Interest received on state and local government bonds is generally excludable from gross income. A state or local bond is basically an obligation of a state or political subdivision, and the term state includes the District of Columbia and any possession of the United States. Tax exempt bonds are an attractive investment for many investors because the after tax return on such bonds is considerably higher than taxable bonds.
Interest received on state or local bonds is excludable from gross income when bond proceeds are used exclusively for traditional government purposes. However, interest on state and local bonds used to benefit other persons is not tax free when it is from:
1. Private activity bonds that are not exempt
2. State or local bonds that have not been issued in registered form
3. Arbitrage bonds
All interest received from the three bond categories listed above will be completely taxable for the relevant tax year.
Private Activity Bonds
Private activity bonds are issued by state and local governments to help finance private business. Private activity bonds that qualify for tax exemption include:
1. Except facility bonds that are used to fund airports, water facilities, waste disposal facilities, electric energy or gas facilities
2. Qualified mortgage bonds which are used to fund certain owner occupied residences
3. Qualified veterans mortgage bonds which are issued by one five states
4. Qualified small issue bonds which have a face amount of $1 million or less
5. Qualified student loan bonds
6. Qualified redevelopment bonds
7. Qualified tax exempt organization bonds
Tax exempt interest received by the taxpayer for these type of bonds is not included for the regular tax computation but is included in the alternative minimum tax calculation.
In order to restrict the number of long term bearer obligations and to maintain liquidity in the financial markets, certain obligations must be issued in a registered form in order to be tax exempt. A registration required bond means any bond other than a bond which:
1. Is not of a type offered to the public
2. Has a maturity of not more than one year
3. Is issued abroad with safeguards to ensure that the obligations are sold and resold only to persons who are not U.S persons and that no interest is payable to any U.S person.
These rules basically apply to certain bonds that have been issued after August 15, 1986 and for which is a requirement for tax exempt interest qualifications.
An arbitrage bond is a bond that has been denied tax exempt status unless a special tax or rebate is paid to the United States. Arbitrage bonds are used for speculative purposes by state or local issuing authorities. A bond issue becomes an arbitrage issue if the proceeds are used to buy other obligations, frequently federal obligations that have a higher yield than the state issue.