Interest on municipal bonds is generally excluded from federal income tax when the bond is issued by:
- A state
- The District of Columbia
- A U.S. possession
- A political subdivision of any of the above
The bond must finance a public purpose. Even when interest is excluded, capital gain or loss may apply when the bond is sold.
Political subdivisions include:
- Port authorities
- Toll road commissions
- Utility service authorities
- Community redevelopment agencies
- Qualified volunteer fire departments (for certain post‑1980 obligations)
Private Activity Bonds
Not all municipal bond interest is tax‑exempt.
A bond becomes a private activity bond if:
This is the private loan financing test.
Private activity bonds often finance:
- Sports facilities
- Industrial parks
- Airports
- For‑profit hospitals
Tax Treatment
- Nonqualified private activity bonds → interest is taxable
- Qualified private activity bonds → interest is tax‑exempt, but is an AMT preference item
Form 1099 Reporting
Form 1099 distinguishes between:
- Qualified Private Activity Bond Interest
- Reported separately
- Must be included as an AMT preference item
- Still excluded from regular taxable income
- Nonqualified Private Activity Bond Interest
- Included in taxable interest
- Not separately identified
This distinction is frequently tested on the EA exam.
Example (Rewritten)
- Interest on a bond used to build a public bridge → excluded
- Interest on a bond used to build a sports arena → taxable
Both amounts appear on Form 1040, but only the taxable portion is included in income.