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The interest from municipal bonds is tax free at the federal, state and local levels as long as the investor resides in the same state or municipality as the issuer. However, if you buy municipal bonds in the secondary market and then sell them later at a gain, that gain will be taxable at ordinary long- or short-term capital gain rates. Municipal bonds pay a commensurately lower rate than other bonds as a result of their tax-free status.
Reporting tax-exempt interest. Total your tax-exempt interest (such as interest or accrued OID on certain state and municipal bonds, including zero coupon municipal bonds) reported on Form 1099-INT, box 8, and exempt-interest dividends from a mutual fund or other regulated investment company reported on Form 1099-DIV, box 10. Add these amounts to any other tax-exempt interest you received. Report the total on line 8b of Form 1040A or Form 1040.
If you file Form 1040EZ, enter “TEI” and the amount in the space to the left of line 2. Do not add tax-exempt interest in the total on Form 1040EZ, line 2.
Form 1099-INT, box 9, and Form 1099-DIV, box 11, show the tax-exempt interest subject to the alternative minimum tax on Form 6251. These amounts are already included in the amounts on Form 1099-INT, box 8, and Form 1099-DIV, box 10. Do not add the amounts in Form 1099-INT, box 9, and Form 1099-DIV, box 11, to, or subtract them from, the amounts on Form 1099-INT, box 8, and Form 1099-DIV, box 10.
Interest from private activity bonds (issued to fund stadiums, hospitals, housing projects and so on) is generally free of ordinary income tax, but that income is included as part of the AMT calculation. If you're subject to AMT, the interest you thought was free from income tax could end up getting taxed at a rate of 28% on the margin—which means a 4% yield shrinks to 2.88% after taxes! Although private activity bonds generally sport a slightly higher yield than regular municipal bonds of comparable maturity and quality, it's generally not nearly enough to overcome the AMT hit.
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