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.
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.