Tax Treatment of Municipal Bonds — Review for the Series 7 Exam

By Steven M. Rice

Municipal bonds may be backed by taxes or by a revenue-producing facility, and you will be tested over the tax treatment of municipal bonds on the Series 7 exam.

Practice questions

  1. Dallas, Texas, is issuing $100 million general obligation bonds at a discount from par with a coupon rate of 2.5%. If the bonds are issued at 90 and there are 30 years until maturity, how is the discount treated to purchasers of the new issue if the bond is held to maturity?

    A. The discount is accreted annually and not taxed on the federal level.

    B. The discount is accreted annually and treated as federally taxable income each year.

    C. The discount is not accreted annually but treated as taxable income at maturity.

    D. The amount of the discount is treated as a long-term capital gain subject to tax on both the state and federal level.

    Answer: A. The discount is accreted annually and not taxed on the federal level.

    The interest received from municipal bonds is federally tax-free. When investors purchase municipal bonds that were issued at a discount, the difference between the purchase price and par value is also treated as part of the tax-free income.

    The discount would be accreted over the 30 years until maturity and wouldn’t be taxed on the federal level. An investor of these bonds wouldn’t be subject to a capital gain or loss unless the bond(s) is sold.

  2. Which of the following bonds generally have the lowest yields?

    A. AA rated corporate bonds

    B. GO bonds

    C. T-bonds

    D. cannot be determined

    Answer: B. GO bonds

    For Series 7 purposes, you can assume that municipal bonds have the lowest yields of all bonds. You may have chosen T-bonds (Treasury bonds) because they would be the safest, but then you didn’t take into consideration the tax advantage of investing in municipal bonds.

    Municipal GO (general obligation) and municipal revenue bonds have lower yields because the interest investors receive is federally tax-free. Therefore, municipalities are able to offer lower pre-tax yields to investors than with other debt security investments.

  3. Holders of which of the following municipal securities may be subject to alternative minimum tax?

    A. BANs

    B. special assessment bonds

    C. GO Bonds

    D. IDRs

    Answer: D. IDRs

    IDRs (industrial development revenue bonds; also IDBs or IRBs) are municipal bonds backed by a corporate lessee. Because they may be non-public purpose bonds, the interest received from these bonds may be subject to alternative minimum tax (AMT).