The AMT and Muni Bonds

Even after April 15, investors who own certain types of municipal bonds should be aware of potential Alternate Minimum Tax (AMT) liabilities.

AMT is a separate tax computation under the Internal Revenue Code that, in effect, eliminates many deductions and credits and creates a tax liability for an individual who would otherwise pay little or no tax. In recent years, more and more people have found themselves subject to the AMT.

The unique feature that sets municipal bonds apart from all other capital market securities is that the interest earned on them is exempt from federal income taxes. Also called “tax exempts” the interest on bonds issued in one state is also usually exempt from that state’s income taxes, and in some cases from local income taxes.

Municipal bonds, securities sold by state and local governments to finance capital projects, are also issued for purposes that are outside the realm of pure governmental functions. Such bonds include those issued for not-for-profit 501(c)(3) organizations and other “private activity” issuers such as airports and certain types of housing agencies.

“Private activity” municipal bonds are subject to the federal alternative minimum tax. In 1986, the Tax Reform Act required that interest on private activity bonds (other than 501(c)(3) obligations) issued after August 7, 1986 be included in the calculation of AMT income for federal tax purposes.

According to the IRS Web site, for 2008 the exemption amounts for figuring the AMT have increased, and this amount depends on your filing status. You may have to pay the AMT if your taxable income for regular tax purposes, combined with certain adjustment and tax preference items (including interest on certain private activity bonds), is more than the following exemption amounts below:

• $69,950 if you are married filing a joint return or a qualified widow(er),
• $46,200 if you are single or head of household, or
• $34,975 if you are married filing a separate return.

The yields on AMT bonds are higher, reflecting the risk that they could become taxable to some investors at some point in time. If an investor purchased an AMT bond before he or she became subject to the AMT, the investor achieved a higher yield at that time than if he or she had purchased a non-AMT bond. However, as financial circumstances may change over the years, investors may find that they are now subject to this tax.

Most individuals hold municipal bonds in one of two ways–either they own the bond outright, or they own municipal bond funds.

Determining if an individual bond is subject to AMT is fairly simple, and there are several places to find this information. When you purchase a bond, a confirmation is sent to you, which includes many identifying details about the security, including the name, maturity and whether the income is subject to the AMT. If the bond was purchased in the primary market, an official statement was sent to you. The front cover of the official statement will tell you if the bond is subject to the AMT. If you maintain an account at a securities firm, you should be able to find out that information from your account representative. If you know the CUSIP number, you can also access the AMT information.

The sponsor of the fund may have purchased bonds subject to the AMT to increase the yield on the fund, especially in past years when overall interest rate levels have been low. The fund’s prospectus describes the types of securities that the sponsor is allowed to purchase, including the types of bonds by purpose, ratings, and whether it will purchase up to a percentage of bonds subject to the AMT. In a national or state specific fund, this percentage can range from zero percent upward to 20 percent or even higher.

Financial institutions have to send you a Form 1099, which in the case of municipal bond funds will detail how much of your interest income may be subject to the AMT. You may be surprised to see this amount if you were not aware that the fund included AMT bonds, or if your circumstances changed from when you first bought the bonds and were indifferent to the AMT.

Experts agree that municipal bonds play an important role in a diversified portfolio. In making the initial decision to purchase a tax-exempt bond you should calculate the taxable equivalent yield to determine if municipals are the right fixed-income investment for your own situation.

If the AMT is a factor in your financial picture, and you purchase municipal bonds, you should read all of the offering documents to familiarize yourself with the bond or the bond fund’s holdings. The vast majority of municipal bonds are non-AMT, so there are options in finding the appropriate investment if you choose to purchase bonds individually. If you choose to purchase bonds through funds, mutual fund companies are now marketing funds that are “AMT-free”, or contain no AMT obligations in response to the greater numbers of people who are finding themselves subject to the AMT. Consult your tax or investment professional for the best advice for your own situation.