What's the benefit of buying municipal bonds on the secondary market?

Question

"Buy munis!", they say... "they're tax exempt!", they say... but are they? It looks like you're paying income tax on most of the Yield To Maturity (since interest rates have gone up so much, many older bonds are selling at a significant discount), even though the picayune interest payments are tax exempt.

I ask this, because according to page 4 of Tax Treatment of Bond Premium and Discount:

MARKET DISCOUNT – TAX-EXEMPT BONDS

Tax-exempt bonds purchased with market discount after April 30, 1993 are subject to the same rules as taxable discount bonds

• If the discount is accreted each year – The accreted discount is treated as ordinary interest income and is subject to federal income tax. This accreted discount is taxable despite the fact that the bond itself is considered a tax exempt bond.

• If the discount is not accreted annually – Any gain attributed to the market discount that was not accreted is subject to federal tax as ordinary interest income when the bond is disposed of. Any gain beyond that amount is taxed as a capital gain.

Answer 1

Yes, capital gains from the sale or redemption of municipal bonds is taxable; it's just the interest that is tax-free. Even then it's typically only state-tax-free in your own state. States often tax the interest on municipal bonds to owners that do not reside in the state.

To be fair, it's still a benefit, it's just not as blanket a benefit as "Munis are tax free" would lead you to believe.