Tax Treatment for Selling Municipal Bonds

Municipalities issue bonds to raise funds for road construction projects.
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When you sell your municipal bonds, the interest is usually exempt from state and federal taxation. But some states, looking for new revenue sources, have started taxing bond interest. The tax issues you face when you sell your municipal bonds depend on your state of residency and whether you sold a bond that was issued in another state. In some cases, your bond interest may qualify as taxable income under the federal alternative minimum tax.

In-State Bonds

When you sell municipal bonds issued by your home state, the interest you earn is exempt from state taxation. It doesn’t matter if you live in a city or county other than the one that sold the bonds. As long as the bonds were issued by a municipality in your state, you do not pay state tax on the interest. If your state has a personal income tax or an intangible tax, you disclose the bond income on the return but don’t pay tax on the proceeds.

Out-of-State Bonds

Many states tax the interest you earn on municipal bonds that are issued by another state. If you live in a state with a personal income tax or an intangible tax, you must file the appropriate tax return to report and pay tax on the income. By paying tax on your out-of-state bond interest, you lose the tax-free advantage of investing in municipal bonds issued by your home state. However, if you sell municipal bonds issued by a U.S. Territory, such as Guam or Puerto Rico, that interest is always exempt from state tax.

Federal Taxation

The interest you earn when you sell your municipal bonds is exempt from federal taxation. However, the Internal Revenue Service still wants to know how much interest you made. Disclose the total amount of municipal bond interest on your individual income tax return Form 1040, Line 8b. You do not have to attach an itemized list detailing every municipal bond you sold. If you itemize your deductions on Schedule A, you can deduct the amount of state tax you paid on your bond interest.

Alternative Minimum Tax

When you sell your private issue municipal bonds, you may have to pay federal income tax on the proceeds. Municipal bonds are considered private issue when 10 percent or more of the funds raised go for a private sector purpose. For example, a municipality that sells bonds to raise money to build a football stadium has issued private issue bonds. Most of the income generated goes to the sports team owners and not to the municipality. Your income tax professional can calculate your potential alternative minimum tax liability to determine if you owe tax on the municipal bond income.

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