Capital Gains Tax and Losses of Municipal Bonds

Even though the interest paid on municipal bonds is tax exempt, a holder can recognize capital gains or capital losses that are subject to federal income tax on the sale of such municipal bonds, just as in the case of a taxable bond. The amount of capital gains or capital losses are equal to the difference between

   1. the sale price of the municipal bond and
   2. the holder's tax basis in the municipal bond (the amount the holder paid for the bond originally, including any additions to such basis, such as OID as discussed in the following section).

Thus, if a municipal bonds holder purchased a $5,000 face amount municipal bond for $5,000 and then sold the municipal bond for $5,200, the holder would have a capital gains of $200.

Typically, the purchase and sale price of a municipal bond includes the dealer's markup; however in cases where a commission is charged, it should be taken into account by the holder in computing gain or loss.

There are currently two types of capital gains: long term capital gains and short term capital gains. Long term capital gains require that the municipal bonds be held for more than 12 months before they are sold; short term capital gains are the result of holding a bond for 12 months or less. The maximum tax rate on long term capital gains is 20% and the maximum tax rate on short-term capital gains is 38.6% (which is also the maximum tax rate on ordinary income.) Furthermore, the 20% maximum tax rate on long term capital gains is reduced to 18% in the case of bonds acquired after 2000 that are held for more than five years.

Click here to read more about Capital Gains and Capital Gains Tax

When municipal bonds are sold, an investor may also recognize capital losses if the sale proceeds (adjusted for selling costs) are less than the municipal bonds holder's tax basis. In such a case, capital losses are first applied against capital gains of the same type to reduce such gains. Thus, a long term capital loss will first reduce long term capital gains, and a short term capital loss will first reduce short term capital gains. Any excess long term capital loss is used to offset short term capital gains. Any excess short term capital loss is used to offset long term capital gains. Any capital losses remaining after offsetting all available capital gains can then be used to reduce ordinary income by up to $3,000 per year, with any losses in excess of that amount available to be carried forward indefinitely to reduce capital gains or ordinary income in future years under the same procedures.