The Handbook of Municipal Bonds

CHAPTER 7

Summary of Federal Tax Requirements for Tax-Exempt Bonds

Perry E. Israel, J.D., LLM Law Office of Perry Israel

 

 

 

This chapter provides a very broad outline of the federal income tax rules relating to tax-exempt municipal bonds. The topics covered include the rules relating to arbitrage, the private activity bond rules, and the remaining miscellaneous rules, including special rules for advance refunding bond issues.

The Internal Revenue Code (the Code) and the Income Tax Regulations (the Regulations) lay out a complex set of rules that govern whether the interest on municipal bonds will be excluded from gross income under Section 103⁵³ of the Code (i.e., whether the bonds will be what are generally called tax-exempt bonds). In typical convoluted fashion, the Code first provides that interest on obligations (bonds, notes, or other things treated as debt obligations for federal tax purposes, such as certain financing leases) issued by a state or local government will be excluded from gross income,⁵⁴ but then goes on to say that such interest will not be exempt if the bonds are private activity bonds, arbitrage bonds, or otherwise fail to meet other requirements.⁵⁵ Then the Code says that even private activity bonds may be tax exempt if they are “qualified private activity bonds,” but the interest on such bonds will generally (but not always) be treated as a special preference item for purposes of the alternative minimum tax.⁵⁶

All the provisions in the Code relating to ...