When you think of municipal bonds you probably also think of tax-exempt interest income. But did you know some municipal bonds generate taxable income?
Build America bonds, created in 2009 as part of the stimulus bill, are an example of this type of municipal bond. Like other muni’s, build America bonds are issued by state and local governments to fund construction projects.
However, because the federal government offers tax credits for build America bonds, the interest you receive is taxable.
Why invest in a taxable municipal bond? The idea is that the federal tax credit reduces the cost of the bond to the state or local government, which in turn can increase the interest rate. In addition, when you buy bonds issued by the state where you live, the interest is generally free from state income tax.
How does the credit work? The municipality issuing the bond can choose to receive the credit itself. These “direct payment” bonds are similar to regular taxable bonds. You get your interest payment in cash and report it on your income tax return.
Alternatively, the municipality can issue “tax credit” bonds. When you invest in this kind of build America bond, you apply for a credit on your federal income tax return of 35% of the net interest you receive. Both the interest and the credit are included in your gross income.
The credit reduces your tax liability dollar for dollar and can be applied against the alternative minimum tax. You can carry any unused amount to future returns.
Depending on your tax bracket, build America bonds may be a sensible addition to your portfolio. Please call if you would like more information.