Muni Bonds Generate Tax Free Interest - Or Do They?

Muni Bonds Generate Tax Free Interest Or Do They? Here is an overview of municipal bonds including potential tax liability.

Municipal bonds (also known as “munis”) are attractive to many investors because the interest income is exempt from federal income tax and in many cases, state and local taxes as well. In addition, munis often represent investments in state and local government projects that have an impact on our daily lives, including schools, highways, hospitals, housing, sewer systems and other important public projects.

Municipal bonds are a solid way to earn interest that can be free of federal income tax liability. While it is true that interest earned on municipal bonds is tax free, selling the bonds or owning a mutual fund that buys and sell municipal bonds can still have a level of tax liability. The liability comes not from the earned interest paid ion the bonds but on any profit earned from the sale of a bond.

At the outset, it should be understood that the term “municipal bonds” is typically used to describe all tax-exempt bonds, whether or not they are actually issued by a municipality (as opposed to a state, county or other political subdivision). Although such bonds are commonly referred to as “tax-exempt,” there are numerous federal and state tax consequences associated with the acquisition, ownership, and disposition of such bonds.

Your specific tax situation should be considered
when making any changes to your investments.

Even though the interest paid on a municipal bond is tax-exempt, a holder can recognize gain or loss that is subject to federal income tax on the sale of such a bond, just as in the case of a taxable bond. The amount of gain or loss is equal to the difference between
i. the sale price of the bond and
ii. the holder’s tax basis in the bond (the amount the holder paid for the bond originally, including any additions to such basis, such as OID as discussed in the following section).

Thus, if a holder purchased a $5,000 face amount municipal bond for $5,000 and then sold the bond for $5,200, the holder would have a capital gain (if held the required time period) of $200. Typically, the purchase and sale price of a municipal bond includes the dealer’s markup; however, in cases where a commission is charged, it should be taken into account by the holder in computing gain or loss.

Watch the video below for more information on Municipal Bonds.

If you are considering investing in municipal bonds make sure you conduct a thorough and complete investigation before committing to purchase.