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AMT and Private-Activity municipal bonds By Kristina Zvinakis Contributor to South-Western Federal Taxation Series. Municipal bonds have been a popular investment for high-income taxpayers. This is because the interest paid by such bonds, as much of the discussion about it notes, is almost always exempt from Federal income taxes. This refers to municipal bonds that are used for private activity. These bonds are issued to attract private capital for projects with some public benefit. These bonds are used by states and cities to borrow for private companies and non-profits. This lowers borrowing costs for entities that might otherwise have to turn to bank loans or corporate bonds for financing. Private-activity municipal bond issuances can be used to finance projects such as student loans, refinances, and the construction of hospitals, airports, and affordable rental housing. Private-activity bonds that meet the requirements of IRC SS 141 are considered qualified for regular income tax purposes. Interest earned is exempt from Federal income tax. The interest earns an Alternative Minimum Tax (AMT), preference, even if the bond qualifies. Should high-income taxpayers avoid private activity bonds, given that they are more likely to be paying AMT. One thing to consider is that AMT preferences in a taxpayer’s income do not automatically trigger an AMT liability. The tax preference may not directly impact a taxpayer’s liability, especially in the 2019-2025 TCJA period, when AMT exemptions or exemption phaseouts are significantly higher than their pre-TCJA counterparts. Another consideration is that private activity bonds may have other benefits than AMT taxpayers. Investors who are residents in the state where the bond was issued could have their interest income exempted from state taxes. This would mean that the bond’s effective yield would be higher than the stated one. Private activity bonds are backed in part by the state and local governments. This may reduce exposure to risks that could impact the value of (taxable corporate) bonds. Private activity bonds may be a good investment for tax deferred retirement accounts, such as IRAs or 401Ks, because of the tax-deferral provided on the earnings.1 This suggests that even with the AMT preference and possible AMT liabilities, high-income taxpayers might consider private activity municipal bonds. Ideas for Classroom Discussions or Assignments Internet Research. Municipal bonds are generally considered a good investment as the interest income they earn is generally not tax-deductible. To quantify the tax benefits of a municipal bond relative to a taxable corporate bonds, which tax rate should be used? The tax benefit should be evaluated using either the taxpayer’s marginal rate (the tax paid for every dollar of income) and/or the effective tax rate (the average rate). This website can help with the calculation of a bond’s yield: https://www.thebalance.com/calculating-tax-equivalent-yield-417147. These formulas can also help calculate the yield of a private activity bond (with potential AMT consequences). The IRS training website has detailed information on the requirements for qualified private activities bonds. The information on this IRS webpage (https://www.irs.gov/pub/irs-tege/P1L11QPAB.pdf) can be utilized to learn about the volume caps and maturity limitations for private activity bonds, as well as the types of facilities for which private activity bond issuances cannot be utilized. Tax policy Despite the popularity and appeal of municipal bonds among investors. Congress frequently considers revoking or limiting their tax-free status. Recent speculation regarding the TCJA provisions suggested that Congress would reduce many of the tax benefits associated municipal bonds. For instance, see https://www.cbo.gov/budget-options/2018/54793. The TCJA made the most significant changes to municipal bond refinancings. (A bond issuance could be refinanced to get a lower interest rate. Find a business article (e.g. Investors Want Municipal Bonds but They Are Very Rare) that discusses the post-TCJA refinancing provisions regarding municipal bonds. Explain the changes and why they might lead to fewer municipal bond issuances than before. This is despite investor demand. SWFT CHAPTERS – SWFT Individuals Chapters 4 and 12 SWFT Essentials Chapter 17 Interested to earn FREE CPE Credit Contact your Cengage Account Executive