New laws make choosing bonds more difficult - column

Healthcare Financial Management, April, 1989 by William G. Kistner

New laws make choosing bonds more difficult

Recent tax law changes and broad economic pressures on interest rates have complicated the decision of where to invest money.

Bonds, bond funds, and other fixed-income investments have long been popular because of their relatively low risk and guaranteed return. Of course, municipal bonds had an additional selling point--the accrual of income free from Federal taxes.

Although the Tax Reform Act of 1986 kept municipal and certain "private activity" bonds nontaxable, other changes brought by the 1986 Act and subsequent tax laws such as the alternative minimum tax (AMT), passive loss rules, and investment interest limitations have added a new dimension to the investment decision process.

Coupled with these tax law changes are such economic forces as an increase in demand for municipal bonds by investors looking for those last few tax breaks, a widespread fear of the stock market since October 1987, an upheaval in the credit markets triggered by the Federal budget deficit, and a change in presidential administrations. These factors make it more difficult to decide whether to buy taxable or tax-exempt bonds.

Prior to the Tax Reform Act of 1986, the decision on taxable versus tax-exempt bonds hinged on one fairly straightforward calculation: a taxpayer's marginal tax bracket, or the rate at which a taxpayer's last dollar of income was taxed. At the higher brackets, such as the pre-1986 50 percent top-end tax rate, many taxpayers were better off buying municipal bonds because the after-tax return on taxable bonds was less than that of lower interest yielding municipals.

Generally, a taxable bond should be selected over a tax-exempt municipal bond, assuming equal risk, only if the taxable bond's interest earned will compensate for the additional tax liability arising from the income on the bond.

Although the marginal tax bracket should still be considered, the drop in tax rates and the eventual narrowing of tax brackets to two, 15 percent and 28 percent for tax year 1989, has lessened the strength of this test. Other factors must now also be considered.

ALTERNATIVE MINIMUM TAX. You may or may not be subject to the AMT for bond investments depending on your other individual taxes. The 1986 Act changed the AMT calculations with respect to municipal bonds.

Tax-exempt bonds issued prior to Aug. 8, 1986, are generally exempt from all Federal taxation. Post-Aug. 8, 1986, bonds fall into one of three categories: fully tax-exempt municipal bonds, fully taxable private activity bonds, and tax-exempt private activity bonds subject to the AMT. The interest on the last category is treated as a tax preference item in calculating any AMT liability.

If you are subject to the AMT based on permanent preference items such as interest on private activity bonds, you are not allowed the minimum tax credit (MTC) in future years. Therefore, you may be better off buying higher-yielding taxable bonds.

If you are entitled to the MTC, analyze your marginal tax bracket. The alternative minimum tax rules and computation are complex. If you are potentially subject to the AMT, you may need to consult your tax adviser to maximize your bond investments.

PASSIVE ACTIVITY RULES. Under current law, some taxpayers are allowed to offset their regular income with losses of up to $25,000 from rental real estate activities. If taxable interest causes the taxpayer to exceed an adjusted gross income of $100,000, the $25,000 rental loss allowance begins to phase out. In that case, municipals are favorable.

The investment interest deduction is limited to your investment interest. Purchasing taxable bonds instead of tax-exempt bonds allows you to deduct more investment interest expense.

STATE TAXES. Most states tax interest earned on municipal bonds, except for the interest earned on bonds from that state or municipalities within that state. Some states tax all municipal interest, no matter what the source is, while others exempt all municipals from state taxation. Your marginal tax bracket analysis should include any applicable state tax rates as well.

Given these tax considerations and the current economy, the investment appeal of tax-exempt bonds may decline. Interest rates on U.S. Treasury bills and notes, which are fully taxable at the Federal level and generally tax-exempt by most states, are at a three-year high. For most investors, a combination of short-term T-bills and longer-term municipals, rates on which are relatively high, appears advantageous considering both tax and economic factors. Base your personal investment decision on your individual Federal and state tax situations and your feelings about risk and the future of interest rates.