Why Some Bonds Are Tax-free

In these uncertain times, what investments are the 'safest'

? This is a question more people are asking as they see companies fail, go bankrupt or simply cease providing dividends to their shareholders. The joke is that your 401k is now a 201k and retirement just means you will work as hard for less pay.

Tax exempt bonds, like those issued by municipalities like school districts, cities and state agencies to raise funds, are a great investment for the average investor. The tax exempt status of the bond means the investor does not have to pay income taxes on the revenues earned from the bonds. Tax exempt bonds can be a good investment for companies needing to have a stream of revenue that is not taxed. These bonds are not subject to taxation because the Internal Revenue Service is paid an arbitrage rebate if the return on the funds invested exceeds a certain amount.

How is the arbitrage rebate amount calculated? A small municipality has the same guidelines to follow as a large one, but often does not have an employee dedicated to just rebate calculations because of their complexity. Funds that are subject to arbitrage rebate are project funds, reserve funds, debt service funds, refunding escrow funds, cost of issuance funds and transferred proceeds. Arbitrage rebate is accumulated from when the bonds are issued until they mature. Interest rates can fluctuate during this time period causing excessive or negative yields for the bond. Calculating the arbitrage rebate requires the net of the positive and negative amounts over the life of the bond. Rebate payments are required every 5 years and at the final date of the life of the bond debt.

The idea behind the laws of arbitrage minimize the benefits of investing debt proceeds in the marketplace and remove incentive to issue debt earlier than required as well as leave debt outstanding and debt issue overage amounts. This helps govern municipality spending on a fiscal level and helps insure responsibility in spending and debt management.

Like all tax payers, the municipal bonds are subject to review and audit by the Internal Revenue Service. The IRS is the governing body for the arbitrage rebates and the collecting agency as well. Bond issuers must keep all records and data three years and one day past the final maturity date of the bonds in a hard copy. Using an outside firm to handle the arbitrage rebate calculations and paperwork can provide needed expertise for bonds issued.

by: Art Gib

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