3.5 Tax Treatment of Municipal Bonds

3.5 Tax Treatment of Municipal Bonds

A bondholder’s “after tax” return on a bond depends in part upon how interest on the bond is treated in calculating the bondholder’s income for federal and state income tax purposes. If interest is not taxed, a lower interest rate paid by the public agency issuer will result in the same after tax yield to the holder as interest at a higher rate that is taxed. All other things being equal, a bond for which the interest has more favorable tax treatment can be sold bearing interest at a lower rate than the interest rate paid on another bond with less favorable tax treatment.

The federal income tax treatment of interest on bonds (commonly referred to as the bond’s “tax status”) issued by public agencies generally falls into one of three major categories:

1. Interest is included in the gross income of the holder (Taxable Bonds).
   
   
2. Interest is not included in the gross income of the holder but is treated as a “specific preference item” in calculating the holder’s alternative minimum tax (AMT) liability (if any). That is, it is added to income for AMT purposes and effectively taxed at the AMT rate for holders subject to the AMT (AMT Bonds).
   
   
3. Interest is not included in the gross income of the holder and is not a “specific preference item” for purposes of the AMT (Non AMT Bonds).

Most bonds issued by public agencies are Non AMT Bonds.

The tax status of a particular bond may depend on a number of factors, including the date of issuance of the bond or any bond refunded by the bond. For example:

• Bonds that fail to meet the requirements for federal income tax exemption described in Chapter 4, Federal and State Tax Law Requirements are taxable bonds.
  
  
• Tax exempt private activity bonds (including the private activity bond portion of airport and port bonds) other than single family mortgage revenue bonds, multifamily housing bonds, and qualified 501(c)(3) bonds are AMT Bonds. See Section 4.7, Qualified Private Activity Bonds.
  
  
• Tax exempt governmental bonds, single family mortgage revenue bonds, multifamily housing bonds, and qualified 501(c)(3) bonds are Non AMT Bonds. See Section 4.6, Governmental Bonds/Private Activity Bonds. 

Bonds issued by California public agencies are also exempt from State of California personal income taxes regardless of the federal income tax treatment. See Section 4.1, California Tax Exemption. The benefit of California tax exemption to California investors generally allows the federally tax exempt bonds of California public agencies to be sold at interest rates lower than the interest rate on comparable federally tax exempt bonds issued by public agencies in other states. Most bonds issued by public agencies are Non AMT Bonds.

Federal tax law may also affect the after tax return to investors in other ways. Tax credit bonds, for example, provide a tax credit to bondholders and bank qualified bonds can be held by a bank without a reduction in the bank’s deduction for interest cost. See Section 4.11, Bank Qualified Bonds. This benefit to bondholders allows public agency issuers to reduce borrowing costs by increasing investor demand.