Municipal bonds are commonly tax-free at the federal level, but can be taxable at state or local income tax levels or under certain circumstances.
An Overview of Municipal Bonds
A municipal bond, also known as a muni, is a debt security used to fund capital expenditures for a county, municipality or state. One of the major advantages of munis is that they are typically exempt from federal income tax. They are often excused from local and state tax as well, particularly when the bond’s investor lives in the state in which the bond was issued.
Essentially, when investors buy a municipal bond, they loan money to the bond’s issuer in exchange for a specified number of interest payments over a set period of time. The end of this time period is referred to as the bond’s maturity date, defined as when the investor’s full investment principal is returned. Municipal bonds, because they are tax-exempt, are popular among individuals in higher income tax brackets.
While munis are generally assumed to be tax-free, investors should determine a bond’s tax consequences before investing. If an individual invests in a bond issued by an agency of their home state, there is rarely state tax charged. However, if they buy the bonds of another state, their home state may tax their interest income from the bond. While interest income is usually tax-exempt for municipal bonds, capital gains realized from selling a bond are subject to federal and state taxes. The short- or long-term capital gain, or loss, on a bond sale is simply the difference between the selling price of the bond and the original purchase price of the bond.
Municipal Bonds and Capital Gains Tax
When buying munis on the secondary market, investors must be aware that bonds purchased at a discount (less than par value) will be taxed upon redemption at the capital gains rate. Note that this tax does not apply to coupon payments, only the principal of the bond.
For example, the table below shows three different bonds, all maturing in two years and all of which give the buyer a return of 4% if purchased at their net present value price:
| Bond | Required Rate of Return | Coupon Rate | Cash Flow at End of Year 1 (Coupon) | Cash Flow at End of Year 2 (Coupon+ Principal) | Net Present Value |
| Par | 4% | 4% | $4 | $104 | $100 |
| Premium | 4% | 6% | $6 | $106 | $103.77 |
| Discount | 4% | 2% | $2 | $102 | $96.22 |
The difference between the net present value and the principal payment at maturity is taxed at a capital gains rate of 15%. In this case, the discount bond (from above) will be worth less to the buyer, as shown below.