Tax-Exempt Bonds

• Tax-exempt bonds may be issued by state governmental agencies and local municipalities to fund projects for the public good. The interest on municipal bonds is free from federal income taxation, similar to the way interest on U.S. bonds are free from state income taxation. Tax-exempt bonds typically offer a lower interest rate than comparably rated corporate bonds. Unlike bonds issued by the U.S. Treasury, which are backed by the full faith and credit of the United States government, municipal bonds involve a level of risk, based on the financial solvency of the issuing governmental agency.
  
  

Market Fluctuation

• Municipal bonds are typically issued in $5,000 increments. They are issued at face value and pay a fixed interest payment twice per year. The issuing organization redeems the bond at face value upon maturity. Once the bond is issued it may be traded in the secondary market where it is subject to market forces that may cause the price of the bond to fluctuate up or down. Bonds are sensitive to changes in the prevailing interest rate, and the price of the underlying bond will typically move in the opposite direction of the prevailing interest rates. If interest rates rise, the price of the bond will decrease, and vice versa. The price of the bond may also be affected by an increase or decrease in the financial stability of the issuing agency.
  
  

Selling A Tax-Exempt Bond

• Investors typically buy and sell tax-exempt bonds in the secondary market through an investments broker. If you sell the bond for more than you paid for it, you will have a capital gain. If you sell the bond for less than you paid for it, you will have a capital loss. The gain or loss from the sale of the bond is a taxable event, whether or not the interest you received from the bond was exempt from taxation.
  
  

Capital Gains

• A municipal bond is a type of security, and gains or losses from the sale of securities are treated as either long-term or short-term capital gains. If you sold the tax-exempt bond for a gain after holding it for longer than one year, the gain is considered to be long-term and is taxed at the lower long-term capital gains rate. If you sold the tax-exempt bond for a gain after holding it for one year or less, the gain is considered to be short-term and is taxed as ordinary income. You must report all capital gains, both long- and short-term, on Schedule D of IRS Form 1040.