What Does Tax-Exempt Revenue Bonds Mean?
Municipal governments issue revenue bonds to raise capital for cities, counties and states across the U.S. The bonds are used to fund particular projects, and interest payments are made to the bond holders. The federal government does not assess tax on income from most municipal revenue bonds. Therefore, these bonds are referred to as tax-exempt revenue bonds.
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How Revenue Bonds Work
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Local governments use revenue bonds to cover the upfront costs of revenue-generating projects, such as toll roads or housing programs. Money raised from the bonds pays for the construction of the toll road or the building of government subsidized homes. The bond holders receive monthly, quarterly or annual interest payments that are funded with toll road fees or mortgage payments received from people who buy the government subsidized homes. Bond terms normally last between six months and 30 years, and bond holders get their principal back at the end of the bond term.
State Taxes
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People who buy bonds issued by municipal governments in the state in which they reside do not have to pay income tax on the bond's interest. This provision makes bonds especially attractive for people who live in states with high income tax levels. Investors who live in states such as Florida that have no state income tax can buy tax-exempt revenue bonds from anywhere in the U.S. and not have to pay income tax at the state or federal level.
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Bond Risks
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When a project tied to a revenue bond does not generate sufficient income to cover bond payments, the bond holder may experience irregular interest payments. In a worst case scenario, if a project tied to a revenue bond goes bankrupt, the bond holders not only lose the interest they are due but also stand to lose their principal. Municipalities also issue general obligation bonds backed by the municipal government and taxes. Revenue bonds are not obligations of the government and are only backed by the project the bonds were used to fund.
Other Considerations
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Interest payments from revenue bonds normally are tax-exempt, but some municipalities occasionally issue bonds with higher interest rates that are not tax-exempt. Additionally, people who sell the bonds and receive more for the bonds than the original purchase price may have to pay capital gains tax, because only interest payments are tax-exempt. Some people in high tax brackets are subject to the federal Alternative Minimum Tax (AMT). This tax requires high earners to pay tax regardless of the origin of their income, and some municipal bond interest payments create an AMT burden for high earners.
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