Those "Tax-Free" Munis: Look Again

If you've owned $100,000 of Greater Peoria Airport Authority bonds since they were issued in 1994, you could look forward to $5,600 in tax-free interest every year. If, after you calculate your 2003 income tax, you find yourself subject to the alternative minimum tax -- well, sorry, you'll give up more than one-quarter of that interest to taxes. "Whatever the taxes, it's more than zero, and more than an investor anticipated," says Michael Decker, senior vice-president of the Bond Market Assn.

Why are these bonds taxed under the AMT? The AMT disallows tax-free interest when the bond is deemed to be financing for a "private activity," not for the public weal. While issued by a public agency, they may actually support a private-sector activity, such as a housing project, hospital, or industrial park. Internal Revenue Service regulations say that if 10% of the proceeds go to a private party and 10% of the repayment comes from one, then the entire bond issue is declared private activity, subject to the AMT. Some 9% of the muni bonds sold since 1991 are AMT bonds. Annual issuance climbed every year through 2002, when it hit $28.4 billion. When the tally is complete, 2003 issuance will likely be down about 20%.

Now, with all the AMT concerns, investors need to reevaluate their tax-exempt holdings, whether in individual bonds or bond funds. For an individual muni bond, check either last year's 1099 or the original registration statement. Both should say if the bond is subject to the AMT.

A mutual-fund prospectus will say whether the fund is allowed to invest in AMT securities. It should also say the amount of bonds it is allowed to purchase, which is usually capped at 20%. Yearend tax reports from fund companies will show what percentage of a fund's income came from private-activity bonds -- what's added back to income for AMT calculations.

If you're clearly in the AMT camp, stick to AMT-free funds. Fidelity Investments, for example, just announced that five of its municipal money-market funds will not invest in AMT securities. One of its funds already is AMT-free. Nuveen, Oppenheimer, PIMCO, Scudder, and T. Rowe Price also offer AMT-free funds. Vanguard says its AMT holdings are below the 20% limit in most funds -- but has not yet decided if it will offer AMT-free alternatives.

For those who aren't AMT payers, these bonds can be a good deal. They yield up to a half percentage point more than non-AMT bonds of similar credit quality. Still, that extra yield won't make up for the tax hit if the AMT finally catches up with you.

By Toddi Gutner

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