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A municipal bond represents a loan to the issuing municipality, in exchange for regular interest payments and the promise of a return of the face amount of the bond upon maturity. Investors in high-income tax brackets can benefit from buying municipal bonds because their interest is typically exempt from federal income taxes. While interest payments on municipal bonds might be free from federal income taxes, capital gains from selling tax-exempt bonds for a profit, are not.
The Internal Revenue Service considers just about everything you own, from your home to your lawn mower, to be a capital asset. That includes your investment securities, such as your stocks and bonds. If you sell a capital asset, such as a municipal bond, for more than you paid for it, you have a taxable capital gain. You must report the gain on Form 1040, Schedule D.
Capital gains resulting from the sale of your tax-exempt bonds are taxed at different rates, depending on whether your holding period was short-term or long-term. If you owned the bonds for one year or less before you sold them, your gain is short-term and is taxed at your ordinary income tax rate, which could be as high as 35 percent in 2012. If you owned the bonds for longer than one year, any gain from the sale is considered long-term and is taxed at the more advantageous long-term capital gains rate. With a few exceptions, the top long-term capital gains tax rate was 15 percent as of the 2012 tax year.
Tax-exempt bonds trade in the secondary market after their initial issue. The market price for these bonds fluctuates based on such factors as changes in the credit rating of the issuing municipality and changes in prevailing interest rates. Bond prices tend to move in the opposite direction of prevailing rates, so if interest rates fall, the market price of your bonds is likely to increase. If prevailing interest rates rise, the market price of your bonds typically falls. If you sell your tax-exempt bonds for less than you paid, you have a capital loss, which you can use to offset your capital gains or other income.
When figuring your capital gains or losses on your tax-exempt bonds, you can include the cost of purchasing your bonds, such as commissions and transaction fees, with the purchase price to determine your cost basis. You can subtract the cost of selling your bonds from the sales price. If you borrow money to buy certain investment securities, you can deduct the interest on that loan. The investment interest deduction does not apply if you use the money to buy tax-exempt bonds.