Municipal Bonds’ Treatment in Jeopardy With Debt Ceiling: Taxes

A reprieve the $3.7 trillion municipal bond market received in the U.S. budget agreement last week may be only temporary.

The deal extended several types of narrowly focused bond-related activities, such as funding school renovations or paying for construction projects in New York near the area of Sept. 11, 2001, terrorist attacks. It revised the alternative minimum tax, and without that, some types of bonds could have been unattractive to tens of millions of taxpayers. It didn’t eliminate the tax exemption on municipal bond income, an idea contemplated by lawmakers.

The trouble is, the accord leaves Washington lawmakers in search of new revenue to resolve longer-term deficits. That has placed the favorable tax treatment associated with municipal bonds -- enjoyed by taxpayers since the enactment of the Revenue Act of 1913 -- in jeopardy, Bloomberg BNA reported.

While presidential candidates from both parties discussed concepts that would limit tax deductions, exemptions and exclusions -- the idea of capping the amount of income not counted in taxpayers’ gross income was mentioned -- those ideas were absent from the budget deal that averted the more than $600 billion in tax increases and spending cuts that made up the so-called fiscal cliff.

Changing the tax treatment of municipal bonds is still a topic of discussion on Capitol Hill and may catch the attention of lawmakers in the next 60 days because their compromise only put off a series of spending cuts known as sequestration until March. The topic also may be part of discussion on how to fund the government after the March 27 expiration of the resolution paying federal government bills.

Concerned Market

A key feature of those talks is how to devise a longer-term strategy to reduce the federal deficit by utilizing spending cuts and targeting methods of raising additional taxes. Many policy makers have identified the exemption of municipal bond income from tax as a possible revenue raiser, lawyers and accountants told BNA.

“The concern is that although there will presumably be spending reductions, they will also be looking for revenue raisers,” said Edwin G. Oswald, a partner at Orrick Herrington & Sutcliffe LLP. “And I think the municipal market is concerned about their involvement with being a raiser.”

President Barack Obama has proposed capping the deductibility of municipal bonds at a 28 percent rate instead of the current top level, now 39.6 percent.

Tax Overhaul

The 113th Congress may also pursue an overhaul of the tax code, which could also impair municipal issuance.

“There is serious talk on Capitol Hill of undertaking tax reform,” said Michael Decker, managing director of the Securities Industry and Financial Markets Association. “It’s not clear what the schedule for that might be, what the process for undertaking that debate would be on the Hill.”

“But if and when there is a serious attempt to make substantial reforms to the tax code, I think that there’s a risk that the tax exemption could be curtailed or eliminated,” said Decker, the co-head of SIFMA’s municipal securities activities.

The possibility of municipal-bond income losing its exemption from tax is as great as any time since 1986, when major tax reform was ushered into law during the Reagan administration, said George Friedlander, Citigroup Inc. senior municipal strategist.

Municipal bonds losing their tax favored treatment “is a very real threat,” said Mike Nicholas, chief executive officer of the Bond Dealers of America.

Some Good

The law’s revision of the alternative minimum tax means bonds subject to the AMT will now likely be attractive to tens of millions of investors on a permanent basis. Without the change, those investors could suffer adverse tax consequences. Many qualified private activity bonds are subject to the alternative minimum tax.

Other parts of the law may be seen as benefiting municipal and other tax favored bonds. One section extends a housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds.

Another extends the use of qualified zone academy bonds, instruments that may be used to raise money to renovate schools, buy equipment, develop curricula and train school personnel. Those bond proceeds cannot be used to fund new construction.

The law also extends the eligibility to issue New York Liberty Zone bonds, tax-exempt facility bonds. No new issuance was allowed after Jan. 1, 2005, under the program, though legislators have continually extended the expiration date.

Longer Term

“The upshot is that this particular bill is not harmful and I definitely think it has the potential for being beneficial in the short term” to municipal bonds, said Kimberly C. Betterton, a partner at Ballard Spahr LLP.

The longer term is another story. The law delayed until March 1 a list of spending cuts that includes the elimination of a federal subsidy to state and local government issuers of taxable bonds, commonly known as direct payment bonds, in exchange for the subsidy, the amount of which is a percentage of interest payments on the issued bonds.

Action by Congress to eliminate the subsidy may materially disrupt municipal markets and increase tax risks associated with issuing or investing in the bonds, practitioners said.

Reducing or eliminating the federal government payment would disrupt investors’ tax strategies, and the cuts may trigger redemption options for issuers, which may be advantageous for issuers while hurting outcomes for investors.

Just how Congress will deal with direct payment bond subsidies is still unknown. Already, municipal issuers and their advocates have stepped up congressional lobbying efforts. A group known as Municipal Bonds for America, formed Oct. 10, is contacting federal legislators in an effort to preserve the tax favored status of municipal bonds.

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