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How to benefit from tax-exempt bonds

VISTA, Calif. – Tax-free bonds provide investors with tax-free interest income. Tribes and municipal entities such as tribes, states, counties and cities are qualified to issue such bonds. Money from the issuance of tax-free bonds is used to finance public projects. For example, many roads, schools and water treatment facilities are built with financing from tax-exempt bonds.

Some public projects involve federal, state, local government and tribal funding. As an example, a public road may connect several counties in different states together but runs through a reservation. In that case, several municipalities may join the tribe in issuing bonds to finance the project together.

Due to the tax-free nature of interest earned, these bonds benefit the issuers (borrowers) and the bondholders (investors). Similar to per capita or revenue sharing income, interest income is taxable to individual investors at ordinary income tax rate. This means interest income is added to other income, which are altogether subject to certain tax rates.

For a single enrolled tribal member who earns $40,000 a year from his job and has no mortgage or other deductions, his marginal tax bracket is 25 percent as of 2005. If this tribal member invests $10,000 in a bank account that pays 3 percent, he gets $300 interest income, but nets $225 because $75 is paid out in taxes.

If this investor puts $10,000 into a tax-free bond that also pays 3 percent, the $300 interest income is federally tax-free and may be state tax-free. The latter depends on two scenarios: whether he lives on the reservation and if the reservation has a personal income tax; and if he lives off the reservation, whether or not he lives in the same state as the issuer.

In order to attract investors to finance their municipal ventures, states usually exempt income taxes on bonds issued from their own state. The federal district of Washington, D.C., exempts income tax on all municipal bond interest from all states. Because Puerto Rico is a U.S. commonwealth, investors from all states can invest in those bonds state tax-free.

Since most tribes do not assess an income tax to their residents, municipal interest income is likely to be tribally tax-free.

The reason for federal tax-free interest is based on the principles of federalism, specifically federal – state reciprocal tax immunity. Historically, the principles of federalism disallow the federal government to interfere in the affairs of state and local governments and vice versa. The arrangement is reciprocal, meaning that both sides must do the same.

Federal – state reciprocal tax immunity means that the federal government (hence the Internal Revenue Service) cannot collect taxes from municipal bond investments. Meanwhile, state and local governments (state and local tax authorities) cannot collect taxes from U.S. Treasury or agency bonds.

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Earning tax-exempt income isn’t that simple, as Congress enacted an alternate minimum income tax in 1969. This is an additional way that the IRS requires taxpayers to calculate minimum taxes due. In the past, many affluent taxpayers used tax shelters to avoid paying taxes. However, with inflation indexing of income, nowadays middle-class investors of tax-free bonds may be subject to an alternative minimum tax.

Middle-class individuals are defined as those earning more than $75,000 per year. Usually, municipal bond interest alone would not trigger an alternative minimum tax. However, certain types of private activity bond interest are not tax exempt for AMT purposes.

Private activity bonds are those issued by a tribe to build a casino, hotel or other for-profit ventures. Many cities also use private activity bonds to finance non-governmental projects such as a sports stadium, industrial development, student loan financing or low-income housing. Some individual investors of these bonds may be subject to alternative minimum taxes.

Due to tax advantages, municipal bonds issues offer lower interest rates to investors and save on borrowing costs. According to statistics gathered by the Bond Market Association, the Treasury borrowed (issued) nearly $4.4 trillion in 2005. All municipalities together issued approximately one-tenth of that amount, to $458.7 billion.

As a note, federal mortgage and farm programs issued through the Federal Home Loan Bank, Federal National Mortgage Association and Federal Farm Credit together issued nearly $12 trillion in 2005.

Tribes have attempted to issue tax-exempt bonds. Bond financing earmarked for casino and hotel projects were determined taxable by the IRS. However, as reported in the May 11, 2005 issue of Indian Country Today (“California bill seeks to allow tribal tax-exempt bonds” by James May, Vol. 24, Iss. 48), bonds issued for Indian health clinics have not met such controversy.

According to a June 9 Bloomberg report, AAA 20-year term tax-exempt bonds bore an average interest of 4.29 percent, while a comparable Treasury issue yielded 5.31 percent.

Typically, financing needs in excess of $5 million and term of five years makes sense, in light of underwriting costs and legal expenses. A normal process can take between six and nine months to fund.

For tribes seeking economic independence, infrastructure such as roads, water, sewage and waste treatment, energy and communications, and law enforcement is absolutely necessary. If there are adequate collateral from the project and means from tax revenues or investment returns to make repayment of interest and principal, tax-exempt financing can be a viable source of capital.

<i>Cynthia Tam, CFP®, sets up investment and benefits programs for tribes. She can be reached at ctam@investors or (619) 200-6277. CA 0D69514. Securities offered through Investors Capital, member NASD/SIPC. Advisory Services offered through Investors Capital Advisory, 230 Broadway, Lynnfield, MA; (800) 949-1422.</i>