Taxation of Muni Bonds from out-of-state: Individual vs. Fund

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
terrapin
Posts: 13
Joined: Tue Oct 02, 2007 11:17 am

Taxation of Muni Bonds from out-of-state: Individual vs. Fund

Post by terrapin » Mon Oct 30, 2017 6:42 pm

I have a portfolio of individual munis (as well as some money in a Vanguard muni fund). I live in California and so I hold a number of CA munis, but also hold some from out of state. Most of my out-of-state munis were purchased at a premium. Come tax time, I amortize the premium on the out-of-state bonds and subtract that from the coupon payments in order to calculate my income that is subject to state taxes.

I do have a question that I'll get to soon..

I recently dug up a thread from a few years ago, discussing pros/cons of individual bonds vs. a fund, where Larry Swedroe mentions that one benefit of owning individual bonds is that you can amortize the premium of out-of-state bonds and subtract that income from your state taxes. Which is exactly what I do per above. Swedroe says that bond funds that contain out-of-state bonds can't do this, and so are less favorable than individual bonds (for that and many other reasons in his opinion). In sum, an identical out-of-state premium bond held individually vs. in a fund will have different tax consequences.

My question is: is this really a disadvantage that funds have, and if so, exactly how? If a fund holds premium bonds, it is true that it's distribution will be higher than it's SEC yield, and you aren't able to to amortize the premium to account for that. But doesn't the fact that the NAV of the fund will decrease over time, as the premium bonds drop in value, make up for that? It seems that with individual bonds, you get to reduce your state income taxes, but with a fund, you will end up with a capital loss (albeit unrealized until you sell) that can be used to reduce federal and state income taxes.

I realize now that if what I say is true, that owning premium bonds in an in-state fund is beneficial as you would be able to realize a capital loss from the NAV dropping over time as the premium bonds reach maturity. But I'm sure it's not that simple. Can anybody shed more light on this?

Thanks!

stlutz
Posts: 4011
Joined: Fri Jan 02, 2009 1:08 am

Re: Taxation of Muni Bonds from out-of-state: Individual vs. Fund

Post by stlutz » Tue Oct 31, 2017 12:10 am

There is the question of how the fund accounts for it and then the question of how this plays out when you buy the fund.

Suppose that on 1/3/2017 the stlutz Intermediate Term Tax Exempt fund buys a with a coupon of 4% maturing in 2027 at a price of 110. That bond has a yield of 2.84%. The fund will distribute income based on the yield to maturity when it acquired the bond. So, it will amortize the premium. So, it will pay out $2.84 every year, not $4.00.

On 1/3/2018, you buy into my fund. Suppose by that time that interest rates had dropped by 1%. So, the YTM of the bond is now 1.84% and it trades at 117.84.

The fund will continue to make distributions of $2.84 every year. Had you bought this bond yourself on 1/3/2018, you would pay CA tax based $1.84 (i.e amortizing based on when you bought the bond).

So, the fund does in factor amortize the premium. However, it amortizes based on when it acquired the bond, not when you invested in the fund.

Buying the bonds individually would work in your favor if rates decline between the time the fund buys a bond and when you did. It works against you if rates go up.

Hopefully I'm making sense here...

terrapin
Posts: 13
Joined: Tue Oct 02, 2007 11:17 am

Re: Taxation of Muni Bonds from out-of-state: Individual vs. Fund

Post by terrapin » Tue Oct 31, 2017 8:50 am

That makes perfect sense. Thanks for the reply! I didn't realize that funds don't distribute the entire coupon when they purchase premium bonds. I didn't know that, and now I feel pretty ignorant. All that matters w/respect to my question is movement of interest rates; whether a bond is premium or not is irrelevant.

Thanks again.

Post Reply