Private Activity and Taxable Municipal Bonds

Taxable and Private Activity Municipal bonds are munis which are not totally tax-exempt.

Municipal bonds are best known for being Federal tax-exempt as well as tax-exempt if you reside in the state in which the bond was issued ( for example California residents pay no state tax on a municipal bond issued by California). But some types of municipal bonds do not provide this benefit. In general, these types of municipal bonds pay higher interest to compensate investors.

Private Activity Municipal Bonds

Some types of municipal bonds are issued to raise money for non-governmental puposes. This might include constructing affordable housing, paying for a new airport, or helping fund a non-profit arts center. These "private activity" municipal bonds are subject to the Alternative Minimum Tax (AMT), a Federal tax designed to limit deductions taken by higher income individuals. While fewer than 4 million people had to pay the AMT in 2007, this number is expected to rise to over 20% of households by 2010 according to the Congressional Budget Office.

These municipal bonds are attractive to some people because they carry a higher interest rate than tax-exempt municipal bonds to compensate individuals for potentially having to pay Federal taxes on the gain. Since not all investors are subject to the AMT, these might indeed be attractive for some. But investors should be cautious as more and more people become subject to the AMT. You may purchase the bond at a time you are not paying the AMT only to become subject to it several years later.

Determining if a Municipal Bond is Subject to the AMT

If you purchase individual municipal bonds, it is relatively easy to avoid private activity munis. You can ask your broker if the bond is a Private Acitvity bond and counts towards the AMT. The front cover of the official bond statement will also indicate whether it is subject to the AMT. Remember, in general, municipal bonds issued to fund private and non-profit projects are the ones that are often subject to the AMT. Purely municipal projects (schools, sewer systems, municipal building projects) are not subject to the AMT.

Where it gets a bit trickier is if you purchase a municipal bond fund. You must go through the prospectus, which will list the percentage of AMT bonds it might purchase as part of its portfolio. Fund managers purchase private activity municipal bonds because their higher returns increase the return on the fund. This percentage can range from 0% to 20%.

Because more and more people are becoming subject to the AMT, mutual fund companies are creating and marketing "AMT Free" municipal bond funds. If you are or think you will become subject to the AMT, look for these options.

Taxable Municipal Bonds

Taxable municipal bonds are used by states and municipalities for projects that the Federal government does not believe serve a greater public good or which the government should be subsidizing. Types of projects include the construction of a new sports stadium, convention centers, and other quasi-governmental projects.

Like private activity municipal bonds, taxable municipal bonds generally pay higher interest rates to compensate holders for the loss of tax-exemption. These bonds are protected from early redemption by call protection features. While the bonds are not Federally tax-exempt, they may be locally or state tax exempt from the location that issued them.

Often states that exhaust their allowed limit of tax-exempt bonds turn to taxable bonds to finance private development projects. The taxable municipal bond market has grown significantly and over the last five years over $90 billion in taxable municipal bonds have been issued.