Most people are familiar with the notion that interest income associated with municipal bond investments is “tax free,” which in most cases is true. However, not all municipal bonds are created equal — some possess certain characteristics which can render their income indeed taxable.
The complication arises for taxpayers who are burdened with the alternative minimum tax, and who have invested in a certain kind of muni bond – the so-called “private activity bond.”
These are bonds which satisfy either the “private business use” test, or the “private loan financing” test defined in the Internal Revenue Code. Generally speaking, such bonds are municipal borrowings, the proceeds of which are used to finance nongovernmental activities — such as those of private businesses which the municipality is courting for one reason or another.
So before immediately diving into a portfolio of muni bonds, taxpayers should assess their specific situation (in particular regarding whether they may otherwise be paying AMT), and then the specifics of the bonds they are purchasing, so they are not surprised when April 15 rolls around and they find they are, indeed, paying some tax on what they thought were tax-free investments.