Municipal Bonds and Their Tax-Exempt Status

What do you need to know about the tax-exempt status of your municipal bonds?  Quite a lot.  By no means I am an expert on municipal finance or tax code.  Many clients of Pawleys enjoy the safety and income of their South Carolina tax-free municipal bonds. Statistics show us that across the country, municipalities have a sound track record. It is a complex market, however, and every bond should be evaluated individually. Here are a few tidbits for you to consider as an investor seeking tax-free income.

There is a special department within the Internal Revenue Service called the Office of Tax Exempt Bonds.  This office acts as a resource to the world of municipal finance.  When state and local governments finance airports, hospitals, recreational and cultural facilities, schools, water and sewer infrastructure, roads, and facilities and equipment for police, fire and rescue services, the bond issues normally meet the standards for the interest paid to the bondholders to be exempt from federal, state and local taxation. 

The IRS code requires that the funds raised for such issues must meet certain requirements to ensure that the interest is not taxable.  The municipalities even have to follow certain rules after issuance to retain the tax-exempt status.  If any level of private activity is financed by a municipal debt issue, the bonds may lose tax-exempt status.   For example, if a private company moves into a facility previously used by local government, any outstanding bond issues that financed the building are at risk of losing tax-exempt status.  Normally in this type of situation the municipality will “defease” or call the bond in early and pay remaining principal and interest to the bond holders.  Bonds issued that may support private activity such as hospitals, ports (air or water!), or industrial facilities may be at risk of not having or losing tax exempt status.  Municipalities are also disallowed tax exempt status from certain “arbitrage” situations where debt is issued and the money raised is then reinvested in higher interest securities.

When you invest for tax-free income, you might consider starting with highly rated “general obligation” bonds that are backed by the full faith of the issuer.  These may include general state, county or city issues, or even local school bonds.  “Revenue” bonds generally pay a higher rate of interest, but as you read above, may be very complex to understand even for the most seasoned investor or advisor.  Be sure to check the bond indenture to know exactly how proceeds from the bond are being used, and double-check the underlying financial condition of the issuer or project, especially on revenue-backed bonds.

Municipal bonds have a strong track record and historically low default rate, but be careful as you venture into this intricate market.

© 2012 Pawleys Investment Advisors, LLC.  All rights reserved.

One thought on “Municipal Bonds and Their Tax-Exempt Status

  1. Pingback: South Carolina Tax-Free Municipal Bond Terms & Definitions | Pawleys Advisors

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