Municipal bond swaps are used by a variety of investors to do everything from increase the investor’s yield to lower the amount an investor pays in taxes. In general, a bond swap is an investment technique in which a person sells a bond and then buys a different bond with the money earned from the sale. Municipal bonds are good bonds to swap because it’s not too difficult to find two bonds with similar credit ratings, coupons, maturity periods and prices.
In a municipal bond swap, an investor swaps one bond for a different one to take advantage of current market and/or tax conditions. Swapping bonds for tax purposes is the most common of all types of municipal bond swaps. In general, any investor holding bonds that are currently selling below their current amortized purchase price and who also has taxable income (from either direct income, capital gains, or other sources) whose tax liability could be offset by taking a tax loss could potentially benefit from municipal bond swapping.
In short, in order to lower a tax bill, a person must be able to show that they have taken a loss on an investment. This loss is them subtracted from the income made by other investments or simply from the income earned by a person or couple within a year. Through trading assets that are currently selling below their purchase price with those that are trading above their selling price, an investor can show that he or she has taken an investment loss. This allows an investor to reduce or eliminate the capital gains taxes he or she would have paid on their profitable trades during the current tax year.
A traditional tax swap takes place in two steps. First, an investor has to sell a bond that is worth less than what he or she paid for it. Then, the investor needs to buy a municipal bond with very similar characteristics. It is important for the investor to not purchase an identical bond, or the swap is not valid.
For example, take the case of an investor who owns a $50,000, ten year, AA rated municipal bond with a 4.00% interest rate that was originally bought five years ago. If interest rates increase and now new bonds are getting issued with a 4.50% interest rate, the value of the municipal bond owned by the investor will fall to about $48,000. If the investor sells his or her bond, he or she will realize a $2,000 capital loss. This capital loss can be used to offset any capital gains the investor has earned within the present tax year. The loss can also be used to offset earned income.
After taking the loss, the investor should then purchase a new AA rated 4.00% municipal bond, maturing in five years, at an approximate cost of $48,000. Be sure that the new bond comes from a different issuer. The new bond will have the same yield, maturity and quality as the old bond, but the investor will have taken a loss that can save him or her money on his or her taxes. Of course, if the investor holds the new bond until it matures, he or she will realize a $2,000 gain at the end of five years. At that time the income from the bond will be taxable as ordinary income.