Trends & Developments - Feb 2011 - After-Tax Investment Returns: A Primer On Tax-Exempt Municipal Bonds
With interest rates remaining near historical lows and the potential for higher income tax rates after 2012, investors subject to high tax rates may want to allocate a portion of their investment assets to tax-exempt municipal bonds. In addition to potential increases in the regular income tax rates, starting in 2013 the Health Care and Education Reconciliation Act of 2010 imposes a 3.8% Medicare tax on the unearned income of individuals with modified adjusted gross income above certain levels. For married persons the threshold amount is $250,000. For a single individual the threshold amount is $200,000. However, since this new Medicare tax will not apply to tax-exempt municipal bond interest, tax-exempt municipal bonds will yield even more when compared to after-tax yields on many other investments.
Of course, a proper evaluation of which (and how much) tax-exempt obligations should be included in an investment portfolio must include factors such as credit risk, diversification, duration, fluctuations in market value due to changes in market interest rates, yields available on alternative investments, risk tolerance, etc. Obligations of the U.S. Treasury, which are exempt from state and local (but not Federal) income taxes, are another fixed income alternative.
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COMPARING TAX-EXEMPT AND TAXABLE BOND RATES
The above chart shows examples of the rate of taxable interest income (the "taxable equivalent rate") which would have to be earned by an individual subject to a 35% Federal income tax rate, combined with the highest 2010 marginal state/local tax rate in the individual's resident jurisdiction, to equal a specified yield entirely exempt from income taxes. The prospect of even higher tax rates increases the attractiveness of high grade tax-exempt municipal bonds for high income taxpayers because the taxable equivalent rates would also be higher.
These relatively high tax equivalent rates should increase the demand for debt obligations of the states or their political subdivisions, the District of Columbia, or a United States possession, the interest on which is excluded from gross income. Even though this type of income is exempt from Federal (and often state) income taxation, individuals are required to report the amount of their tax-exempt interest income and exempt-interest dividends from mutual funds on their Federal income tax returns.
If a municipal bond is purchased for an amount (not including accrued interest) in excess of the face amount payable at maturity (or at an earlier call date), the excess over the face amount ("premium") must be amortized (i.e., written off) without any allowable deduction, since it is actually an offset to the tax-exempt yield. This amortization reduces the bond's tax basis, so that no capital loss results when the bond matures, but can result in a taxable gain or loss if the bond is sold. The premium is supposed to be amortized on a "yield to maturity" basis.
Example:On January 15, 2008, an investor purchased for $120,000 a tax-exempt obligation maturing on January 15, 2015 with a stated principal amount of $100,000, payable at maturity. The obligation provides for unconditional payments of interest at 7.5% of stated principal or $7,500 per year, payable on January 15th of each year. The amount of bond premium is $20,000 ($120,000 - $100,000).
Based on the remaining payment schedule of the obligation and the investor's cost, the yield to maturity is 4.149388 %, compounded annually. The bond premium allocable to the accrual period ending on January 15, 2009 is the excess of the qualified stated interest allocable to the period ($7,500) over the product of the adjusted acquisition price at the beginning of the period ($120,000) and the yield (4.149388 %, compounded annually). This produces a dollar yield of $4,979.27 the first year. Therefore, the bond premium allocable to the first accrual period is $2,520.73 ($7,500 - $4,979.27). The basis of the bond is reduced to $117,479.27 ($120,000 - $2,520.73). Using these facts, the amortization and the basis of this bond for the following years are as follows:
|January 15||Dollar Yield||Payment||Amortization||Basis|
Thus, if the bond is held to maturity, no gain or loss is recognized at that time. If the bond is sold on January 15, 2012 for $115,000, a long-term capital gain of $5,728.04 ($115,000 - $109,271.96) is recognized (even though the interest on the bond is tax-exempt).
The above example is oversimplified because municipal bonds usually pay interest twice a year, resulting in two accrual periods each year. Also, if a bond is callable by the issuer before maturity, the amortization is computed on the assumption that the bond will be called at that date.
If a bond originally issued at its face amount payable at maturity is bought for less than its face amount, the difference is known as "market discount." This occurs when market interest rates have risen since issuance and/or there has been a decrease in credit quality. Since no amortization of the market discount is allowed for tax purposes, there will be a taxable gain recognized if the bond is held to maturity or sold for more than its cost. For bonds purchased before April 4, 1993 this gain is treated as a capital gain, but the market discount on tax-exempt municipal bonds acquired after April 3, 1993 is taxed as ordinary income.
Many tax-exempt municipal bonds are originally issued for less than their face amount and do not pay periodic interest ("zero coupon bonds"). At maturity, these bonds pay the investor not only recoupment of their issue price but also the difference between their issue price and face amount (referred to as "original issue discount"). The bond's yield-to-maturity is computed and the original investor's basis of the bond is increased (accreted) based on this yield, so that the bond's tax basis will equal its face at maturity.
Example:Assume an investor purchases a tax-exempt municipal bond at original issue for $600. The bond has a $1,000 face value and matures in 20 years. The yield to maturity on this bond would be 2.5705%. After one year (two 6 month accrual periods) the investor's tax basis will be $615.52 (the $15.52 is the accretion of original issue discount). If at that point the original investor sells the bond for $620, a $4.48 taxable gain is recognized. The person who purchases this bond at $620 will still have original issue discount accretions, but they will be reduced by $4.48 over the remaining life of the bond.
In the alternative, assume that the original holder sells the bond after one year for $600. That investor will recognize a $15.52 capital loss ($615.52 accreted basis — $600). The purchaser will continue to have original issue discount accretions based on the $600 issue price and a $15.52 market discount gain at maturity, which will be taxed as ordinary income.
ADDITIONAL FEDERAL TAX ASPECTS
Other aspects of the Federal tax treatment of tax-exempt municipal debt obligations should be kept in mind:
1. Investment expenses (e.g., custodian fees and investment advisory fees) which are directly related to tax-exempt income cannot be deducted in computing taxable income. If an expense cannot be specifically allocated to either taxable or tax-exempt income, then an allocation of the expense must be made.
One acceptable method of allocation of indirect expenses is to use the same ratio as tax-exempt interest bears to total investment income. Other methods based on the particular facts and circumstances may be appropriate.
2. Interest expense on indebtedness incurred to purchase or carry tax-exempt obligations cannot be deducted. This provision can cause unrelated investment interest expense to become nondeductible, since no deduction is allowed for interest on indebtedness incurred or continued to purchase or carry tax-exempt obligations: In certain situations, this principle could result in the non-deductibility of interest on funds borrowed to purchase or carry other invesstments.
3. The otherwise tax-exempt interest on certain private activity bonds issued after August 7, 1986 – generally, those issued by a municipality where some portion of the proceeds is used in carrying on the business of a non-governmental entity – is an item of tax preference for alternative minimum tax (AMT) purposes. Thus, for some taxpayers the interest on these bonds is subject to a 28% Federal tax rate. However, this item of tax preference does not apply to private activity bonds issued in 2009 or 2010.
4. A portion of the proceeds on "stripped" tax-exempt obligations may be subject to tax at ordinary income rates. A stripped obligation is created by removing the unpaid interest coupons (payment rights) from the obligation, so that ownership of the maturity value (principal) is separated from the periodic interest payments.
5. The value of tax-exempt bonds is included in the gross estate of a decedent for Federal and state estate tax purposes.
STATE TAX TREATMENT
The state tax treatment of interest from municipal bonds may cause otherwise tax-exempt income to be taxable. Generally, all income received from municipal bonds issued by a taxpayer's resident state (or a subdivision thereof) is exempt from taxation. (Illinois and Oklahoma, for example, tax interest income on their own municipal debt securities.) The income received from tax-exempt municipal bonds issued by another state is usually taxable on resident tax returns. This also includes accreting original issue discount. However, the District of Columbia, Indiana and North Dakota, for example, do not tax interest income from tax-exempt municipal debt securities.
Interest on bonds issued by a United States possession or territory (e.g., Puerto Rico) is exempt from Federal and all state income taxation.
Expenses attributable to out-of-state municipals — e.g., bond premium amortization, custody fees, etc. — are generally deductible on state returns when the related interest is taxable.
As the above rules indicate, tax-exempt bonds are not the simple bonds which people used to keep in their vaults, clip the coupons on every six months, and never report on a tax return. Most tax-exempt obligations are now book-entry obligations, rather than paper bonds. The interest on tax-exempt municipal obligations is required to be disclosed on Federal tax returns. Moreover, in certain situations such obligations can produce taxable income and tax compliance can be somewhat complex. Nevertheless, the higher after-tax yields available to higher income taxpayers should continue to make tax-exempt municipal bonds an attractive investment.
Trends & Developments – February 2011