Many investors prefer municipal bonds and funds because any income generated is generally free from income taxes. This tax break translates to a higher after-tax yield compared to other government or corporate bonds, particularly for wealthy individuals that fall into higher tax brackets. Muni bonds also tend to be relatively safe compared to many other bond classes, since they’re often backed by state or local governments that can impose taxes.
In this article, we will look at a lesser-known feature of municipal bond funds recently explored by Allan Roth that could lead to a negative tax rate in some cases.
Buying at a Premium
Most municipal bonds are issued at a premium these days, since record low interest rates have increased demand without an equivalent increase in supply. The way these premiums are handled differ depending on whether an investor holds individual muni bonds or muni bond funds (including mutual funds, ETFs and closed-end funds). And the latter creates a unique tax loophole that certain investors may want to consider in order to significantly reduce their tax burden or even generate a tax benefit.
The IRS requires that investors purchasing individual muni bonds amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year investors must reduce their basis in the bond and the tax-exempt interest by the amortization amount for the year. This prevents investors from selling the bond a year later and claiming a loss, since they were repaid the principal and have no economic loss.
Muni bond funds are treated differently in the eyes of the IRS, since the amortization of the premium doesn’t impact the cost basis and tax losses can be incurred. For instance, a muni bond fund with an SEC yield of 1.25% (e.g. the true income without any return of capital) and a distribution yield of 2.25% (e.g. income that includes the return of capital) has 1% return of principal from an economic point of view – which could translate to a 1% tax loss.
Impact on Taxes
Investors can realize a negative tax rate when a municipal bond fund’s return of principal exceeds the income generated from interest payments. After selling the bond fund, the investor would have been paid a combination of these two in cash and could recognize a loss equal to the return of principal. These losses could be applied towards the IRS limit of $3,000 per year or be used to offset any capital gains that have been realized.
The downside is that investors may be required to hold the muni bond funds for six months in order for the losses to be permitted by the IRS. In addition, it’s important to consider various other factors like the direction of interest rates and funds’ credit risks, which could have a much bigger impact on returns than the modest change in tax rate. The upshot is that this tactic could provide a ‘free’ benefit, and represents another reason to consider funds over individual bonds.
The Bottom Line
Municipal bonds are a great way for investors to realize higher after-tax yields, but a lesser-known benefit can be gained with muni bond funds. By keeping these factors in mind, investors may be able to take advantage of the current low interest rate environment that has led to higher muni bond premiums. However, it’s important to keep in mind some of the pitfalls such as the minimum holding time and other risk factors that may influence the funds.