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When non-taxable muni bond interest is taxable – how to avoid a big tax bill

 

The advantages of tax-free interest. Many of you invest in muni bonds as a tax planning strategy to minimize taxes. When you analyze this investment, you probably compute the interest, tax effect this income, and then compare it to a taxable investment with a similar risk profile.

Most individuals are cash-basis taxpayers, reporting income on their tax returns as it is received in cash. They go through the years reporting the income from their interest checks on their tax returns, paying tax on any taxable interest income and not paying tax on interest received on their muni bonds.

It isn’t that simple. Because of market fluctuations, most bonds are purchased at a premium or discount compared to the par value of the bond. This adjusts the stated interest rate to the market rate at the time of purchase. What happens to the income from the discount, the difference between the par value of a bond, say $1,000 and the purchase price, say $936, or a $64 discount? Let’s assume that the bond is redeemed by the municipality. This happens if the municipality can get better terms or the bond reaches maturity. So they redeem the bond for $1,000 for which you paid $936. The $64 becomes reportable on the tax return when it is sold or redeemed by the issuer.

Is the discount taxable? If you bought the bond at the time the debt was issued, the discount becomes an “original issue discount” and is non-taxable interest income. If you bought it one day after the date of issue, the discount becomes taxable as ordinary income. It doesn’t make much sense but that is the treatment.

Now comes the tricky part. If you bought the bond the day after the issue or some later date at a discount, you must keep track of what you paid for it (basis). Why? Because you can deduct the basis from the redemption price and from your taxable interest income. For instance, if a municipality issued the $1,000 bond at an original issue discount for $920 and you bought it later for $970, when they redeem the bond, they report $80 as taxable interest income to the IRS which shows up on a 1099 from your broker. Your broker will generally keep track of you basis for you and show it on your 1099 as a reduction of the gain and a reduction of the taxable interest income. However, if you have switched brokers since you purchased the bond, you may not have made the selling broker aware of your basis of $970. The broker will send you a 1099 showing a $920 capital gain and $80 ordinary income. If you have switched brokers and sold a muni bond or had a bond redeemed, you need to be aware of this possible over reporting of interest income.

This could cost you money. The trouble is, if they didn’t know your basis because the transaction took place with a prior broker, most brokers 1099s don’t make it obvious that the taxable interest income can be offset by some of the basis. There is nothing to alert your tax return preparer about this situation on the 1099 as currently formatted. Not knowing this, the taxpayer may end up paying tax on the entire $80 rather than offsetting it with basis. That will be an unpleasant surprise, especially for those taxpayers who are heavily invested in muni bonds and expecting non-taxable interest.

This may go undetected because of the format of the 1099s. When switching brokers, make certain that they get your basis from previous broker’s transactions into their records. If taxable interest looks too high, get your tax return preparer alerted to look into the basis information. Otherwise, you may unwittingly pay tax on income that should have been reduced by basis.

 

 

In an interesting recent article “Your Clients and Their Children: The Problems With Joint Bank Accounts” by Andrew Rice there is a recurring question that pops up during elder and estate planning: should I add my child to my bank account? When a senior begins to lose their ability to manage their finances like paying the bills, these accounts can seem like a viable option. However, the article outlines five risks that both the parent and child should consider:

1. Withdrawal Rights: Each person on a joint bank account is legally considered a full owner when it comes to withdrawing money from the account. This means the child can fully deplete the bank account at any point in time should they choose to do so.

2. Creditor Issues: The bank account becomes an asset for both parties on the account. If the child should get into financial difficulties and has a creditor with a judgment against them, the creditor could legally garnish the entire bank account regardless of the parent’s involvement.

3. Divorce and Legal Issues: As noted above, the account becomes an asset of the child; therefore, it is also subject to potential claims by a divorcing spouse of the child or a lawsuit/judgment against the child.

4. Bypassing the Will: Joint bank accounts bypass the will of a deceased person, and the will does not impact the money in a joint bank account. This could create a dispute among other beneficiaries as the child on the joint account would get the entire proceeds from the account after the parent’s death, whether or not other assets stipulated in the will were to be divided equally.

5. Gift Taxes: adding a child to a parent’s bank account is indirectly making a gift, which may or may not be subject to gift tax for the parents.

One alternative to a joint bank account is a type of account commonly referred to as a “convenience account.” Certain states allow these accounts, which let others have access to the account and make deposits and withdrawals. The account legally obliges the helper to act as the elder’s agent, and any money in the account becomes part of the elder’s estate, to be divided in accordance with a will or the law. If there is a need for someone to provide this type of assistance to an elderly person and the children are not a viable option, your trusted accountant can always provide this service as well.

 

 

The Government Finance Officers Association held its annual conference in San Francisco this past week. Edwin Lee, the mayor of San Francisco opened the conference speaking about transparency in government including sharing data with innovative businesses that develop mobile applications that can be utilized by everyone.

In San Francisco looks to tap into the open date economy, Alex Howard identifies San Francisco as one of the first cities to launch an open data platform. One app cited is the Rec & Park app, built by San Francisco-based startup Appallicious, which enables citizens to find trails, dog parks, playgrounds and other recreational resources on a mobile device. At the conference the Mayor talked about a mobile app to identify parking space availability. How great is that? When you are looking to find a parking place, no more driving around block after block.  In all honest, I can’t claim to be a big app user but the thought of utilizing government data to make our lives run more smoothly is very attractive to me.

California Lt. Governor, Gavin Newsom, (also a former Mayor of San Francisco) delivered the keynote address on Tuesday. Much of his speech revolved around his new book, Citizenville,  which explores the need for citizens to become more involved in their government and how technology can help facilitate this endeavor.

As you might suspect, Citizenville is a play on Farmville, the popular game in which players spend hours maintaining their virtual farms. Newsom’s Citizenville’s concept is to combine the fun of a game with the social good of solving problems. A way to engage from the bottom up instead of the top down bureaucracy.

Newsom believes in complete transparency for every agency with exceptions only to protect public safety or personal privacy. Opening up the data and making it available to ordinary people. Encouraging people and businesses to use that data in a useful innovative manner. Engaging people on their terms with new technologies and social media.

Innovation should drive change and provide solutions. Who wants to play?

 





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