Tax-exempt bonds are valid debts owed by state and local governments. The interest on these bonds is tax-exempt. This means you don't pay federal income tax on the interest.
State and local bonds are very attractive to taxpayers who are in higher income tax brackets because the interest on them is tax-free. The interest earned on a bond issued by any state, including the District of Columbia, qualifies for tax-exempt status. In addition, local government bonds qualify. So, interest on bonds issued by cities, counties and townships is tax-free.
Nonqualifying State and Local Bonds
Some state and local bonds don't qualify. For example, these categories of state and local bonds don't qualify for tax-exempt status:
- Most private activity bonds
- Arbitrage bonds
- Bonds that aren't registered
Private Activity Bonds
A private activity bond is a bond issued by or on behalf of a local or state government to finance the project of a private user. Usually, interest on these bonds is taxed. To be tax-free, the bonds must be qualified. The following categories of private activity bonds are qualified bonds under federal tax laws:
- Exempt facility bonds. These are issued to finance various types of facilities owned or used by private entities, including airports, docks and certain other transportation-related facilities; water, sewer and certain other local utility facilities; solid and hazardous waste disposal facilities; certain residential rental projects (including multi-family housing revenue bonds); and certain other types of facilities
- Qualified 501(c)(3) bonds. These are issued to finance a facility owned and utilized by a 501(c)(3) organization
- Qualified mortgage bonds, also known as single family mortgage revenue bonds. This bond type is issued to fund mortgage loans to finance owner-occupied residential property
- Qualified redevelopment bonds. Private activity bonds issued to finance certain acquisition, clearance, rehabilitation and relocation activities for redevelopment purposes by a governmental entity in designated devastated areas
- Qualified small issue bonds. Private activity bonds issued to finance manufacturing facilities
- Qualified student loan bonds. Private activity bonds issued to finance student loans for attendance at higher education institutions
- Qualified veterans' mortgage bonds. Private activity bonds that are general obligations of a state issued to fund mortgage loans to finance owner-occupied residential property for veterans
Arbitrage bonds are lower-rate debt security issued by a municipality prior to the call date of the municipality's existing higher-rate security, and they don't qualify for tax-exempt status.
Bonds that aren't registered don't qualify for tax-exempt status. Registered bonds are recorded on the books of the issuer by the trustee, and interest is paid by mail to the holder of record.
US Government Issued Bonds
The interest on bonds issued by all levels of government isn't necessarily excludable from gross income. Interest on bonds issued by the US Government is generally included in gross income.
Reporting State and Local Bond Interest
Even though state and local bond interest is exempt from federal income taxation, it is still reported on your income tax return. Since tax-exempt interest is used in determining the extent to which Social Security benefits are included in gross income, this information aids the IRS in determining if taxpayers receiving these benefits have properly determined how much of those benefits, if any, are required to be reported in their gross income.
Interest from state and local bonds is excluded from state taxation if the interest is paid by the state in which the taxpayer lives. This is also true if the interest is paid by a local government within the state. So, it may be advantageous for individuals to invest in a bond of the state where they live even though the rate of interest might be somewhat lower than a state bond issued by another state.
Gain on the Sale of State and Local Bonds
The tax-exempt status of state and local bond interest doesn't apply to the recognition of gain or loss on the sale of such bonds. The gains from selling state and local bonds aren't excluded from gross income.
Questions for Your Attorney
- Which private activity bonds are tax-exempt?
- Is the interest on any bonds that are issued by the US Government tax-exempt, for purposes of either federal or state taxes?
- When is it best to buy bonds that are issued by a state other than the one a person lives in?