Chapter 15 Tax Treatment of Municipal Bonds

Question 1

Corporate Equivalent Yield

Example: If an investor is in 28% federal tax bracket, what interest rate would they have to receive on a corporate bond to have the same after tax income as on a municipal bond yielding 6%?

Answer 1

Municipal Yield / (100% -investor’s Tax Rate) = Taxable Equivalent Yield

MC Hammer

6% / 100%-28%. = .06 /  .72 = 8.33% corporate yield 

The investor would have to buy a corporate bond yielding 8.33% to be equal of the 6% municipal bond yield.

Question 2

Current Yield

Answer 2

Annual Interest / Market Price

Question 3

Municipal Bond Premiums- premiums must be amortized

Answer 3

over the life of the bond, results in an amortized(reduced) cost basis for tax purposes. Accounting process determines the annual adjustment called “straight line method”

Example: In a Corporate Bond, if you bought it at a premium, lets say $1,200, and held to maturity( 10 years), you would receive $1,000 par, back at maturity, incurring a $200 loss for taxes.
But with Municipal Bond, you would have to write off $20 per year x 10= $200, or $20 annually.

If you sell the Municipal Bond EARLY, lets say in 5 years, you have written off $100( $20 per year x 5= $100). So now you NEW cost basis is $1,100 and NOT $1,200

Note: premiums on corporate bonds may either be amortized over the life of the bond or taken as a loss in full at maturity.

Question 4

Original Issue Discount(OID)-

Answer 4

treat the discount as interest income and not as capital gain, favorable as interest income is tax exempted.

Question 5

Secondary Market Discount

Answer 5

when the bonds are bought at a discount in the secondary market, the discount generally be treated as Ordinary Income which is fully taxable to the investor in the year the bond is sold.

Municipal Bonds trading at a discount are more volatile because they are more sensitive to interest rate changes than bonds trading at a premium.

Question 6

Swaps

Answer 6

Reason to Swap a bond

1. Upgrade a portfolio by switching into a higher rated bond
2. Extend or shorten time to maturity
3. Increase income or yield
4. Realize capital losses for tax purposes

NOTE: Accrued interest would not be a reason to do a municipal bond Swap.

High Bracket individuals, commercial banks, and insurance companies are large buyers of municipal bonds due to the tax exempt status of the bond interest.

Charitable institutions, IRA’s and pension funds DO NOT benefit from the tax exempt status of municipal bonds since the companies are tax-free or tax deferred.

Question 7

The Market for Municipal Bonds

Answer 7

Blue List- listing of Municipal bonds for sale by dealers( NO LONGER EXIST)
Does not contain quality of rating.

Inventory and listing of Municipal Bonds available in the secondary Market can also be found in the BOND TRAC and BOND EXPRESS.

The Bond Buyer- a daily newspaper giving the news and happening in the municipal market. Gives info about new issues.

Question 8

30 day visible supply

Answer 8

measures the total number of new issues coming to market in the next 30 days. A good indicator of the expected supply in the new issue market for municipals. Broken down into two numbers:

Question 9

Issues of General Obligation to be sold on

Answer 9

competitive basis

Question 10

Issues of Revenue bonds to be sold on

Answer 10

negotiated basis

Question 11

Bond Buyer Index

Answer 11

index that is made up of 20 General Obligation bonds each with 20-year maturities. A good indicator of the yield that buyers would receive if they purchased a similar bond.

Question 12

Bond Buyers Revenue Bond Index

Answer 12

the average yield of 25 specific revenue bonds each with 30 year maturities.

Question 13

The Municipal Bond Primary Market

Answer 13

When a new issue of municipal bonds will be offered to the public, the municipality will hire a broker dealer to handle the distribution.
The managing underwriter is the firm that serves as head of the syndicate group and determines the scale on a serial bond or the pricing on a term bond issue.

Question 14

Earning Coverage or Debt Service Coverage

Answer 14

reelects the number of times by which the revenues for a period exceed the debt service payable in that period. Bond debt service found by dividing the municipality’s revenues by the annual interest and principal payments( debt service)

Earning coverage is the net revenue divided by debt service .

For Example: If a municipality has a revenue of 8,000,000 and 2,000,000 of interest and principal to be repaid that year, the coverage would be
8,000,000 = 4
2,000,000 1

The lower the debt service coverage, the lower the price of the bond and the higher the yield due to increased risk related to the payment of interest and principal on the issue.

Question 15

Settlement Date for municipals bonds

Answer 15

Regular Way- 2nd business day
Cash Trade- same day
When, as and if issued. Settle on a date agreed upon by both parties.
Settled between firms with “Clearing House Funds”
If not regular way, settlement date would be agreed between the buyer and seller.

Question 16

Long-Term Capital Gains

Answer 16

are realized profits that are earned on asset held for 12 months plus 1 day or longer trade date to trade date. The gain is taxed at the rate of 15%

Net Long Term Gain x .15= Tax Liability
Example: A customer has a long-term capital gain on common stock of 3,500. He is in the 24% tax bracket. What is his tax liability?
3,500 x .15= $525

Question 17

Capital gains/ losses are reported are form

Answer 17

8949 part II

Question 18

Short-term Capital gains

Answer 18

are realized profits that are earned on assets held 12 months or less trade date to trade date. The gain is taxed at the investor ordinary income tax rate.

Question 19

Stock dividends

Answer 19

are other form that a corporation may pay a shareholder. Not treated as ordinary income. Stock dividends are used to reduce the cost basis.
Example: You buy 100 shares @ $8 per share= $800, then later receive a 10% stock dividend.
Original amount $800 = $7.27 per share( new cost basis)
Original #sharesx % 110

Question 20

Wash Sale Rule

Answer 20

if a customer sells securities at a loss, and within 30 days before or after the sale purchase “substantially identical” securities, the loss is not allowed in the current year for Federal Income tax purposes. The customer must not purchase the same security which was sold for at least 31 days. To include convertible bonds, options, and convertible preferred stock.

Question 21

Corporate taxes

Answer 21

common and preferred dividends received by a corporation from another corporation are 50% excluded from taxable income ( only 50% is subject to taxes)
Income from REITS would not qualify for the exclusion. (Applies to corporations)

Question 22

General Tax Information

Answer 22

Alternative Minimum Tax(AMT) – certain taxpayers obtain tax advantages which reduce or eliminate their tax liability.

Question 23

Maximum gift tax exclusion for gifts in a single year to one person

Answer 23

$15,000 and for married couple it is $30,000.

Question 24

An investor buys 8% bond that will mature in 10 years for $1080. After 8 years the bond would have an adjust cost basis

Answer 24

80 premium = $8 annual adjustment
10 years
$8 x 8 years= $64 reduction in cost
$1,080-$64 = $1,016 adjusted cost basis at the end of 8 years

Question 25

Introduction to Direct Participation Programs(DPP)

Answer 25

General Partners have unlimited liability.
Limited partners have a limited liability to their risk.

Limited partnership are pass-through entities. Each partner reports their share of income and expenses on their personal tax returns on form K-1.

Advantages
Conduit Theory- income and expenses flow through to the limited partners.

Limited partnership DOES NOT pay federal income taxes

Capital Cost can be depreciated(cost of building and machinery)

Disadvantages
Limited of liquidity
Lack of control over management( general partner)
Loss of all or part of the investment
Potential AMT consequences

Investors should consider:
Projected rate of return
Possible changes in the federal tax code

Question 26

Characteristics of DPPs

Answer 26

A Certificate of Limited Partnership must be filed with the Secretary of State in the state where the partnership is formed to protect the interests of the limited partners.

A DPP offered to the public must be registered with the SEC.

A 10% maximum underwriting spread is permitted for a DPP program

Question 27

Subscription Agreement

Answer 27

application from an investor that is signed by the general partner( becomes final when the general partner signs the agreement)

Must contain a statement that the investor read the prospectus and understands the risks
Investors Social Security number or Tax ID Number
A statement that the investor has sufficient annual income and net worth
NOTE: Does not require the source of funds from the investor.

Question 28

Upon dissolution of a limited partnership, claims would be paid off in the following order:

Answer 28

Creditors- secured, then general ( unsecured)
Limited Partners- profits claims, then capital claims
General Partner- profits claims, then capital claims

Question 29

Main types of Real Estate DPPs

Answer 29

1.Residential property( apartment building)
2. Commercial property( shopping malls)
3. Industrial property( factories)
4. Government assisted housing( low income housing)
5. Condominium securities ( time shares)
6. Raw Land- an investor would purchase unimproved or raw land for appreciation or capital gains

Question 30

Cash flow with deductions( except deprecation)

Answer 30

Example: Revenue 600,000
Operating Expense 300,000
Managers Fee 100,000
Interest 190,000
Deprecation 110,000

What is the cash flow?
600,000 Revenue
-590,000 All deductions( except deprecation)
$10,000 cash flow

Question 31

Oil and Gas Partnerships

Answer 31

The four types of oil and gas investment programs are

1.Exploratory Drilling Program- look for new oil and gas wells( greatest risk and returns)

2. Developmental Drilling Program- drill new wells in areas of proven reserves. (less returns)
3. Balanced Drilling Program- drill both for Exploratory and Developmental wells
4. Oil and Gas Income Program- buy properties with proven oil and gas reserves that are already producing. ( lowest capital risk)

Question 32

Capital Asset Pricing Model(CAPM)-

Answer 32

Risk free rate + Beta x( Expected return on the market- risk free rate)

Question 33

Fundamental and Technical Analysis

Answer 33

Fundamental Analysis consists of Management, earning, Company outlook( guidance), company annual report( 10K), 10 Q quarterly earning and price/earning ratios

Technical Analysis- Trading Volume, Moving averages, Advance/Decline ratio, odd lot theory, Timing of purchases and sales, Support and resistance levels.

Stock Market Index- NYSE Composite Index, Dow Jones Industrial Average, Dow Jones Composite Average, Value Line Index, Standard and Poor’s Index(SPY), and Wilshire Index.

Question 34

Alpha measures

Question 35

Beta