Not Always Tax-Free: 7 Municipal Bond Tax Traps


Investment-grade corporate bonds are issued by companies with credit ratings of Baa3 or BBB- or above by Moody’s or S&P, respectively, and therefore have a relatively low risk of default. Companies issue corporate bonds to raise capital for a number of reasons, such as expanding operations, purchasing new equipment, building new facilities, or just for general corporate purposes. Major rating agencies like Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P) issue a credit rating for bonds. Bond ratings represent the rating agencies’ opinion of the issuer’s creditworthiness and ability to repay its debt, based on its financial position, management, and other factors. A bond term refers to the length of time between the date the bond was issued and when the bond matures. Bonds with terms of less than four years are considered short-term bonds.

  • A futures contract that is a hedging transaction generally produces ordinary gain or loss.
  • Unused losses are treated as sustained in the next tax year.
  • If you receive stock rights that are taxable, the basis of the rights is their fair market value at the time of distribution.
  • If you have a reportable transaction understatement, you may have to pay a penalty equal to 20% of the amount of that understatement.
  • This interest, however, as well as all interest earned after the reissue, is income to the former co-owner.

After you figure this interest exclusion, use a separate Form 4952 to figure your actual deduction for investment interest expenses and attach that form to your return. If the proceeds are more than the expenses, you may be able to exclude only part of the interest. You could have chosen to treat all of the previously unreported accrued interest on Series EE or Series E bonds traded for Series HH bonds as income in the year of the trade. If you made this choice, it is treated as a change from method 1. The person who acquires the bonds includes in income only interest earned after the date of death. You and your spouse each spent an equal amount to buy a $1,000 Series EE savings bond.

Closing Thoughts on I-Bond Tax Considerations

For updates on listed transactions, loss transactions, and transactions of interest, go to Because there are many abusive tax shelters, it is not possible to list all the factors you should consider in determining whether an offering is an abusive tax shelter. However, you should ask the following questions, which might provide a clue to the abusive nature of the plan. Stripped preferred stock is any stock that meets both of the following tests.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets. For example, roughly 10% of recently issued munis were taxable. Taxable muni bonds generally yield more than tax-free bonds to make up for the difference. Donating an I bond before it matures to charity while you’re alive will also accelerate taxation of the interest income. As with gifts to other people, giving away bonds you already own to your alma mater, favorite museum or other charitable organization doesn’t let you avoid the tax on previously untaxed interest. You’re still taxed on all that interest in the year the donation is made.

If you use an accrual method, you report your interest income when you earn it, whether or not you have received it. You constructively receive income when it is credited to your account or made available to you. If you acquire short-term discount obligations that are not subject to the rules for current inclusion in income of the accrued discount or other interest, you can choose to have those rules apply. This choice applies to all short-term obligations you acquire during the year and in all later years. You cannot change this choice without the consent of the IRS. Under method (2) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction.

Any loss or deduction not allowed because of this limit is carried over and treated as a loss or deduction in the next tax year. Generally, S corporation distributions, except dividend distributions, are considered a return of capital and reduce your basis in the stock of the corporation. The part of any distribution that is more than your basis is treated as a gain from the sale or exchange of property. The corporation’s distributions may be in the form of cash or property.

Another Possible Tax On Original Issue Discount (OID):

Attach a statement to your Form 1040 or 1040-SR explaining why the amount shown on line 1 of your Form 1040 or 1040-SR is different from the amount shown on your Form W-2. For stock issued before October 10, 1990, you include the redemption premium in your income ratably over the period during which the stock cannot be redeemed. See Original Issue Discount (OID), earlier in this chapter. You do not have to pay tax on OID on any stripped tax-exempt bond or coupon you bought before June 11, 1987. However, if you acquired it after October 22, 1986, you must accrue OID on it to determine its basis when you dispose of it.

If you pay off the lien to avoid foreclosure and loss of your property, you are entitled to repayment from the builder or contractor. If the debt is uncollectible, you can take a bad debt deduction. Henry Lloyd, an officer and principal shareholder of the Spruce Corporation, guaranteed payment of a bank loan the corporation received.

How do I get the tax exclusion?

This is done on the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet. If dividends on an insurance contract (other than a modified endowment contract) are distributed to you, they are a partial return of the premiums you paid. Do not include them in your gross income until they are more than the total of all net premiums you paid for the contract. A corporation that declares a stock dividend may issue you a scrip certificate that entitles you to a fractional share.

Tax Exempt Bonds

This form will help you with the specific interest income that is taxable. The website also helps you to view a history of taxable earnings. You will not have to pay the state taxes for the bond income.

Bond mutual funds hold a large number of bonds with a variety of maturity dates, interest rates, and credit ratings. This can make it much easier to diversify your bond portfolio because the fund invests in the bonds and you have an interest in a suspense account definition meaning small amount of each bond within the fund rather than investing a large sum into a single bond. Income from bonds issued by the federal government and its agencies, including Treasury securities, is generally exempt from state and local taxes.

Income Generation

This is true even if the other co-owner redeems the bonds and keeps all the proceeds. The interest from Treasury bills, notes, and bonds is taxable at the federal level but not at the state and local levels. Some U.S. government agency securities, such as those issued by Fannie Mae, are taxable at the federal level but exempt from state and local taxes.

Because of the high inflation rate, I bonds are now paying an interest rate of 5.27%, which is a healthy, safe return on your investment. This rate applies for bonds issued through April 30, 2024. The inflation rate changes every six months from the bond’s issue date.