Are Municipal Bonds Taxable in California?

Municipal bonds are loans made by investors to state or local governments to help pay for public projects like schools, highways, or water systems. In return for the loan, the government entity pays the investor periodic interest payments. A primary attraction of these bonds is their preferential tax treatment. This article clarifies the federal and California state tax rules for California residents investing in municipal bonds.

Federal Tax Treatment of Municipal Bond Interest

Internal Revenue Code Section 103 establishes that interest income from bonds issued by states and local governments is not included in gross income for federal tax purposes. For example, if an investor earns $2,000 in interest from a bond issued by a city to fund a new library, that $2,000 does not need to be reported as taxable income on their federal return. This exemption allows government entities to offer lower interest rates on their bonds compared to corporate bonds, making them an affordable way to finance public works.

However, this exemption may not apply to certain “private activity bonds” (PABs), which are issued for projects primarily used by a private entity. These bonds might fund projects like a sports stadium or an airport terminal operated by a specific airline. While many PABs are tax-exempt, some are federally taxable or can have implications for the Alternative Minimum Tax.

California State Tax Treatment of Bond Interest

The tax treatment of municipal bond interest at the state level in California depends on where the bond was issued. The state’s rules are designed to encourage investment within California, creating a tax advantage for residents who purchase bonds issued by their home state.

California Bonds (In-State)

For a California resident, interest from bonds issued by the State of California or its municipalities is exempt from state income tax. This creates a “triple-tax-free” benefit, as the interest is exempt from federal, state, and any applicable local California income taxes. This makes California municipal bonds particularly attractive to residents, especially those in higher state income tax brackets. This preferential treatment means a California investor can achieve a higher after-tax return from a lower-yielding California municipal bond compared to a higher-yielding bond from another state.

Non-California Bonds (Out-of-State)

Interest income from municipal bonds issued by other states is fully taxable by California at ordinary income tax rates. While this “out-of-state” bond interest is still exempt from federal tax, it must be included on the investor’s California state tax return.

An exception exists for bonds issued by U.S. territories like Puerto Rico, Guam, and the U.S. Virgin Islands. Federal law prohibits states from taxing this interest, so for a California resident, it is exempt from both federal and California state taxes.

Exceptions to Tax-Free Status

The tax-free status of municipal bonds applies to interest payments. However, other events, like selling a bond or purchasing it under certain conditions, can result in taxable income at both the federal and state levels.

Capital Gains

The tax exemption for municipal bonds does not extend to profits made from the sale of the bond. If an investor sells a municipal bond for a higher price than their purchase price, the resulting profit is a capital gain, which is taxable on both federal and state returns. For example, if a California bond was purchased for $10,000 and later sold for $10,500, the $500 profit is a taxable capital gain. The tax rate depends on the holding period; assets held over a year may qualify for lower federal long-term capital gains rates, but California taxes all capital gains as ordinary income.

Alternative Minimum Tax (AMT)

Certain municipal bond interest, while exempt from regular federal income tax, can be subject to the Alternative Minimum Tax (AMT). The AMT is a separate tax calculation designed to ensure that high-income individuals pay at least a minimum amount of tax. Interest from specific private activity bonds is considered a “tax preference item” that must be added back into income when calculating AMT liability. Investors receive a Form 1099-INT that will indicate if any of their tax-exempt interest is subject to the AMT.

Market Discount

Taxable income can also be generated if a bond is purchased on the secondary market for a price below its face value, creating a “market discount.” For instance, if a bond with a $1,000 face value is bought for $950, the $50 discount is not considered tax-exempt interest. When the bond is sold or matures, the market discount is treated as taxable interest income. A “de minimis” rule allows small discounts—less than 0.25% of the face value for each full year until maturity—to be treated as a capital gain rather than ordinary income.