Over the past year and half, interest rates have increased significantly. For most investors, the increase in interest rates is welcome. But for issuers of tax-exempt bonds, or cities, states and other qualifying governmental entities, the rise in interest rates may be a cause for concern.
Under the Internal Revenue Code (Code) and Treasury Regulations (Regulations), governmental entities are allowed to issue tax-exempt bonds to finance many different capital projects such as constructing public infrastructure and utilities, government buildings, and public schools.
A tax-exempt bond is a promise by the governmental entity to pay back the principal amount of the bond with interest. Because the interest on tax-exempt bonds is not subject to federal income taxes, investors are willing to accept lower interest rates on the bonds. For the interest on tax-exempt bonds to be and remain tax-exempt, governmental entities must comply with several rules in the Code and Regulations. One such rule, known as the “yield restriction rule,” requires governmental issuers to invest tax-exempt bond proceeds in investments with yields that are lower than the interest rate on the bonds. Failure to comply with this rule could result in the interest on the tax-exempt bonds being taxable.
Specifically, the yield restriction rule prohibits the investment of the proceeds of tax-exempt bonds at a yield that is higher than the bond yield by more than 0.125% such investments being called “higher yielding investments.” If the proceeds are invested in higher yielding investments, the issuer will earn a profit, or arbitrage, on the proceeds of the bonds.
However, earning arbitrage on bond proceeds does not automatically cause bonds to lose their exempt status. In the 1950s and 1960s, much like today, interest rates were high making it difficult for governmental issuers to comply with the yield restriction rule. Therefore, Congress enacted an additional rule, known as the “rebate rule,” allowing governmental issuers to pay, or rebate, to the Internal Revenue Service any arbitrage earned on the proceeds of tax-exempt bonds.
Arbitrage is required to be calculated every five years following the date the tax-exempt bonds are issued. Any arbitrage earned during this five year period must be rebated to the Internal Revenue Service. In addition, the Code requires that governmental issuers retain records related to the tax-exempt bonds such as arbitrage calculations and rebate payment information until at least three years after the bonds are paid off.
Generally, if governmental issuers earn arbitrage and fail to pay rebate to the Internal Revenue Service, the tax-exempt bonds may lose their tax-exempt status and the interest would be taxable to the investors. However, there are several exceptions to the yield restriction rule and the rebate rule that may apply. Because this article barely scratches the surface of the ins and outs of arbitrage and rebate, these exceptions will be the topic of future articles.
Due to the current high interest rate environment, it is important for governmental issuers to know how its tax-exempt bond proceeds are invested and if arbitrage is being earned. Paying close attention to these post-closing investment rules and maintaining proper record retention practices help governmental issuers ensure that the interest on their bonds remains tax-exempt and that the investors remain happy.
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FAQs
Municipal bonds generate tax-free income and therefore pay lower interest rates than taxable bonds. Investors who anticipate a significant drop in their marginal income-tax rate may be better served by the higher yield available from taxable bonds.
Why issue tax-exempt bonds? ›
Tax-exempt bonds generally offer lower interest rates and longer tenors than most taxable bonds, making them a well-suited and attractive means of financing energy efficiency or renewable energy projects for eligible borrowers.
What is the interest rate on tax-free bonds? ›
The rate of interest offered on tax-free bonds generally ranges between 5.50% to 6.50%, which is fairly attractive when considering the tax exemption on interest for these bonds. A bondholder receives the interest annually.
What is the tax-exempt status of a bond? ›
Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes. * You will, however, have to report this income when filing your taxes. Municipal bond income is also usually free from state tax in the state where the bond was issued.
Are tax-exempt bonds risky? ›
Municipal bonds generally carry less risk than stocks and are tax-exempt, which for higher tax-bracket investors effectively increases the return rate. It's crucial to highlight though, that they may not be the best choice for everyone and should be considered in light of personal financial circ*mstances.
Why do high interest rates hurt Treasury bonds? ›
Alternatively, if prevailing interest rates are increasing, older bonds become less valuable because their coupon payments are now lower than those of new bonds being offered in the market. The price of these older bonds drops and they are described as trading at a discount.
Who benefits from tax-exempt bonds? ›
The proceeds of the bonds are used to finance projects that benefit the community such as roads, schools, bridges, sewers, parks or water treatment. Most bonds issued by government agencies are tax-exempt.
How do tax-exempt bonds work for dummies? ›
THE BASICS A. What is a tax-exempt bond? A tax-exempt bond is an obligation of a state or political subdivision the interest on which is exempt from federal income taxation. The interest income is also usually exempt from income taxation of the state in which the issuer of the obligation is located.
What effect does interest on tax-exempt bonds have on the taxation of Social Security benefits? ›
Although tax-exempt interest is not itself taxable, it can cause the taxation of additional social security benefits because the interest is added to adjusted gross income to form a larger modified adjusted gross income.
Are bonds safe if the market crashes? ›
Where is your money safe if the stock market crashes? Money held in an interest bearing account like a money market account, a savings account or others is generally safe from losses stemming from a stock market decline. Bonds, including various Treasury securities can also be a safe haven.
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
Paper I bonds are only available in multiples of $50.” There are also limits on how many I bonds you can buy each year. Individual purchase limits for I bonds are $15,000 per calendar year — $10,000 worth of electronic I bonds and $5,000 worth of paper I bonds.
How do I report tax-exempt bond interest? ›
Tax-exempt interest.
In general, your tax-exempt stated interest should be shown in box 8 of Form 1099-INT or, for a tax-exempt OID bond, in box 2 of Form 1099-OID, and your tax-exempt OID should be shown in box 11 of Form 1099-OID. Enter the total on line 2a of your Form 1040 or 1040-SR.
Are tax-exempt bonds secured? ›
Because the bonds are secured by a specific tax and NOT by the general taxing power of the issuer, the bonds are NOT general obligation bonds. revenues received from a specific source. Generally, the source of revenues is the facility financed with the proceeds of the bonds.
How long do you have to spend tax-exempt bond proceeds? ›
Generally if all bond proceeds are spent within 6 months after the issue date, the rebate requirement is met and no rebate is due. The 6-month spending exception applies to all types of tax-exempt bonds, including 501(c)(3) bonds and other private activity bonds and applies to refunding as well as new money issues.
What are the advantages of tax-exempt bonds? ›
Municipal Bonds
Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes. In addition, interest on the bonds is exempt from State of California personal income taxes.
What is a tax-exempt interest rate? ›
Tax-exempt interest is interest income that is not subject to federal income tax. In some cases, the amount of tax-exempt interest a taxpayer earns can limit the taxpayer's qualification for certain other tax breaks.
Do bond premiums reduce tax-exempt interest? ›
PREMIUM – TAX-EXEMPT BONDS
Investors are required to amortize the premium in these cases. However, because the interest from the bond is tax-exempt, the amortized premium does not create a current-year tax benefit for the investor (unlike with premium on a taxable bond).
What is the difference between taxable bonds and tax-exempt bonds? ›
The main difference between a taxable municipal bond and a tax-exempt muni is that taxable munis pay interest income that's subject to federal and state income taxes, whereas tax-exempt munis pay interest income that's generally exempt from federal and state income taxes.
