How Are Municipal Bonds Taxed: Federal, State, AMT, and Capital Gains

Municipal bonds are taxed favorably but not uniformly: interest on most state and local bonds is exempt from federal income tax, often exempt from state tax if you live in the issuing state, and sometimes exempt from local tax too. Capital gains from selling a muni before maturity are fully taxable. And a handful of situations, including the alternative minimum tax, Social Security benefit calculations, and Medicare premium surcharges, can still pull tax-exempt interest into your tax picture.

Federal Tax on the Interest

Federal law excludes interest on bonds issued by states, cities, counties, and other local governments from your gross income.¹ The IRS does not collect income tax on the coupon payments from a standard municipal bond.

You still have to report the interest. Tax-exempt interest goes on line 2a of Form 1040.² The number matters even though it is not taxed directly, because the IRS uses it in other calculations, including Social Security benefit taxation and Medicare premium surcharges.

State and Local Tax on the Interest

Most states exempt interest on bonds issued within their own borders from state income tax. Buy a bond from your own state, and you generally avoid both federal and state tax on the coupon. If your city levies an income tax, a bond issued by that city or a local authority within it can be triple tax-exempt — free of federal, state, and city tax.

Out-of-state municipal bonds work differently. Your home state generally taxes that interest the same way it taxes a corporate bond or bank account. A few states have no income tax, so the in-state distinction does not matter for their residents.

When Muni Interest Is Federally Taxable

The same statute that creates the exemption carves out three categories of bonds whose interest is fully federally taxable:¹

Non-qualified private activity bonds. When more than 10 percent of a bond’s proceeds go to a private business use, it is a private activity bond. Some private activity bonds still qualify for tax-exempt status, including certain airport, hospital, and affordable housing issues, but those that do not qualify produce taxable interest.³
Arbitrage bonds. If an issuer invests bond proceeds in higher-yielding securities to profit from the rate spread, the interest loses its exemption.
Bonds that fail registration or other procedural requirements set by federal law.

The official statement issued at the time of sale tells you which category a bond falls into. Your broker’s trade confirmation and the Form 1099 you receive will also indicate whether the interest is taxable or exempt.

Private Activity Bonds and the AMT

Even qualified private activity bonds, whose interest is exempt from the regular federal income tax, are treated differently under the alternative minimum tax. Their interest counts as a tax preference item and gets added back when calculating AMT liability.⁴ These bonds finance projects with significant private involvement, such as privately operated airports, sports stadiums, or industrial development facilities.

A bond falls into the private activity category when more than 10 percent of proceeds are used for a private business purpose and more than 10 percent of the debt service is secured by or derived from that use.³ If AMT exceeds your regular tax, you pay the higher amount, and the exemption on those bonds can effectively disappear.

For 2026, the AMT exemption is $90,100 for single filers, phasing out at $500,000 in AMT income, and $140,200 for married couples filing jointly, phasing out at $1,000,000.⁵ Well below those phase-out thresholds, private activity bond interest is unlikely to trigger AMT. Near them, even a modest amount can tip the balance. The bond’s official statement discloses the classification.

Capital Gains When You Sell

The federal exemption applies to interest, not gains. Sell a muni for more than you paid, and the profit is a capital gain subject to federal and usually state tax.

Held one year or less: short-term gain, taxed at your ordinary income rate, up to 37 percent for 2026.⁵
Held more than one year: long-term gain, taxed at 0, 15, or 20 percent depending on taxable income.⁶

The 2026 long-term brackets:

0 percent on taxable income up to $49,450 (single) or $98,900 (married filing jointly).
15 percent above those amounts up to $545,500 (single) or $613,700 (married filing jointly).
20 percent above the 15-percent ceiling.⁷

High-income investors may also owe the 3.8 percent Net Investment Income Tax on the gain. Tax-exempt interest itself is excluded from NIIT, but capital gains from selling munis are not, so the top effective federal rate on a long-term gain can reach 23.8 percent.⁸ Your broker reports the sale proceeds and cost basis on Form 1099-B.⁹ State income tax applies to these gains, even in states that exempt the same bond’s interest.

Bonds Bought at a Discount

When you buy a muni on the secondary market below face value, part of the eventual profit may be taxed as ordinary income rather than a capital gain. The IRS uses the de minimis rule to decide which.

Multiply 0.25 percent of face value by the number of full years remaining to maturity. If your discount is at or below that number, the gain at sale or redemption is a capital gain.¹⁰ If it exceeds the threshold, the gain is ordinary income, potentially taxed as high as 37 percent.

An example: a $1,000 face-value bond with 10 full years remaining has a de minimis threshold of $25 (0.25% × $1,000 × 10). Bought at $980, the $20 gain is a capital gain. Bought at $960, the $40 gain is ordinary income. Accrued market discount above the threshold is reported as taxable interest on Schedule B, not as tax-exempt interest.¹¹

Some bonds are issued below face value from the start and carry an original issue discount (OID). If you buy a tax-exempt OID bond at its original issue price and hold to maturity, the discount is treated as additional tax-exempt interest, not a taxable gain.¹² OID bonds bought later on the secondary market have greater exposure to the market discount rules, because the de minimis OID rule that shelters small discounts on taxable bonds does not apply to tax-exempt bonds.

Bonds Bought at a Premium

If you pay more than face value for a tax-exempt muni, federal law requires you to amortize the premium over the remaining life of the bond and reduce your cost basis accordingly.¹³ Unlike with taxable bonds, there is no deduction for the amortized premium. The basis reduction is mandatory; the offsetting tax benefit is not.

Each year, your adjusted basis drops by the premium allocated to that period. If the premium allocated for a period exceeds the interest payment for that period, the excess is a nondeductible loss.¹⁴ At maturity or sale, gain or loss is measured against the reduced basis, not what you originally paid. Skipping the amortization tracking leads to overstated losses or understated gains at disposition.

Effect on Social Security and Medicare

Even when muni interest escapes federal and state income tax, it can raise two other retirement costs.

Social Security Benefit Taxation

The IRS decides how much of your Social Security benefits are taxable using “combined income,” which equals your adjusted gross income, plus half your benefits, plus any tax-exempt interest. Municipal bond interest is added back in, so a large muni portfolio can push combined income above the thresholds.¹⁵

Individual filers: above $25,000 in combined income, up to 85 percent of benefits become taxable.
Joint filers: the threshold is $32,000.

Neither figure has been adjusted for inflation since enactment, so they reach more retirees each year.

Medicare Part B Premium Surcharges

Medicare calculates Part B premiums using modified adjusted gross income, and MAGI explicitly includes the tax-exempt interest reported on line 2a.¹⁶ Above certain thresholds, you pay an Income-Related Monthly Adjustment Amount (IRMAA) on top of the standard premium. For 2026, the standard monthly Part B premium is $202.90, and surcharges can more than triple that.¹⁷

The 2026 IRMAA thresholds start at $109,000 MAGI for individual filers and $218,000 for joint filers, with surcharges rising in steps to as high as $487.00 per month at the top tier.¹⁷ IRMAA is based on your tax return from two years earlier, so a spike in municipal bond income in one year can raise premiums two years out.

Comparing a Muni Yield to a Taxable Bond

p>Because muni interest is tax-exempt, a bond paying 3.5 percent can deliver more after-tax income than a corporate bond paying 5 percent, depending on your tax bracket. The comparison uses tax-equivalent yield:

Tax-equivalent yield = tax-exempt yield ÷ (1 − your marginal tax rate)

In the 32 percent federal bracket, a muni yielding 3.5 percent has a tax-equivalent yield of 3.5% ÷ (1 − 0.32) = 5.15 percent. A taxable bond would need to pay at least 5.15 percent to match. If the bond is also exempt from your state tax, add the state rate to the marginal rate in the formula. The higher your combined tax rate, the more the exemption is worth, which is why municipal bonds tend to favor investors in higher brackets.

1
Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds
2
Internal Revenue Service. Form 1040, U.S. Individual Income Tax Return
3
Office of the Law Revision Counsel. 26 US Code 141 – Private Activity Bond; Qualified Bond
4
Office of the Law Revision Counsel. 26 USC 57 – Items of Tax Preference
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
7
Internal Revenue Service. Revenue Procedure 2025-32, 2026 Adjusted Items
8
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
9
Internal Revenue Service. Instructions for Form 1099-B (2026)
10
Municipal Securities Rulemaking Board. Tax and Liquidity Considerations for Buying Discount Bonds
11
Internal Revenue Service. Instructions for Schedule B (Form 1040)
12
Municipal Securities Rulemaking Board. About Original Issue Discount Bonds
13
Office of the Law Revision Counsel. 26 US Code 171 – Amortizable Bond Premium
14
eCFR. 26 CFR 1.171-2 – Amortization of Bond Premium
15
Social Security Administration. Must I Pay Taxes on Social Security Benefits?
16
Social Security Administration. Medicare Income-Related Monthly Adjustment Amount – Life-Changing Event
17
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles