Municipal bonds offer multiple tax advantages

Key Points

Q Are there any negative tax implications associated with buying municipal bonds?

Second, muni interest may also be exempt from state income tax. If an investor pays a combined tax (federal and state) of 38%, a 6% muni that is free from both state and federal tax equates to a taxable equivalent return of 9.68%.

Third, investing in munis can help minimize or avoid reductions in itemized deductions and personal exemptions that are sometimes phased out for high-income taxpayers, depending on their adjusted gross income (AGI). As tax-free interest does not count toward your AGI, investing in munis can help minimize or avoid the reduction.

There are, however, some disadvantages associated with munis that should be considered. The interest earned on a certain class of municipal bonds called "private activity" bonds is exempt from regular income tax but is treated as a tax preference item for purposes of the alternative minimum tax (AMT). Such investments could effectively increase your overall tax liability. The new stimulus law suspended this rule for 2009 and 2010. During these two years, investments in any type of municipal bonds, including private activity bonds, are excluded from the AMT calculation.

Another concern relates to the impact on Social Security benefits. Up to half of an individual's Social Security benefits are subject to tax if half of the benefit plus modified AGI (MAGI) exceeds certain thresholds. For this purpose, MAGI includes municipal bond income, meaning that owning municipal bonds can actually increase the tax owed on Social Security benefits.

Most munis have call provisions that allow the issuer to redeem the bonds before maturity. The exact provisions can differ significantly between bonds, so carefully review these provisions before purchasing a bond.

From a pricing standpoint, bond values move inversely with interest rates. If rates go down after your purchase, the bond may increase in value. Consider the possibility that you may have to pay capital gains taxes on a municipal bond when you redeem it if you bought the bond at a discount from par value, or if you sell it at a higher price than what you paid for it.

If you are interested in investing in munis, be sure to conduct a careful review of the authority issuing the bonds to ascertain their creditworthiness. Remember also to keep your municipal bond portfolio diversified to reduce the risk associated with any individual holding.

Q I am considering renting out our vacation home to gain some income as well as tax benefits. What do I need to know?

A Special tax rules apply if you decide to rent out a home for part of a year. These rules affect longtime landlords as well as those renting for the first time.

The rental income generated by a vacation home can offset some of the costs of ownership. Although the income is taxable, you may claim offsetting deductions for a portion of your expenses. For instance, if you rent out the home for 80% of the time and use it personally for 20% of the time, you can deduct 80% of your insurance, repair costs, and depreciation on the property.

If you incur a loss on the rental and your rental-related expenses (including mortgage interest and property taxes allocable to the rental) exceed the income, the tax picture becomes more complicated. Under the passive activity loss rules, you can use losses from a rental activity only to offset losses from other passive activities. However, if you are an active participant in the rental (ie, you make management decisions), the tax consequences depend on your income level and the level of your family's personal use.

Joel M. Blau, CFP, Ronald J. Paprocki, JD, CFP, CHBCJoel M. Blau, CFP, (top) is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com