

Most clients come to Dodson with investment portfolios already in place and many are not happy with some aspects of them. Instead of what they have, they want a specific goal-oriented plan. "We look at where they are now" Dodson said, "and if their current holdings are serving their goals, I see no need to replace them." If an investment shows no promise of being anything other than an underperformer, then its time to cut the losses and put the money to a better use.

--Peter D. Fleming
COPYRIGHT 1996 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:includes case study
Author:Fleming, Peter D.
Publication:Journal of Accountancy
Date:Apr 1, 1996
Words:3770
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