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Difficulty: EasyGovernment, Municipal, and Corporate Bonds

An investor residing in California purchases a newly issued U.S. Treasury note. Which statement correctly describes the taxation of the interest income earned from this investment?

  1. The interest income is subject to federal income tax, but exempt from state and local income taxes.Answer
  2. B
    The interest income is exempt from federal income tax, but subject to state and local income taxes.
  3. C
    The interest income is fully exempt from federal, state, and local income taxes.
  4. D
    The interest income is subject to both federal and state income taxes.

Answer

Interest income from U.S. Treasury securities is subject to federal income tax, but exempt from state and local income taxes.
Interest income generated by U.S. Treasury securities (Bills, Notes, and Bonds) is always subject to federal income tax, but is exempt from state and local income taxes regardless of which state the investor resides in.

Step-by-Step Solution

1
Identify the issuer of the bond.
The bond is issued by the U.S. Federal Government (U.S. Treasury note).
Tax rules differ based on whether a bond is issued by a corporation, municipality, or the federal government.
2
Apply federal debt security taxation rules.
Interest is taxable at the federal level, but exempt at state and local levels.
Under federal law, state and local authorities are prohibited from taxing interest paid on direct obligations of the U.S. government.

Key Concept

Taxation of U.S. Government Debt Securities
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Topics

Government, Municipal, and Corporate Bonds

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