As investors file their 2018 tax returns, they may be surprised by the impact of the newly imposed limit on deductions for state and local taxes (SALT). Residents of high tax states, in particular, may face higher federal tax liability because they can only deduct up to $10,000 for SALT. We believe municipal bonds can help manage taxes. The more income an investor can generate from municipal bonds, the less exposure to potentially higher federal taxes resulting from the SALT cap.
In the past, without the cap, many taxpayers were able to have a much bigger deduction. The SALT cap now limits deductions against federal taxes for state and local taxes paid up to $10,000 annually. Therefore, those who previously deducted SALT amounts well in advance of the $10,000 cap could see higher federal taxes this year.
Residents of high tax states, especially those who historically took large SALT deductions against their federal tax liability, may want to consider increasing their municipal bond income as a means of managing their tax burden. Municipal bond interest is still federally tax-exempt.
Additionally, investors could consider adding Alternative Minimum Tax (AMT) bonds to their portfolios as a means of increasing the yield of their portfolio, possibility without added tax liability. In addition to changing deductions, the 2017 tax law also modified the calculation on AMT. While estimates vary, some major tax organizations predict these tax changes will result in dramatic declines in the number of tax payers subject to AMT. AMT bonds typically trade at higher yields than municipal bonds that aren’t designated as AMT.
AMT bonds are private activity bonds that primarily benefit private interests. One such example might be a municipal airport authority that issues bonds to construct a maintenance facility for the exclusive use of a commercial airline. Such bonds would be deemed AMT bonds. Because the investor demand for AMT is typically low, the yields are often attractive. As investors review their tax returns this year, they may want to see if adding AMT bonds to their municipal bond portfolio makes sense.
Individual investors should consult with their tax planners and/or financial advisors as to the tax implications of these policy changes on their tax liability. Investors that will be subject to greater federal tax liability due to the SALT cap may want to consider municipal bonds as a way to help ease the impact of the SALT cap. Though SALT may pose specific challenges for residents of high tax states, municipal bonds may well provide some relief.