7660 / Is interest on obligations issued by state and local governments taxable?

Interest on certain categories of private purpose bonds is tax-exempt, although tax-exempt interest on some private activity bonds is a tax preference item for both the individual and corporate alternative minimum tax (note that the corporate AMT was repealed for tax years beginning after 2017, see Q 7662, Q 777).¹

Interest on general purpose obligations of states and local governments (i.e., states, territories, possessions of the United States, or political subdivisions of any of them, or the District of Columbia) issued to finance operations of the state, local government, or instrumentality is generally tax-exempt. In addition, some obligations are tax-exempt under special legislation.

In a case of first impression, the issue in Department of Revenue of Kentucky v. Davis was Kentucky’s system of exempting from state income taxes the interest on bonds issued by Kentucky or its political subdivisions, but not on bonds issued by other states and their subdivisions—and specifically, whether that differential tax treatment violated the Commerce Clause of the United States Constitution. After paying state income tax on out-of-state municipal bonds, the taxpayers (George and Catherine Davis) sued for a refund claiming that Kentucky’s differential taxation of municipal bond interest impermissibly discriminated against interstate commerce in violation of the Commerce Clause. The trial court granted judgment for the Commonwealth of Kentucky, but the Kentucky Court of Appeals reversed the trial court’s ruling, finding that Kentucky’s system of taxing only extraterritorial bonds ran afoul of the Commerce Clause. (The Supreme Court of Kentucky denied the motion for discretionary review by the Commonwealth of Kentucky.) The Supreme Court of the United States (in a plurality opinion) reversed the judgment of the Kentucky Court of Appeals, and remanded the case. Relying primarily on recent precedent,² the Court stated that issuing debt securities to pay for public projects is a quintessentially public function with a venerable history, likely motivated by legitimate objectives distinct from simple economic protectionism. The Court determined that Kentucky’s tax exemption system favored a traditional government function, without any differential treatment favoring local entities over substantially similar out-of-state interests and, thus, concluded that this type of law does not impermissibly discriminate against interstate commerce for purposes of the dormant Commerce Clause.³

Whether a particular issue meets the requirements for tax exemption can involve complex legal and factual questions. Law firms specializing in municipal debt offerings, often called “bond counsel,” provide legal opinions concerning the validity of bond issues that generally include the exemption of interest from federal income tax. These opinions are customarily printed on the bonds. It has been held that where bonds issued by a city as tax-exempt were later found invalid under state law, the interest on them was not excludable from gross income under IRC Section 103(a).⁴ Where a county housing authority refused to pay a rebate to the federal government relating to bonds that were ruled to be arbitrage bonds by the Service and not tax-exempt, the interest was not excludable from the gross income of bondholders under IRC Section 103(a).⁵

Where tax-exempt bonds trade “flat” because interest is in default, see Q 7671.

Bonds issued after June 30, 1983, must be in registered form in order to be tax-exempt (see Q 7698 and Q 7699).

Tax-exempt interest is included in the calculation made to determine whether Social Security payments are includable in gross income. It has been determined that although this provision may result in the indirect taxation of tax-exempt interest, it is not unconstitutional (see Q 677).⁶ (The direct-indirect distinction probably does not matter anyway. The Supreme Court held in 1988 that there is no constitutional requirement that interest on state and municipal bonds be excluded from the federal income tax base.)⁷

Every person who receives tax-exempt interest (and who is required to file an income tax return) must report for informational purposes the amount of tax-exempt interest received during the tax year on that return.⁸ The Code requires the reporting of tax-exempt interest paid after December 31, 2005.⁹ The Service released transitional guidance regarding the information reporting requirements for payments of tax-exempt interest on state or local bonds.¹⁰