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Tax-exempt interest is income that the law excludes from taxation. All gross income in the U.S. ordinarily is subject to taxation. The definition of gross income is all income that a person earns. This definition includes investment income and all other income, regardless of the source. The U.S. congress enacted the Tax Reform Act of 1986 to create tax-exempt interest on certain types of government-issued bonds.
State and local governments generally have the authority to issue bonds to generate revenue to pay for whatever public improvements it deems necessary. It may also issue bonds to help finance governmental operations. Investors purchase the bonds as an investment vehicle and earn tax-exempt interest. Hence, a bond in this context is an investment device. U.S. tax law defines a bond as a debt obligation.
A debt obligation is not strictly limited to a bond under U.S. tax law. A debt obligation means a person is required to pay a debt. In the context of tax-exempt interest, a debt obligation includes other types of instruments that obligate the government to pay a debt. This includes finance leases, installment purchase agreements, and any other device a government issues as a debt obligation. This means U.S. tax law will treat these other devices as bonds for tax purposes, thereby entitling holders of such instruments to enjoy tax-exempt interest.
U.S. federal tax law, however, requires taxpayers to report tax-exempt interest on their tax returns. Reporting the interest income does not mean that it is suddenly taxable. The Internal Revenue Service (IRS) simply requires that taxpayers report tax-exempt interest. The amount of tax-exempt interest is a factor in other tax calculations. It is relevant for calculations relating to Social Security taxable benefits and the earned income credit.
U.S. tax law does not afford tax-exempt interest for all bonds issued by a state or local government. For example, the law excludes certain private activity bonds even though such devices are debt obligations of the state or local government. U.S. tax law excludes certain types of obligations based on certain tax rules. This means investors must pay tax on the interest that these devices generate. State and local governments generally authorize private activity bonds to generate revenue for activities that are non-governmental.
The laws concerning tax-exempt interest on government-issued bonds are extremely complex. It is necessary to consult with a tax professional to ensure that the IRS will recognize the tax-exempt status of a particular type of bond. Furthermore, an investment expert can advise an investor on whether investing in a tax-exempt bond is suitable for the investor based on the unique circumstances of a specific investor.