By: Kristina Zvinakis, Contributor to the South-Western Federal Taxation series
Traditionally, municipal bonds are an appealing investment for high–income taxpayers because, as much of the discussion about them notes, the interest paid by such bonds is “almost always” exempt from Federal income tax.
The “almost always” reference relates to private activity municipal bonds. Such bonds are issued to attract private investment for projects that have some type of public benefit. States and cities utilize these bonds to borrow on behalf of private companies and nonprofits, lowering borrowing costs for entities that might otherwise turn to corporate bonds or bank loans for financing. Examples of projects funded by private-activity municipal bond issuances include providing or refinancing student loans, building airports, hospitals, or affordable rental housing.
If a private-activity bond meets the requirements in IRC § 141, the bond is considered qualified for regular income tax purposes and the interest earned is not subject to Federal income tax. However, even if the bond is qualified, the interest creates an Alternative Minimum Tax (AMT) preference. Given that high-income taxpayers are more likely to be in AMT, should such taxpayers avoid investing in private activity bonds?
One consideration is that the presence of an AMT preference in a taxpayer’s economic income does not necessarily trigger an AMT liability. Especially in the 2019-2025 TCJA timeframe, when AMT exemptions and exemption phaseouts are substantially higher than their pre-TCJA counterparts, the tax preference might not directly affect an individual taxpayer’s liability.
An additional consideration is that even where a taxpayer is in AMT, the additional cost of the tax preference might be offset by other benefits of owning private activity bonds. For example, the interest income earned could be exempt from state taxes for investors who reside in the state of issuance. This would result in the bond having an effective yield higher than the stated yield. Like other municipal bonds, private activity bonds are backed by state and local governments and may result in less exposure to risks that impact the value of (taxable) corporate bonds. Additionally, private activity bonds might make a good investment for tax-deferred retirement accounts (e.g., IRAs and 401Ks), as a result of the tax-deferral provided to the earnings of these accounts.1
These considerations suggest that high-income taxpayers might consider investing in private activity municipal bonds even in the presence of the AMT preference and potential AMT liabilities.
Ideas for Classroom Discussion or Assignments
- In general, municipal bonds are perceived to be a good investment because the interest income paid on such bonds is generally not taxable. Which tax rate should be utilized to quantify the tax benefit of a muni bond as compared to a taxable corporate bond? Should the tax benefit be evaluated utilizing the taxpayer’s marginal tax rate (the tax paid on the next dollar of income) or effective tax rate (the average tax rate)? This website can help with the calculation of a bond’s yield: https://www.thebalance.com/calculating-tax-equivalent-yield-417147. The formulas can also be used to calculate the yield on a private activity bond (incorporating potential AMT consequences).
- The IRS training website provides detailed information about the requirements for qualified private activity bonds. The information on this IRS webpage (https://www.irs.gov/pub/irs-tege/P1L11QPAB.pdf) can be utilized to learn about the volume caps and maturity limitations for private activity bonds, as well as the types of facilities for which private activity bond issuances cannot be utilized.
- Despite the popularity of municipal bonds among investors, Congress regularly considers limiting or revoking their tax-free status. Most recently, speculation surrounding the provisions of the TCJA suggested the Congress would curtail many of the tax benefits associated with municipal bonds. For instance, see https://www.cbo.gov/budget-options/2018/54793.
Ultimately, the most significant change made by the TCJA was to municipal bond refinancings. (A bond issuance might be refinanced to take advantage of a lower interest rate.) Find a business press article (e.g., Investors Want Municipal Bonds, but Issuance Is Rare) discussing the post–TCJA refinancing provisions for municipal bonds. Explain the provisions and why the change might result in fewer, rather than more, municipal bond issuances, despite investor demand for such bonds.
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