Private Activity Bond

Nadia Efremov is in the 32% federal bracket and lives in a state with a 6% income tax that exempts interest on bonds issued within the state. Her adviser compares an in-state general obligation bond yielding 3.4% with an in-state airport revenue bond, structured as a private activity bond, yielding 3.9%. Assume Nadia is subject to the alternative minimum tax. Which statement is most accurate?

1. A.The private activity bond interest is a tax preference item added back for AMT purposes, so its 3.9% yield is not fully tax free to her, while the GO bond interest is free of both federal and state tax.Correct. Private activity bond interest is an AMT preference item, and an in-state GO bond escapes both federal and her state income tax.
2. B.Neither bond raises an AMT issue, because only corporate bond interest can be a tax preference item.Incorrect. Corporate bond interest is ordinary taxable income, not a preference item. Private activity municipal interest is the classic preference item.
3. C.The private activity bond is exempt from AMT but taxable at the state level, while the general obligation bond is taxable federally.Incorrect. It reverses both rules. The private activity bond is the one with AMT exposure, and municipal GO interest is federally exempt.
4. D.Both bonds are fully exempt from federal and state tax, so she should simply take the higher 3.9% yield.Incorrect. This ignores the AMT preference treatment of private activity bond interest, which is the entire point of the comparison.

Why: Interest on a private activity municipal bond is a tax preference item that is added back to income when computing the alternative minimum tax. For a client who is actually subject to AMT, the 3.9% yield is therefore not fully tax free at the federal level, and the extra yield the bond offers is partly compensation for exactly that. The general obligation bond, by contrast, is exempt from federal tax and, because it was issued in her own state, also exempt from her 6% state tax. The comparison must be made on an after-AMT basis, not on stated yields.

Verrell Sunning, a client of Ashcombe Wealth, is a high earner who has paid the alternative minimum tax in each of the last four years. Her agent recommends a municipal bond fund concentrated in private activity bonds issued to finance an airport terminal and a sports arena, describing the income as 'entirely tax-free.' The recommendation is:

1. A.Improper only because a single-sector concentration in airport and arena bonds is undiversifiedConcentration is a fair secondary criticism, but the misstatement about the tax treatment is the primary defect.
2. B.Proper, because interest on all municipal bonds is exempt from federal income tax regardless of the issuer's purposeRegular-tax exemption is general, but the alternative minimum tax treats private activity bond interest differently.
3. C.Improper, because interest on private activity bonds is a preference item for the alternative minimum tax, so the income is not entirely tax-free for this clientCorrect. Her AMT history is the fact that makes the tax-free characterisation false for her.
4. D.Proper, because the alternative minimum tax applies only to capital gains and not to interest incomeThe alternative minimum tax has its own base, and specified private activity bond interest is expressly added back into it.

Why: Interest on qualified private activity municipal bonds is generally exempt from regular federal income tax but is a tax preference item that enters the alternative minimum tax calculation for individuals. For a client who has actually paid the alternative minimum tax in four consecutive years, describing that income as entirely tax-free is a material misstatement, and the after-tax yield she will actually realise may be well below the yield she is being shown. The right course is a fund of general obligation and non-private-activity bonds, or a comparison run on her real after-tax figures.

Roswell Barre is subject to the alternative minimum tax. He is comparing two tax-exempt municipal bonds with identical coupons, maturities and ratings: a general obligation bond of a school district, and a PRIVATE ACTIVITY BOND financing a privately operated parking facility. For Roswell:

1. A.The general obligation bond's interest is the preference item, while the private activity bond is fully exempt.Wrong - reversed. Public-purpose general obligation interest is not an AMT preference item.
2. B.Neither matters, because all municipal interest is excluded from the alternative minimum tax computation.Wrong. The exclusion from AMT is not universal; the private activity carve-out is the well-known exception.
3. C.The private activity bond's interest is a preference item includible in his AMT computation, so its after-tax yield to him is lower despite the identical coupon.Correct. Certain private activity bond interest is added back for AMT purposes, which is why such bonds normally carry a higher stated yield.
4. D.Both bonds are fully exempt for every federal purpose, so the two are economically identical to him.Wrong. Regular-tax exemption is not AMT exemption, and that gap is exactly what distinguishes the two bonds for this investor.

Why: Municipal interest is generally excluded from regular federal income tax, but interest on certain private activity bonds is a TAX PREFERENCE ITEM added back in computing the alternative minimum tax. For an investor actually subject to the AMT, that add-back makes the private activity bond's after-tax yield lower than the general obligation bond's, even though the coupons are identical. This is exactly why private activity bonds typically carry a higher stated yield than comparable public-purpose municipals - the market prices in the AMT exposure for the subset of buyers it affects.