Calculating non-exempt interest for California income tax

Question

This question is about how California taxes interest on municipal bonds that are exempt from federal income tax.

I live in California. In 2023 year I received tax-exempt interest from a variety of municipal bonds. The CA "Interest and Dividend Adjustment Worksheet" asks for the following:

• Line B: California state tax exempt interest from federal schedule B.
• Line C: Of the amount on Line B, enter the portion attributable to funds where at least 50% of the assets are not invested in US/California municipal obligations.

I filled in line B based on schedule B, where I calculated my total tax exempt interest minus my bond premium on those bonds. My questions about the next step are:

1. My 1099-INT breaks down my tax exempt interest into CA and non-CA funds and shows three values: "Tax-exempt interest", "accrued interest paid", and "bond premium - covered lot". Is the proper amount to report on line C the tax-exempt interest minus the bond premium?
2. Does it matter that I own bonds instead of "funds" invested in bonds? The instructions seem oddly specific about the interest being from funds.

Answer 1

If the fund invests more than half of its assets in bonds from outside California, then all the fund interest is taxable, including that from CA bonds. See the instructions for the CA FTB form 540 Schedule CA:

Certain mutual funds pay “exempt-interest dividends.” If the mutual fund has at least 50 percent of its assets invested in tax-exempt U.S. obligations and/or in California or its municipal obligations, that amount of dividend is exempt from California tax.

So yes, it does matter if the interest is paid by bonds directly vs by a fund. If your bond is CA-exempt - then all of the interest is CA exempt. Line C only refers to funds.