Module 5 Part 4

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Module 5 Part 4
2013-01-14 12:59:32
Module Part

Module 5 Part 4
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    • Taxation has many important aspects, but you should understand the tax consequences related to:
    • •Interest
    • •Gains on discount bonds
    • •Losses on premium bonds
    Municipal securities are HIGHLY sought after by HIGH TAX BRACKET investors because the interest that is received from the issuer is exempt from federal taxation. Some states do not tax the interest income from bonds, while others tax the interest on bonds from within their state.

    However, for the test, the interest is also exempt from taxation by the state of the issuer only if the bond is owned by a resident of that state.
  3. Example:
    A person living in California buys a Los Angeles, California Unified School District bond. The interest on the bond is not subject to federal income tax. If the investor is a resident of California, it is not taxed by the State of California, either. However, if the investor is a resident of another state that has an income tax (e.g., Oregon), the interest will be taxed by that state (in this example, Oregon).
  4. If a question on the TEST asks if municipal interest is tax exempt, answer "YES" to a FEDERAL TAX EXEMPTION and "NO" to a STATE TAX EXEMPTION. There is one exception:
    •If the state in which the investor resides and the state of the issuer are BOTH given and are both the same, interest on that bond is exempt from that state’s taxes.
  5. The IRS
    Determines the tax-exempt status of interest on municipal bonds through the tax code.
  6. The Bond Counsel:
    Assesses the tax-exempt status of the interest on the bond for the municipality by checking local and state laws and making sure the tax code is followed.
    Refers to the yield for a municipal bond, taking into consideration its tax exemption, compared to the yield for a taxable bond (Corporate or U.S. Government Bond).
  8. To determine a municipal bond yield when given a corporate bond, or to determine the TAXABLE EQUIVALENT SECURITY (corporate bond) given a municipal bond, use the following formula:

    • 100% - TAX BRACKET %

    • Remember to always use the yield, not the coupon, in determining the equivalent yield of either the corporate or municipal bond.
    If this is asked on your exam, you may be given the municipal bond yield and asked for the taxable equivalent yield, or you may be given a corporate bond yield and asked for the MUNICIPAL EQUIVALENT YIELD. Here is an example of each:

  10. Example:

    An investor in the 28% tax bracket wants to compare a 6% municipal that has a current yield of 7% with a corporate bond. What would the corporate bond have to yield to be equivalent?

    Try to do it...
    Always use the CURRENT YIELD, NOT the COUPON, and then do the following calculation:


    • 100% - TAX BRACKET %

    • = 7% Yield
    • 100% - 28%

    • = 7 % Yield
    •       72%

    • = 9.72% Corporate Bond
    • So a 7% yield on a municipal bond would be equal to a 9.72% corporate bond for an investor in the 28% tax bracket.
  11. Example

    A person in the 28% tax bracket is looking at a 15% corporate bond with a yield of 12% and is comparing it to a municipal bond. What yield must the municipal bond have to be equivalent to this corporate bond?

    Try to do it...
    To find this equivalent yield, do the following calculation:

    • 12% = Municipal Bond Yield 
    •               (100% - 28%)

    • 12% = Municipal Bond Yield 
    •                      72%

    • 12% × .72 = Municipal Bond Yield
    • 8.64% = Municipal Bond Yield
  12. When a municipal bond is bought at a PREMIUM or DISCOUNT, and then sold, called, or held to maturity, the gain or loss is treated in one of two ways according to the IRS Code.
    Two different rules apply to municipal bonds bought at a discount: Those bought as a NEW ISSUE (ORIGINAL ISSUE DISCOUNT BONDS) and those bought in the secondary market (from someone else). Only one rule applies to ALL premium bonds.
  13. If a bond is bought at a PREMIUM
    Either as a NEW ISSUE or in the SECONDARY MARKET and held to maturity, there is no loss.

    If a bond is bought in the SECONDARY MARKET at a DISCOUNT and held to maturity, the appreciation is taxed as ordinary income at maturity.

    If a bond is bought in the secondary market at a discount or a premium and sold prior to maturity, a new cost basis must be found. From there, capital gain or loss is determined.
  14. Example
    If an investor buys a discounted municipal bond for $900 in the secondary market that will mature in 20 years, the $100 discount ($1,000 par value - $900 price paid) is accreted over the 20-year period, or equal to $5 per year that the bond is held.

    If the investor sells the bond prior to maturity (for example after eight years), the cost basis is raised by the accreted amount, in this case $40 (8 years × $5 per year) to $940. The $40 is taxed as ordinary income.

    The investor then has a capital gain or loss, depending on whether the sale price is above or below the new cost basis of $940.

    If the investor holds the bond to maturity, the total discount is taxed as ordinary income.

  15. If a municipal bond is issued as a ZERO-COUPON bond (meaning having no set interest rate), or is a new issue interest-bearing bond and is purchased at a discount (called an OIDORIGINAL ISSUE DISCOUNT)
    The appreciation is considered the interest, and, therefore, is tax-free. This means that there is no capital gain on this appreciation.

    • In the previous example, if the bond had been an OID, then the $40 accreted when sold prior to maturity would be tax-free, and the capital gain or loss would still be true. If the bond had been held to maturity, the whole appreciation would be tax-free.
    • When municipal bonds are purchased at a premium, either as an original issue discount or in the secondary market, the amount of the premium must be amortized over the life of the bond.
  16. Example
    A bond with 10 years to maturity is bought at $1,100. The premium is $100 ($1,100 price paid - $1,000 the face amount) and must be amortized over the 10-year life of the bond. This means a drop in value of $10 each year the bond is held. This drop in price of the bond cannot be deducted from the investor’s income tax.

    For example, if the investor sells the bond prior to maturity after four years, the cost basis of the bond is going to be dropped $10 for each year the bond has been held, or $40 (4 years × $10 per year). The new cost basis is now $1,060 ($1,100 - $40), and depending on whether the bond is sold above or below this price determines if the investor has a gain or loss. If the sale price is at $1,060, the investor has neither a gain nor a loss. This is because the IRS believes that the investor is aware of the premium upon purchase and that the interest income compensates for the loss of the premium.

    You do not have to compute this for the TEST, but you must know that the accretion or amortization takes place. Also know that accretion for discount bonds is always taxable if purchased in the secondary market, and the amortization for the premium bonds is never taken as a loss.
    Investors use BOND SWAPS to initiate a sale and a purchase and still be in the same position without being subject to a wash sale. A WASH SALE does not allow the investor to take a loss if the same security is purchased within a 30-day period. This is discussed in the Taxation, Module 17. With a bond swap, the investor has the same position, but with a different security. This is done to avoid wash sale rules. Bond swaps are used for various reasons, some of which are:

    • •To produce a loss to offset a gain for the year
    • •To produce a gain to offset a loss for the year
    • •To increase or change the quality of a portfolio 
    • •To increase income for a portfolio
  18. An investor is shown an 11.5% corporate bond that is being offered at a 10.8% yield. What is the equivalent yield on a municipal bond if the investor is in the 28% tax bracket?
    (A) 7.78%
    (B) 8.28%
    (C) 15%
    (D) 15.97%
    FIRE Drill
    Answer (A) 7.78% yield. The corporate bond is given, so multiply the yield, not the coupon, by 100% - 28%, or 72%. In this case, 10.8 × 72% = 7.776% = 7.78%.
    Traditionally, owners of municipal bonds have been such entities as banks, insurance companies, and individuals. Nonprofit organizations and corporate pension plans do not invest in municipal bonds because they do not need the tax exemption. Therefore, municipal bonds are not considered a good investment for IRA or other retirement accounts, such as corporate pension plans. Know this for the situation questions...
    The interest expenses incurred when municipal securities are bought on margin ARE NOT tax deductible.
  21. All of the following are purchasers of municipal bonds, except:

    (A) Individuals
    (B) Banks
    (C) Insurance companies
    (D) Corporate pension plans
    FIRE Drill
  22. Answer (D) Corporate pension plans. Since corporate pension plans do not pay taxes, they do not need the low, tax-free interest generated via municipal bonds. For safety, they would be better off in U.S. government bonds, which offer higher returns.
  24. The Municipal Securities Rulemaking Board (MSRB) has jurisdiction over the regulation of broker/dealers pursuant to MSRB General Rules G-1 through G-35. The MSRB rules apply to the broker/dealer firms, the registered representatives who work for them, underwriters, and anyone who is involved in the sales or promotion of municipal bonds. The rules do not apply to issuers.
  25. The MSRB writes the rules, but does not enforce them. However, the MSRB states that the following bodies will enforce the rules for them:
    • FINRA (Financial Industry Regulatory Authority) for all securities firms
    •  •The Comptroller of the Currency, for banks
    • •The Federal Reserve Board (the Fed), for banks
    • •The Federal Deposit Insurance Corporation (FDIC)

    In addition, FINRA imposes penalties for any violation of MSRB rules by securities firms.
  26. The SEC also enforces violations of MSRB rules for all others who are non-FINRA members. In addition, the SEC imposes penalties of the Securities Acts and brings legal action against any broker/dealer, registered representative, or person who intentionally commits a fraudulent act or violates the Securities Acts while in the act of selling municipal securities.