A municipal bond is a debt instrument issued by a state or local government. The government uses the funds to finance capital projects and daily operations.
Municipal bonds have unique tax attributes for investors because the interest income is generally exempt from regular federal income taxes.1 The municipal bond, however, will fail to qualify for the tax-exempt exclusion if it meets one of the exceptions under IRC Section 103(b), which include:
- Any private activity bond that is not a qualified bond under Section 141
- Any arbitrage bond described in Section 148
- Any bond not in registered form under Section 149
Municipal interest from a private activity bond requires a more careful tax analysis for the investor. Private activity bonds have two classifications: qualified private activity bonds and nonqualified private activity bonds.
Interest income from a “nonqualified” private activity bond is taxable for regular federal tax purposes, so the municipal bond interest exemption under Section 103(a) does not apply.1 Interest income from a “qualified” private activity bond is still tax-exempt, even though private entities use the proceeds.
Qualified private activity bond interest does require an alternative minimum tax (AMT) adjustment for the preference item on Form 6251 (Alternative Minimum Tax for Individuals). Visit our YouTube channel for a video tutorial on how to complete Form 6251 for qualified private activity bond interest adjustments.
Example of a Municipal Bond & Tax Consequences
John Smith is looking to invest in municipal bonds for the tax advantages.
The State of Florida wants to issue $50,000,000 in Turnpike Revenue Bonds, which it will use to fund several highway renovation projects. The “Tax Status” section of the Official Statement represents that in the opinion of the State’s bond counsel, individual investors may exclude the bond interest income from gross income for federal income tax purposes, and the interest is not an item of tax preference for purposes of the federal alternative minimum tax (AMT).
John Smith purchased $2,000,000 worth of bonds, which pay interest of 3% per annum. He can exclude the interest income from his gross federal taxable income, and he does not have to make any adjustments for AMT because this is not a private activity bond.
John is still required to report the gross amount of tax-exempt interest income on Line 2a, Page 1, of his Form 1040 (US Individual Income Tax Return). However, it is not included in the adjusted gross income (AGI) calculation.
Visit our YouTube channel for a video tutorial on how to report municipal bond interest from Form 1099-INT (Interest Income).
Additional Information and Resource
Investors can find more information related to tax-exempt interest reporting in the instructions for IRS Schedule B (Form 1040).