Municipal bonds have long been a favorite investment class for tax-sensitive investors since the bonds are free from federal – and sometimes state – income tax. While this is true for most muni bonds, investors should carefully consider some key exceptions, including the potential impact of muni bonds on alternative minimum tax (AMT) calculations. These details can be especially insidious when it comes to muni bond funds that have different holdings.

In this article, we’ll take a look at how to find muni bond funds that avoid the AMT penalty for those investors who may be sensitive to that type of tax.

Private activity bonds are municipal securities where the proceeds are used by private entities that act in the public good, rather than going directly to the government. For instance, private activity bonds may finance stadiums, airports, hospitals and housing projects that benefit society in some way. These projects may benefit the public in many ways, but private for-profit and not-for-profit companies ultimately control them.

The Tax Reform Act of 1986 requires that interest on private activity bonds – other than 501©(3) obligations – be included in the calculation of the alternative minimum tax income for federal tax purposes. The alternative minimum tax is an IRS tax computation that eliminates many deductions and credits for individuals who otherwise would pay little or no tax. In recent years, the number of people falling under the AMT has been on the rise.

There are many different ways to determine if a muni bond fund is subject to the alternative minimum tax, and all these methods are relatively straightforward.

The AMT status of a muni bond is clearly stated on the front cover of statements sent out after a purchase is made, while investors who purchase the securities through third parties can contact their account representatives to ascertain that information. Of course, the information also can be found by using the CUSIP to look up the bond’s information and prospectus using a number of online sources.

The information can be a bit more difficult to find when investing in muni bond funds, which hold hundreds of different bonds at any given time. In these cases, investors can find a breakdown of the percentage of bonds subject to the AMT in the fund’s prospectus, which brokers often send to investors, or it may be requested. These percentages vary from 0% to upward of 20%, which makes them extremely important to consider.

The actual amount of interest subject to the AMT is clearly indicated on Form 1099s, which financial institutions send at the end of each tax year. Often, investors are surprised to see the amount if they weren’t aware they were holding muni bond funds with exposure to the AMT. Changing circumstances over the years may prompt investors to revisit their comfort with holding these types of bonds.

Municipal bonds play an important role in many portfolios because of their unique tax-exempt status. But when it comes to private activity bonds, investors should be aware that interest payments may be subject to the alternative minimum tax. These dynamics can be especially difficult when it comes to muni bond funds that hold a number of bonds, some of which may include exposure to the AMT for investors.

If the AMT is a fact for given investors, they should carefully consider their exposure before investing in muni bonds or muni bond funds that may have exposure.

Image courtesy of Arvind Balaraman at FreeDigitalPhotos.net