Home-state tax breaks for munis undergoing scrutiny

INVESTING in mu- nicipal bonds is- sued in one’s home state has two pleasant effects: a sense of civic pride and tax-free income.

The latter benefit is potentially under threat, according to an article in the October issue of Smart Money magazine.

A Kentucky court recently ruled that it’s unconstitutional for states to exempt the income from in-state municipal bonds while taxing income derived from out-of-state munis.

The U.S. Supreme Court will hear the case this fall. If the Kentucky ruling is upheld, each state would need to develop a uniform tax policy for in-state and out-of-state municipal-bond income. In other words, tax either all or none of them.

The plaintiffs in the case say the tax break on in-state municipal-bond income represents a form of economic protectionism by states. The other side argues it’s a state, not federal, issue.

Financial planners interviewed by Smart Money urge investors not to make any portfolio moves until after the Supreme Court rules.

It’s a big case for both investors and governments. Many investors, particularly wealthy ones, rely on municipal-bond income to finance their lifestyles. Without the tax break, they could go elsewhere for income.

Meanwhile, local and state governments depend on the bonds for financing. If they taxed all municipal issues, bond sales could slow. If they extended the tax breaks to out-of-state bonds, interest rates on in-state bonds might have to rise to stay competitive. That could put additional debt-servicing stress on governments.

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