Alternative Minimum Tax Planning Ideas...investment - Private Activity Bonds

Municipal bonds, or "muni bonds" as they are commonly referred to

, offer favorable tax treatment in that the interest earned on them is not subject to tax. This tax-free yield can make them an attractive investment. If an investor is not careful, however, the AMT can apply to make certain muni bonds fully taxable. Unfortunately, many taxpayers discover this only after making the investment.

The general exemption from tax on muni bonds applies only for purposes of the Regular Tax. For purposes of the Alternative Minimum Tax, municipal bonds are divided into two categories those used solely for public purposes, and those used to support private activities. The latter are called "private activity bonds."

There are a number of different types of private activity bonds. Here are the descriptions found on the web site of the Municipal Securities Rulemaking Board (MSRB) - the organization that regulates brokers who deal in municipal securities:

Exempt facility bonds Private activity bonds issued to finance various types of facilities owned or used by private entities, including airports, docks and certain other transportation-related facilities; water, sewer and certain other local utility facilities; solid and hazardous waste disposal facilities; certain residential rental projects, including multi-family housing revenue bonds), and certain other types of facilities. Enterprise zone bonds are also considered exempt facility bonds.

Qualified mortgage bonds Private activity bonds issued to fund mortgage loans to finance owner-occupied residential property.

Qualified redevelopment bonds Private activity bonds issued to finance certain acquisition, clearance, rehabilitation and relocation activities for redevelopment purposes by a governmental entity in designated blighted areas.

Qualified small issue bonds Private activity bonds issued to finance manufacturing facilities in an amount up to $1 million, or higher in certain situations.

Qualified student loan bonds Private activity bonds issued to finance student loans for attendance at higher education institutions.

Qualified veterans mortgage bonds Private activity bonds issued to fund mortgage loans to finance owner-occupied residential property for veterans.

The main problem with private activity bonds is that the yield the taxpayer earns can be significantly less that what he anticipated at the time he made the investment. For example, assume a taxpayer buys a muni bond paying 4% interest. For a tax-free yield this is a pretty good return. Suppose, however, that this is a private activity bond, and that the taxpayer discovers he is stuck in the AMT. In this case the yield is something less than 3% (4% minus the AMT in the 28% bracket makes the actual yield only 2.88%). Perhaps as an investment this yield isn't so attractive any more.

The key, as with all planning, simply is to do a little work in advance. The prospectus on any individual bond has to state if it is a private activity bond. For a muni bond mutual fund, the prospectus would be required to tell the investor if investing in private activity bonds is contemplated by the fund.

The AMT is a yield-killer. A little time spent reading or at least inquiring can go a long way towards protecting that precious yield!

by: George Bauernfeind

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