| DEFINITION: Tax-exempt debt is any bond or other debt issued by state and local governments where interest payments received by investors are exempt from federal income taxes. |
In the case of municipalities…
Municipalities are allowed to issue tax-exempt securities, with the most common being municipal bonds. As long as these securities meet certain requirements for how the proceeds are used, interest received by investors is federally tax-free.
Tax-exempt debt can also be double tax-exempt or triple tax-exempt. Investors that live in the same state as the issuing municipality may be exempt from both federal and state income taxes — hence, double tax-exempt.
Triple tax-exempt is when the interest is exempt from federal, state, and local taxes — assuming the investor’s tax home is located within the municipality. Debt issued by Puerto Rico, Guam, Northern Mariana Islands, American Samoa, and the Virgin Islands is triple tax-exempt for all investors.
However, some interest from tax-exempt debt is subject to the alternative minimum tax (AMT). This includes private-activity bonds that raise funds not used solely for government functions, such as sports stadiums. The alternative minimum tax recalculates your income tax after adding back certain tax-free income items, such as interest from private-activity bonds.
For example, a municipal bond for airport improvements that’s backed by the credit of an airline, and not a state or municipality, is a private-activity bond. The proceeds would be used to improve municipal infrastructure but also benefit the airline, making the interest subject to the alternative minimum tax calculation for investors.
| EXAMPLE: New York’s Triborough Bridge and Tunnel Authority issued $100M in municipal bonds in March 2021 to pay for bridges and toll roads. Investors are receiving a 4% coupon (interest) payment, paid semi-annually, in May and November. The bonds are triple tax-exempt — investors living in New York City won’t owe federal, state, or local income taxes. At maturity, in November 2056, investors will be repaid their initial investment. |
What’s important here?
Tax-exempt debt allows investors to collect interest payments free from federal income taxes. Double tax-exempt debt is free from federal and state taxes, while triple tax-exempt includes federal, state, and local taxes. However, some tax-exempt debt issued by state and local governments used for private projects is subject to the alternative minimum tax.