Munis: Kentucky vs Davis

The Supreme Court has finally agreed to hear the Kentucky vs Davis case which challenges the ability of a State to tax out-of-state muni bonds while giving preference to in-state securities which are not taxed. This case will be heard sometime after the next term begins on October 1st. We are still expecting this case to maintain the current tax system where 40 different states give preference to their own in-state securities. For further information please check our post on April 30 regarding the Supreme Court ruling against the trash haulers.

Muni Bonds: The Kentucky Case

Waste Haulers and the Dormant Commerce Clause

An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas.

Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds.

We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, Waste Haulers and the Dormant Commerce Clause An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas. Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds. We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, it seems likely the current system of taxing out-of-state munis and giving preference to in-state bonds will survive this challenge in Kentucky.

Bonds: Harvesting Losses

There are times when it can be beneficial to realize a loss for tax purposes. Losses can be used to help offset up to $3,000 of current income a year, and capital gains from other investments. They can also be "banked" or carried forward to another year if they can't be used in an existing tax year.

The value of these losses depends upon the taxpayer's marginal tax rate and the capital gains tax rate. The first $3,000 of losses may be used to offset ordinary income. Let's say the investor is in the 35% tax bracket. The value to him/her of this loss is: $3,000*.35%=$1,050. If the size of the loss is greater than $3,000, then the remaining loss can be used to offset capital gains. For example: if the loss is $8,000, there is $5,000 of losses remaining after using the first $3,000 against ordinary income . The value of using these losses to offset capital gains is $5,000*.15= $750. We use .15% as the capital gains tax rate. This rate is scheduled to expire in 2010 and return to the .25% previous rate. The total losses harvested in this example is $1,800 ($1,050 + $750). The higher the tax rate, the more value there is in the loss.

When realizing losses for tax purposes, it is important to remember the Wash Sale Rule. This rule states that when you take a loss on a security, you may not re-purchase the same security for 30 days in order to use the loss on your return. This rule is meant to discourage investors from selling a security and immediately buying it back. If you own stock in Microsoft and realize a loss, you can't buy back MSFT for 30 days and use the loss. What works best in tax loss selling is finding a security that is a good substitute for the security you are selling. Muni bonds are the ideal securities for tax swapping. For example, if you own City of Chandler, AZ 5% coupons due 1/1/2013, you could swap these for City of Scottsdale, AZ 5% coupons due 1/1/2013 in a legalized way around the wash sale rule.

The challenge in doing these types of trades is having low transaction costs. The typical retail client is locked into a buy and hold strategy because their transaction costs are too high. For example, it would not make sense to do the swap above if your cost of doing the trade is greater than the tax savings you generate. The typical bid/ask spread for a retail client is over 2%. If the investor has a $5,000 loss, it is worth $750 to him. If it costs him $2,000 to do the trade, then his position will be impaired $1,250 by doing the trade ($750 - $2,000). Thus, he is locked into a buy and hold strategy. If, however, your transaction costs are $0, then you can save $750 in taxes by doing the trade.

There is significant benefit for investors in knowing what their transaction costs are, and in finding ways to reduce them. The lower the transaction costs, the more beneficial tax loss harvesting becomes. This will result in higher portfolio returns both before and after tax.

Taxes: The Battle Over AMT

It is estimated that the Alternative Minimum Tax, if left unchanged, will raise about $50 billion this year for the Federal Government. This is a tax implemented by Congress several years ago to make sure wealthy individuals pay their "fair share" of taxes. This tax was not indexed to inflation and is now affecting many members of the not-so-wealthy middle class. There is considerable ongoing debate about what to do about the AMT in Congress, because it is not fair to leave it as it is. The Republicans would like to either repeal the tax or mend it for another year. The Democrats would like to change the tax so that more of the tax is paid by the wealthy and eliminate the Republican tax cuts from 2001 and 2003,which are set to expire in 2010, as a way to pay for the AMT fix.

Congress has consistently over-estimated it's ability to implement a "fair" tax code, and under-estimated the impact on the American people and our economy of constantly changing the code. The Alternative Minimum Tax is a good example of why it is time for a change in how Congress views taxes. We believe the Government has proven it's inability to create a fair tax system. Instead, they should simplify the code and beef up the enforcement division of the IRS. A simpler tax code would help to narrow the tax gap and the AMT could be eliminated without having to fret over the $50 billion in lost revenues it generates this year.

The Wall Street Journal on March 21,2007 had an article discussing the current Tax Gap because of under-reporting of taxes due. This amount is estimated to be $345 billion. The table/chart below shows the composition of the tax gap and the decline in the number of IRS enforcement agents over the last 10 years.



We believe much of this under-reported income is caused by the complexity of the existing tax code. The first step for Congress should be to simplify the code. The current system of graduated brackets, deductions, and exceptions creates incentives for taxpayers to find ways around paying taxes. The more complicated we make our tax system, the more money falls through the cracks. For example, a flat tax with no deductions would be simple and easy to implement and enforce. Some may say that a flat tax would be unfair. Our answer to that is: "How fair is it that we are paying taxes and there are $345 billion of taxes owed that others aren't paying?"

Taxes: Tax Freedom Day

This is the time of year to be thinking about taxes. We believe that each investor has a unique tax situation, and we are concerned about their marginal tax rates in the selection process of individual securities for their fixed income portfolios. We believe the last elections were a watershed event for tax rates, and that marginal tax rates are likely to rise in the future. This will probably make tax-free securities more attractive compared to taxable securities for some investors in the future.

The Tax Foundation publishes some interesting data about taxes and their impact on our daily lives. As a way to show how much of our income we pay in taxes, they created Tax Freedom Day. If we assume that we pay our taxes before we can use the rest of our earnings, this would be the day that we are "free" of paying taxes and the rest of our earnings go to us. The later in the year we reach Tax Freedom Day, the more time we are working for the government and the less time we are working for ourselves. This is a valuable way of measuring the bite that taxes are taking from our paychecks, and allows for comparisons over time. The chart below shows Tax Freedom Day for the last 27 years. The axis on the left shows the number of days it takes to get to Tax Freedom Day and the graph shows the results over time. We reached a high of about 123 days in 2000 and now are working about 116 days for the government.


How much do you pay in Federal taxes and how much do you pay in State & Local taxes? The chart below begins in 1900 and shows the number of days over time you work for each of these.

If you are wondering how many days you work to pay for your taxes compared to how many days you work to pay for housing, the chart below gives you the answer. We work 77 days to pay Federal taxes, 39 days to pay State & Local taxes, and 62 days to pay for housing and household operation. Federal taxes is the largest category.

You may also be wondering how the different taxes break down by type of tax. Below is a chart that shows the types of taxes. For example, out of the 77 days you work to pay for Federal taxes, 30 days go to pay for social programs such as Social Security and Medicare.

The amount of time you spend working for the government depends upon where you live. The chart below shows you will be working harder for the government if you live in New York than if you live in Montana. The states in dark blue mean that Tax Freedom Day occurs later in the year than the light blue and white states. We would encourage you to visit the website for the Tax Foundation for further information. We have provided a link to their website on our blog for your convenience.

Bonds: Tax-Free, Taxable, Or Both?

The Problem
Perhaps one of the most confusing decisions facing an investment advisor today is whether some clients with taxable accounts should purchase taxable or tax exempt bonds for their high quality bond portfolios. This decision is straightforward for clients that earn large amounts of taxable income (over $326,450) which puts them into the maximum tax bracket of 35%. Municipal bonds are clearly the most appropriate investment for them. However, this decision is much more difficult when the client has invest able funds of $1-$3 million and very little (if any) taxable income coming from other sources. In these cases, the investment chosen “drives” the amount of taxable income that the client earns as well as their marginal tax bracket. For example, assume the client has an investment portfolio of $3.5 million and taxable income of $100,000. The portion the advisor allocates to the high quality bond portfolio is $800,000. Most advisors struggle with the appropriate mix of bonds for these clients. “Should I buy taxable bonds, tax exempt bonds, or perhaps a mix of both?” What is the proper way to make this investment decision?

Interest rates are constantly changing and so is the relationship between taxable and tax exempt securities along the yield curve. The changes in both interest rates and the inter-market relationships are important factors in the decision making process. The combination of changing rate levels as well as changing income levels makes this decision appear to be challenging.

Marginal Tax Rates
Tax-managing bond portfolios begins with a careful examination of the client’s marginal tax rate. This rate will determine the suitability of different fixed income securities for each client. This rate is dependent on the type of filing of the taxpayer and the level of income the client earns after all deductions are subtracted.

Filing Status
A single person has a higher marginal tax rate for the same level of income than a married person filing a joint return.

Income
We are referring to taxable income after all allowable deductions have been taken. This is the number from line 43 of the 1040 return. This income number can be used to determine the client’s marginal tax rate. Securities available in the tax-exempt and taxable markets can then be compared on an after-tax basis. These after-tax rates are then compared by maturity to determine what works best for each client. These rates and relationships are changing on a daily basis. Frequently, the portfolio is optimized by using a combination of longer maturity munis and shorter maturity agencies.

More emphasis needs to be placed on determining each client’s marginal tax rate. This may be difficult because of the many variables involved which causes this rate to be a “moving target.” Superior bond portfolio performance depends on improving this process.

Ratio of Munis to Agencies
The muni yield curve can be compared to the taxable yield curve to determine the percentage that each of the maturities trade compared to taxables. Munis traditionally trade at lower ratios in the shorter maturities and higher ratios in the longer maturities. The chart below shows the historical ratio of a 10 year muni compared to a 10 year U.S. Treasury bond. The average for the last 3 years is 86%. Recently, this ratio has fallen to 82.4%. This has an impact on after-tax yields and means that an investor needs to be in a higher tax bracket (86%-82.4%=3.6%) for munis to be attractive. This change is about equal to the amount of state tax a married person filing jointly would pay in the state of Arizona.

One way of looking at the current value of a muni compared to a taxable security is to take the ratio (munis/taxable's) and subtract it from 1. We can do this for all maturities along the curve and we get a chart like the one titled Muni/Agency Ratio which shows tax efficiency below. If we compare this graph to the client’s marginal tax rate (the blue line), we can see that munis will be attractive to the investor whenever this ratio is lower than the marginal tax rate. Munis are only attractive to this investor when he begins to look at maturities in the 5 year part of the curve. Munis would be attractive to all investors in the 35% bracket or higher. The advantage of this approach is that the tax-free/taxable ratio is constantly changing. We can monitor the ratios up and down the yield curve and compare them to the client’s marginal tax rate to determine which fixed income security is best suited for his/her needs.
Conclusion

Each individual investor has a unique tax situation. Returns may be optimized when more attention is paid to the marginal tax rate of each client. This requires familiarity with the client's tax return, and an understanding of the client's tax situation.

Muni Bonds: Tax Reporting For Premium Bonds

How To Determine Reportable Tax-Free Income For The Investor

The amount of reportable tax-free income that an investor receives from their municipal bonds may be dependent on the investor’s cost basis in the individual security and the coupon structure of the bond. Many investors mistakenly believe that the coupon received from a muni bond represents their reportable tax-free income to be filed on line 8b of their 1040 tax form. However, this is only the case for all muni bonds purchased at par.

An individual muni bond may be purchased at par ($100), a premium (greater than $100), or at a discount (less than $100). Each of these coupon structures may be treated differently for tax purposes.

Par Bonds

Par bonds are the simplest for tax reporting. All of the coupon income earned during a tax year is reported as tax-exempt income. No adjustments need to be made. This amount is entered on form 1040 as tax-free income on line 8b.

Premium Bonds

Each individual security has an original cost basis. It is important to identify and remember the original purchase yield for a bond bought at a premium. This yield will be less than the coupon of the bond and needs to be calculated to at least 2 decimal places. The premium paid for the bond is amortized down each year, which reduces the basis for the bond by the amount of the amortization. This amortization is deducted from the coupon income earned and the difference is tax-exempt income earned and is entered on the 1040 line 8b. The new amortized cost basis is also used for determining capital gains and losses if the security is sold.

The logic for amortization of premium bonds:

When a bond is purchased at a premium, the coupon rate must be greater than the yield of the bond. Therefore, only part of the money the investor receives is tax-free income, and the rest is considered to be a return of his principal in the form of a coupon payment.

Amortization Calculation

Most premium bonds are amortized using a constant yield method. There are some exceptions for bonds issued before September 27, 1985. We will not discuss these exceptions in this article.

IRS Publication 550 shows how to calculate the amortization of the bond premium.

The amount of the amortization is subtracted from the coupon income which was received during the tax period. The remainder is the amount of tax-exempt interest that is reported on the Federal 1040 Return line 8b.

Example

Purchase on 1/1/05 $100,000 Salt River Project, AZ 5% coupon bonds that mature on 1/1/09 at a yield of 3.00% for a price of $107.485

Let’s calculate the tax-free interest and amortization for the first 1 year period ending 12/31/05.

The bonds mature at par so the total premium paid is $7,485 ($107,485-$100,000. To determine the bond premium amortization we multiply the acquisition cost times the purchase yield ($107,485)*(.0300) to get $3,225. We then subtract this amount from $5,000 which is the amount of coupon earned for 1 year. The result is $1,775. This is our amortization for the year.

For tax reporting purposes we would take the interest earned for the period less the amortization and report this amount as tax-exempt interest earned on line 8b of our 1040 form. This amount would be $5,000-$1,775=$3,225 for tax-exempt interest earned.
Our new cost basis would be $107,485-$1,775=$105,710.
This process would be repeated every period until the bonds mature at 100 on 1/1/09.

IRS Publication 550 (page 35)

Investment Income and Expenses

Bond Premium Amortization

If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year.

How To Figure Amortization

For bonds issued after September 27,1985, you must amortize bond premium using a constant yield method on the basis of the bond’s yield to maturity, determined by using the bond’s basis and compounding at the close of each accrual period.

Step 1:determine your yield. Your yield is the discount rate that , when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage.
Step 2: determine the accrual periods. You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.
Step 3: determine the bond premium for the accrual period. To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result from the qualified stated interest for the period.
Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.

The Problem: Overpaying State Income Tax

Most investors receive a year-end statement from their broker which shows how much interest was earned during the last year. The investor gives this statement to his CPA and the amount is entered on line 8b as tax-exempt interest. This can, under certain circumstances, lead to the overpayment of state income taxes. If the investor owns premium coupon bonds that are not state tax-exempt, and he has not amortized his premium, he will be overpaying his state income tax.

An Example

The investor is an Arizona resident. He owns a municipal bond portfolio that consists primarily of bonds that are premium coupon bonds. Let’s assume that 50% of these bonds are issued by municipalities in the State of Arizona, and that the other 50% are issued by municipalities that are in other states. The interest on the Arizona bonds is exempt from state taxes. The interest on the out of state securities is subject to the state tax in Arizona. Let’s also assume that the investor owns 5% coupons that he/she purchased at an average yield of 3.00%. If the investor does not amortize his coupons he will be paying interest as if he had earned a yield of 5.00%. However, if these premiums are amortized, he will pay tax on 3.00% interest. The table below shows that the investor in this case has reduced his overall yield by .05% by not properly amortizing the premiums of the out-of-state securities.

Calculating Gains/Losses

To continue with our example, let’s assume that at the end of the first year interest rates have risen 1.00% to 4.00%. We decide to take a tax loss and sell the bonds at 4.00%. What is the capital loss that we report on Form 1040 and on Schedule D?

First, we would calculate the dollar price we receive from our sale at 4.00%. The dollar price is $102.80. Thus, we receive $102,800 from our sale. We subtract this amount from our new basis which we calculated above ($105,710)-($102,800) and we get a loss of ($2,910). This is the amount we report on Form 1040 line 13 and on Schedule D.


Conclusion

It is important to remember to amortize the premiums on all holdings of municipal bonds in order to report the proper amount of tax-free interest earned, and to be able to have a proper cost-basis to calculate gains/losses on any sales of the securities. Why not then include this information as part of the year-end report for the client by including an Income Report, and Realized Gains/Losses Report that include these calculations? This will be most helpful for the client’s CPA when he does the tax return next year!