Tax-exempt interest is income excluded from tax, created by the Tax Reform Act of 1986 on certain government-issued bonds. State and local governments issue bonds for public improvements, which investors buy as an investment vehicle, earning tax-free interest. Taxpayers must report tax-free interest, but not all bonds are tax-exempt. It is necessary to consult with a tax professional to ensure IRS recognition of tax-exempt status.
Tax-exempt interest is income that the law excludes from tax. All gross income in the US is normally taxable. The definition of gross income is all income that a person earns. This definition includes investment income and all other income, regardless of source. The United States Congress enacted the Tax Reform Act of 1986 to create tax-exempt interest on certain types of government-issued bonds.
State and local governments generally have the authority to issue bonds to generate revenue to pay for public improvements they deem necessary. You can also issue bonds to help finance government operations. Investors buy the bonds as an investment vehicle and earn tax-free interest. Therefore, a bond in this context is an investment device. United States tax law defines a bond as a debt obligation.
A debt obligation is not strictly limited to a bond under United States tax law. A debt obligation means that a person must pay a debt. In the context of tax-exempt interest, a debt obligation includes other types of instruments that oblige the government to pay a debt. This includes finance leases, installment purchase agreements, and any other device that a government issues as a debt obligation. This means that US tax law will treat these other devices as bonds for tax purposes, thus entitleing holders of such instruments to enjoy this type of interest.
United States federal tax law, however, requires taxpayers to report tax-free interest on their tax returns. Reporting interest income does not mean it is suddenly taxable. The Internal Revenue Service (IRS) simply requires taxpayers to report interest. The amount of interest is a factor in other tax calculations. It is relevant for calculations related to taxable Social Security benefits and the earned income credit.
United States tax law does not provide tax-exempt interest for all bonds issued by a state or local government. For example, the law excludes certain private activity bonds even though those devices are state or local government debt obligations. United States tax law excludes certain types of liability based on certain tax rules. This means that investors must pay taxes on the interest these devices generate. State and local governments generally authorize private activity bonds to generate revenue from non-governmental activities.
The laws regarding tax-exempt interest on government-issued bonds are extremely complex. It is necessary to consult with a tax professional to ensure that the IRS will recognize the tax-exempt status of a particular type of bond. Additionally, an investment expert can advise an investor on whether investing in a tax-exempt bond is right for the investor based on a specific investor’s unique circumstances.
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