Are Capital Gains on Municipal Bonds Taxable?
The tax advantages of municipal bonds have key distinctions. Explore the tax treatment of gains when selling a muni, a crucial detail beyond tax-exempt interest.
Municipal bonds, or “munis,” are debt securities issued by state and local governments to fund public projects. Their primary appeal is that the interest they pay is exempt from federal income tax, making them an attractive option for generating income. However, the tax treatment is not always straightforward. A common point of confusion is whether the profit from selling a municipal bond is also tax-free, which introduces a distinction in how returns are treated.
Interest Income Versus Capital Gains
Understanding the tax implications of municipal bonds requires separating interest income and capital gains. Interest income consists of the periodic coupon payments the bond issuer makes to the bondholder. While this interest is exempt from federal income taxes, it is included in the calculation to determine if a portion of an individual’s Social Security benefits are taxable. If an investor resides in the state that issued the bond, the interest may also be exempt from state and local taxes.
A capital gain is the profit an investor realizes when they sell a bond in the secondary market for a price higher than their cost basis. Unlike the interest payments, this profit is not shielded from federal taxation. Certain “private activity” bonds, which fund projects like airports or stadiums, can generate interest subject to the Alternative Minimum Tax (AMT).
How Capital Gains on Municipal Bonds Are Taxed
The profit realized from selling a municipal bond is subject to federal capital gains tax. The tax rate applied depends on how long the investor held the bond. The holding period determines whether the profit is classified as a short-term or a long-term capital gain.
A short-term capital gain results from the sale of a bond held for one year or less. These gains are taxed at the investor’s ordinary income tax rate, which is the same rate applied to their wages and other regular income.
A long-term capital gain applies when a bond is sold after being held for more than one year. These gains receive more favorable tax treatment and are taxed at lower, preferential rates of 0%, 15%, or 20%, depending on the investor’s taxable income. In addition, individuals, estates, and trusts with income above certain thresholds may also be subject to a 3.8% Net Investment Income Tax on these gains.
Calculating the Taxable Gain
The starting point for calculating a taxable gain or loss is the “cost basis,” which is the original price paid for the bond. This basis must be adjusted when bonds are purchased for a price other than their face value in the secondary market.
One adjustment relates to “market discount,” which occurs when a bond is bought on the secondary market for a price below its face value. The accrued portion of this discount is taxed as ordinary interest income when the bond is sold or matures. The “de minimis” rule provides an exception: if the discount is less than 0.25% of the bond’s face value multiplied by the number of full years until maturity, the gain can be treated as a capital gain.
Another adjustment is the “amortization of premium,” which applies when an investor purchases a bond for more than its face value. The investor must systematically reduce their cost basis over the bond’s remaining life by this premium amount. This process, detailed in IRS Publication 550, prevents an artificial capital loss when the bond matures. Properly accounting for these adjustments is necessary for reporting the taxable gain on Form 8949 and Schedule D.
State Tax Implications
State tax treatment of capital gains from municipal bonds is not uniform and often depends on the bond’s origin. This creates a distinction between bonds issued within an investor’s home state and those issued by other states.
Many states that levy an income tax provide a tax exemption for capital gains realized from municipal bonds issued within their own borders. This “in-state” preference is designed to encourage local investment. An investor living in a state with this rule would not owe any state tax on the profit from selling a bond issued by their own state.
In contrast, these same states will tax capital gains from “out-of-state” bonds. If an investor sells a municipal bond issued by a different state for a profit, that gain will be subject to their home state’s income tax, in addition to the federal capital gains tax.