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Municipal Bonds Tax Dilemmas

A recent trial held in the US Supreme Court is about to endanger one of the benefits of purchasing a municipal bond. Namely, if an investor purchases an issue from the state of which s/he is a resident of the bond is free from state income tax.

What makes municipal attractive to upper income investors is the exemption of the interest income from federal taxes. In order to sell the idea of purchasing bonds that are issued by the state, many states have embarked on tax exemption of local bonds.

Since bonds enjoy additional tax exemption, they can be offered to the public at significantly lower prices. Therefore, if you purchase a local bond that is issued by the state of which you are resident of you may enjoy a free of taxes income. But, this is true only in case the state frees from taxes the interest rate you gain. This is extremely beneficial for investors with high incomes, who are subject to greater income tax rates. Additionally, tax payers who are approaching the high income margin can benefit from this.

The mentioned above case mostly concerns the right of Tennessee to tax bonds that have been issued by out of the state municipalities. On the other hand, Tennessee exempts from taxes local bonds.

On the first meetings of the lower courts, the judgment was in favor of the plaintiffs. However, Tennessee has asked the Supreme Court for a second hearing. If the Supreme Court supports the side of Tennessee, things will remain as they are.

On the other hand, if the Supreme Court confirms the judgment of the lower courts, Tennessee and states in the same position will have to choose from either:

  • Taxing all bonds both local and those of other states, or
  • Don't tax any bonds

However, it is highly unlikely that states will select the second option of not charging any taxes on the income gained from bonds. In case another solution is not found, the probability of taxing the bond income is highly increased.

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