Municipal Bonds and Taxes

Municipal bonds have tax advantages if investors use proper strategies.

Municipal Bonds and Taxes
There are three ways to own municipal bonds

• Purchased at a market discount
• Purchased as an original issue discount
• Purchased at a premium

Municipal Bonds Purchased at Market Discount
Market discounts can occur due to an increase in interest rates or a reduction in the credit worthiness of the issuer. The IRS has ruled that if an investor buys a tax-exempt bond at a market discount to par after May 1,1993, the investor must pay ordinary income tax on the value of the discount, just as if it were a taxable bond. This can be paid over the life of the bond or at maturity.

Municipal Bonds Purchased at Original Issue Discount
When an issuer issues a bond below par, the entire discount is considered tax-exempt. The IRS considers this an issuer-based discount as opposed to a market-based discount. A common example of this is the zero-coupon municipal. The investor can incur a capital gain or loss upon sale of these bonds

Municipal Bonds Purchased at a Premium
If you buy a tax-exempt bond at a premium, you must amortize the premium over the period you own the bond. This amortization reduces your basis in the bond, but unlike a taxable bond, you can't deduct the amortized amount. The premium amortization is not deductible because the interest is not taxable.

Capital Gains and Losses

Capital gains and losses are classified as either short-term or long-term. They are short-term if they occur on an asset that you have held for one year or less. They are long-term if they occur on an asset with a holding period of longer than one year. The long-term capital gains tax rate for most investors is 15%. For investors in the 10% and 15% income tax brackets, the long-term capital gains tax rate is 5%. Short-term capital gains are taxed as ordinary income. Capital losses are first applied against capital gains of the same type to reduce such gains. Thus, a long-term capital loss will first reduce long-term capital gains, and a short-term capital loss will first reduce short-term capital gains. Any excess long-term capital loss is used to offset short-term gain. Any excess short-term capital loss is used to offset long-term capital gain.
Any capital losses remaining after offsetting all available capital gains can then be used to reduce ordinary income by up to $3,000 per year ($1,500 if you are married filing separately), with any losses in excess of that amount available to be carried forward indefinitely to reduce capital gains or ordinary income in future years under the same procedures. (IRS Publication 550)
If you swap a municipal bond that has fallen in price for a similar bond, you may take a deduction for the capital loss that may be used immediately. The new bonds must differ in at least two of the following three criteria:
	Issuer
	Coupon Rate
	Maturity Date
This will satisfy the IRS "Wash Sale" rule which requires a swap into a substantially different security.

Swapping Into a Market Discount Bond
If you swap into a market discount municipal bond, you may owe income taxes on the discount amount of the new bond depending on how it is liquidated in the future. However, as with taxable bonds, an investor can elect to defer this tax over the life of this municipal.

Swapping Into Par, OID or Premium Bonds

One approach when realizing losses in municipals may be to restrict reinvestment to municipals:
	Selling at par or slightly under par
	A premium to par
	That were issued at a discount thereby circumventing the tax rules on market discount bonds

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