Tax Facts

7667 / Is interest on a tax-exempt municipal bond paid by a private insurer because of default by the state or political subdivision tax-exempt?

Yes, interest that would have been tax-exempt if paid by the issuer will be tax-exempt if paid by a private insurer on the issuer’s default.1 It makes no difference whether the issuer or the underwriter pays the premium on insurance obtained by the issuer covering payment of the principal and interest or whether the individual investors obtain their own insurance.2


A bondholder, however, may not exclude from gross income interest paid or accrued under an agreement for defaulted interest if the agreement is not incidental to the bonds or is in substance a separate debt instrument or similar investment when purchased. If, at the time the contract is purchased, the premium is reasonable, customary, and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds, then the agreement will be considered both incidental to the bonds and not a separate debt instrument or similar investment. Under these circumstances, a bondholder may exclude interest paid or accrued under an agreement for defaulted interest.3

If the interest or principal is guaranteed by the federal government, see Q 7668.





1.   Rev. Rul. 72-134, 1972-1 CB 29.

2.   Rev. Rul. 72-575, 1972-2 CB 74; Rev. Rul. 76-78, 1976-1 CB 25.

3.   IRC § 149(b)(1); Treas. Reg. § 1.149(b)-1.


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