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Question

Difficulty: EasyGovernment, Municipal, and Corporate Bonds

An investor who resides in New York purchases a municipal bond issued by the City of Los Angeles, California. How is the interest income from this municipal bond treated for income tax purposes?

  1. Exempt from federal income tax, but subject to state income tax.Answer
  2. B
    Exempt from both federal and state income taxes.
  3. C
    Subject to federal income tax, but exempt from state income tax.
  4. D
    Subject to both federal and state income taxes.

Answer

Interest income from an out-of-state municipal bond is exempt from federal income tax, but subject to state income tax.
Interest generated by municipal bonds is exempt from federal income taxation. However, state tax exemption generally applies only if the bondholder resides in the state where the bond was issued. Because a New York resident purchased a California municipal bond, the interest is exempt from federal income tax but fully taxable at the state level in New York.

Step-by-Step Solution

1
Determine federal tax status of municipal bond interest
Interest from all U.S. municipal bonds is exempt from federal income tax.
Federal law exempts state and local government municipal bond interest from federal income taxation.
2
Determine state tax status for an out-of-state resident investor
Interest from an out-of-state municipal bond is subject to the investor's home state income tax.
States generally grant state tax exemption only to municipal bonds issued by entities within that specific state.

Key Concept

Taxability of Out-of-State Municipal Bonds
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Topics

Government, Municipal, and Corporate Bonds

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