Will the tax exemption on income from municipal bonds survive?

It’s a discussion garnering headlines now, as the incoming Trump administration seeks ways to fund a wide range of tax ideas, and it’s generated a lot of questions from clients.

President-elect Trump has promised to cut a variety of taxes and even eliminate the federal income tax, which alone generates more than $2.18 trillion per year. If those plans are realized, leaders will have to find additional revenue to offset the cost of the cuts.

Where might this revenue come from?

Unfortunately, some think eliminating the tax exemption on interest income from municipal bonds – which costs the U.S. government less than $40 billion each year – would help.

We don’t, and neither do the scores of issuers that depend on tax-free bonds to fund public works projects across the country.

Prior attacks on munis

It’s not the first time tax-free municipal bonds have been targeted in recent years.

In a bid to help raise revenue to fund the Tax Cuts and Jobs Act of 2017, lawmakers unwisely eliminated the tax exemption on advance refunding bonds, a key tool state and local governments use to save money and fund hospitals, schools, bridges and other infrastructure (“Reviving Advance Refunding Bonds”).

An earlier version of the TCJA pushed by Congressional Republicans also sought to eliminate the tax exemption on interest from new private activity bonds. PABs are used by nonprofit organizations and governments to finance projects such as hospitals, nursing homes, colleges, affordable housing and ports.

By the time the law was enacted, the tax exemption on new private activity bonds survived, but the exemption on advance refunding bonds did not.

Soon after it was signed into law, bills emerged to restore the exemption on advanced refunding bonds, but so far, they haven’t advanced in Congress.

A key concern this year among issuers and government budget officials is the tax cuts included in the TCJA that expire at the end of 2025. The incoming administration says it wants to extend those, which would put further pressure on the budget.

Where there’s smoke….

Although the idea is being floated, is the exemption on municipal bonds likely to be rescinded?

Analysts are cautious.

“The likelihood that the tax exemption is materially altered remains low, but the risk is probably at as high a level as it has been in the recent past given the size of projected deficits,” a co-head of research at an investment advisory firm told Bloomberg.

Municipal bonds fund about 75% of U.S. infrastructure and lower borrowing costs for public projects, so it’s difficult to understand the wisdom behind removing the exemption.

Perhaps if lawmakers and the president don’t eliminate the exemption, they’ll try to limit it. They could revisit the exemption on new PABs.

At this point, no one knows for sure.

But we hope you’ll join us in contacting your representative and senators and urge them to preserve the exemption. Tax-free bonds have been a win-win for public works projects as well as investors for more than 100 years.

For investors, a prudent course of action now is to avoid distractions.

If the exemption is somehow compromised or even eliminated, it will apply to new bonds after the law is passed. Meantime, clients are looking for tax-swap opportunities (“Year-End Muni Tax Swap”) and, if cash is available, taking advantage of attractive yields and fortifying their steady stream of tax-free income.