Despite their name, municipal bonds are not limited to those issued by municipalities. They also include bonds from other public entities such as county or state governments. Municipal bonds typically are issued for public projects such as roads, schools and real estate. These bonds offer strong tax advantages, although they are not exempt from all taxes.
Federal Income Tax
The income investors earn from municipal bonds is exempt from federal income taxes. This is a key benefit for investors, and this tax advantage also eliminates an obstacle to public entities in raising money for important projects. However, you are required to report the income you receive from your municipal bond interest payments on your federal income tax return for informational purposes, according to the Securities Industry and Financial Markets Association.
State Income Taxes
Some municipal bond investors must pay state income taxes on their investment. Interest payments are free of state taxes if the investor lives in the state where the bonds are issued. However, nonresidents pay state income taxes on the interest.
Municipal bonds are subject to capital gains taxes the same way that other bonds are. If you sell your bond at a profit, you must pay taxes on the gains you receive from the sale. The rate you pay depends on how long you hold the bond. If you hold it for 12 months or fewer, you must pay taxes at the income tax rate, which can be as high as 35 percent. However, if you sell the bond after holding it more than 12 months, your gains are taxed at the capital gains rate, which can be as high as 15 percent.
Municipal bonds offer lower interest rates than most other bonds, including corporate bonds, so the tax break helps keep municipal bonds competitive on the bond market. A municipal bond with a lower interest rate than a corporate bond could offer an equivalent income to the corporate bond because of the tax advantages. The rules of state income taxes for municipal bonds also encourage residents to invest in projects that will directly benefit them. It gives state residents an incentive to buy state bonds that an out-of-state investor does not have.