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Municipalities borrow money by issuing bonds for sale to the general public. While Governments need money for infrastructure and new projects like any other loan, the bondholders are paid an tax free interest rate on their money. At the end of most issues of a certain term, the Municipality has to pay back the face amount of that loan. This tax free interest payment on municipal bonds makes them highly and this article will focus on Municipal bonds due to their apparent exemption from some or all taxes.
Interest income received by holders of Municipal Bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt. However, if you buy a municipal bond from another investor on the secondary market as opposed to buying directly from the issuer on the primary market, at a discount to its face value, you will owe capital gains taxes on the increase in principal you will receive when the bond is redeemed. The capital gains tax on a long-term gain is 15% (selling a security after holding it for at least 1 year is a long-term gain), whereas the tax on a short-term gain is 35% (selling after holding a security for less than 1 year). The interest is usually still exempt from federal or state tax, unless the bond has specific provisions that stipulate otherwise.
So, if you are going to buy a municipal bond, or any bond for that matter, that has already been issued to someone else, you need to look at the price of the bond relative to its face value to ascertain what the yield to maturity will be. The yield to maturity figure that you will find in a newspaper for a certain bond does not take into account the tax consequences that will be generated once the bond is redeemed. So, you need to figure in the taxes on your capital gains when calculating the yield on a bond that has been purchased at a discount. The strangest thing about a bond, as opposed to a stock, is that if you purchase the bond at a premium (more than the face value), upon redemption you can not claim a capital loss. This seems paradoxical, because you lost money on the purchase, but it still does not count as a loss.
A particularly perplexing aspect of Municipal bonds is known as the de minimus tax rule. This rule asserts that if you purchase a bond at a discount equal to or greater than a quarter point per year until maturity, then instead of paying a capital gains tax on the increase in principal, you will pay taxes equivalent to your ordinary income tax. For a lot of investors, this can be troublesome, because most often bonds are held for more than a year before they can be redeemed anyway, so any gains received on discounted issues are usually subject to the 15% long-term capital gains tax. But, because of the de minimus rule, even if you have held the bond for more than 1 year, and it matures, if the discount was a quarter point per year until maturity, then you will have to pay income tax, which might be 35% if you fall in the highest income tax income tax bracket.
Sometimes, not only are the gains on the principal taxed, but the interest income can be federally taxable as well, depending upon the situation. If the federal government determines that the money raised from the sale of a certain municipal issue is being used for something that falls outside their definition of Municipal use, then they might subject the interest to federal taxes. Also, if the money being raised by the sale of the bond is being used for something that is related to municipal improvements, but is being used to fund the activities of a private corporation to make those improvements, then the interest income might be subject to federal taxes in this instance.
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