Explain why you agree or disagree with the following statement: “All municipal bonds are exempt from...

Explain why you agree or disagree with the following statement: “All municipal bonds are exempt from federal income taxes.”
Explain why you agree or disagree with the following statement: “All municipal bonds are exempt from state and local taxes.”
What is the difference between a tax-backed bond and a revenue bond?

Expert Solution

Municipal Bonds

Interest earned on Municipal bonds are exempt from Federal Income taxes. To that extent, I agree with the given statement. However, the capital gain, if any, arising on sale or redemption of bonds will attract capital gains taxes. Therefore, if a bond is purchased from the secondary market at a discount and held till maturity, the sale price will comprise of short term or long term capital gain, based on the period for which it was held. This capital gain is the difference between the purchase price and redemption value. Even if it is sold in the secondary market before maturity, at a price higher than the acquisition cost, the appreciation in value will be subject to capital gain tax.

Interest on Municipal bonds are exempted from State and Local Taxes within that state only. If an investor purchases bonds issued by Municipalities outside his/ her home state, the home state will levy income tax on the interest on such bonds. Hence the statement given is not fully correct. Also, the capital gain on sale or redemption, if any, will be subjected to levy of taxes by the State.

Tax backed bond is the one intended to be repaid out of the tax income of the issuing authority. Such bonds are also called General Obligation bonds (GO) bonds. Such bonds rely on the taxing power of the issuing authority for servicing the debt obligation. Since Municipalities are empowered with adequate power for taxation , such bonds are considered as safe. On the other hand, Revenue bonds are to be repaid out of the revenues generated by the specific project earmarked. Hence, such bonds carry higher risk than that of the tax backed bonds. As a result, Revenue bonds carry higher interest rate, in order to compensate for the higher risk.

jeff jeffy answered 2 days ago

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