Megan Brooks
The Tax Reform Act of 1986 created two types of tax-exempt obligations: bank-qualified and non-bank-qualified. Non-bank-qualified bonds are less attractive investments since the rate required for profitability may approach the rate of taxable obligations. Non-bank-qualified tax-exempt securities are subject to a 100% disallowance on interest expense deductions, whereas bank-qualified securities are subject to a 20% disallowance. This means that while interest on municipal bonds may be exempt from federal taxes, banks may not deduct the carrying cost of non-bank-qualified tax-exempt obligations, making them less appealing to financial institutions.
| Characteristics | Values |
|---|---|
| Definition | Non-bank qualified bonds are one of the two types of tax-exempt obligations created by the Tax Reform Act of 1986. |
| Interest expense deduction | 100% disallowance for financial institutions |
| Qualified small issuer | Issuers that issue no more than $10 million of tax-exempt bonds during a calendar year |
| Interest | The rate required for a profitable investment may approach the rate of taxable obligations, making them less attractive than bank-qualified bonds |
| Federal corporate tax rate | The decline in the marginal rate from 35% to 21% with the Tax Cuts & Jobs Act effective January 1, 2018, made these investments less attractive to banks and other corporations |
| Exception | The 2009 Recovery Act states that non-bank-qualified tax-exempt securities issued in 2009 or 2010 are not considered in determining the pro rata portion of interest incurred by financial institutions that are disallowed |
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What You'll Learn
- Non-bank-qualified securities are included with bank-qualified securities when calculating disallowed interest expenses
- The nondeductible amount varies depending on whether the security is bank-qualified or non-bank-qualified
- The 2009 Recovery Act provides that non-bank-qualified tax-exempt securities issued in 2009 or 2010 are not considered when determining the pro rata portion of interest incurred by financial institutions that are disallowed
- The Tax Reform Act of 1986 created two types of tax-exempt obligations: bank qualified and non-bank qualified
- Municipal bonds: the interest may be exempt from federal taxes and sometimes state taxes, depending on the state laws
Non-bank-qualified securities are included with bank-qualified securities when calculating disallowed interest expenses
The Tax Reform Act of 1986 created two types of tax-exempt obligations: bank-qualified and non-bank-qualified. The major difference between the two is that the interest expense attributable to carrying tax-exempt securities is generally not deductible for non-bank-qualified securities, whereas bank-qualified securities allow for a 20% disallowance.
For bank-qualified securities, financial institutions can deduct 80% of the carrying cost, which is the interest expense incurred to purchase or carry an inventory of securities. This provision effectively eliminates the tax-exempt benefit of municipal obligations for banks.
For non-bank-qualified securities, the interest expense deduction allocable is 100% disallowed for financial institutions. This means that the interest expense attributable to carrying non-bank-qualified tax-exempt securities cannot be deducted.
It is important to note that the 2009 Recovery Act provides an exception for non-bank-qualified tax-exempt securities issued in 2009 or 2010. These securities are not considered when determining the pro rata portion of interest incurred by financial institutions that are disallowed, up to 2% of the average assets of the institution.
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The nondeductible amount varies depending on whether the security is bank-qualified or non-bank-qualified
The Tax Reform Act of 1986 created two types of tax-exempt obligations: bank-qualified and non-bank-qualified. The demand for these bonds declined as a result of this Act, which required banks to add back a portion of their interest expense on municipal bonds and loans. Banks may not deduct the carrying cost of tax-exempt obligations, which is the interest expense incurred to purchase or carry an inventory of securities.
A "qualified small issuer" is one that issues no more than $10 million of tax-exempt bonds during a calendar year. These obligations are commonly referred to as "bank-qualified bonds". Financial institutions that are C corporations are subject to the TEFRA limitation for both bank-qualified and non-bank-qualified securities. Financial institutions that are S corporations are subject to the TEFRA limitation for non-bank-qualified securities and only for the first three years of electing S-corporation status for bank-qualified securities.
The 2009 Recovery Act provides an exception to the rule above, stating that non-bank-qualified tax-exempt securities issued in 2009 or 2010 are not considered when determining the pro rata portion of interest incurred by financial institutions that are disallowed. This exception applies for up to 2% of the average assets of the financial institution.
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The 2009 Recovery Act provides that non-bank-qualified tax-exempt securities issued in 2009 or 2010 are not considered when determining the pro rata portion of interest incurred by financial institutions that are disallowed
The 2009 Recovery Act introduced a provision that allowed for an exception to the rule that 100% of interest expenses on non-bank-qualified tax-exempt securities are disallowed for financial institutions. This exception applied to non-bank-qualified tax-exempt securities issued in 2009 or 2010, which were not considered when determining the pro rata portion of interest incurred by financial institutions that were disallowed. In other words, these securities were excluded from the 100% disallowance rule.
This exception was limited to up to 2% of the average assets of the financial institution. For example, a bank with $100 million in assets could have $2 million in securities excluded from the 100% disallowance rule. The portion of any obligation not taken into account under this new law was treated as if it were acquired on August 7, 1986, and was considered a financial institution preference item under Section 291(e).
The 2009 Recovery Act amended the initial limitation created by the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, which was changed by the Tax Reform Act of 1986. These acts established the difference between bank-qualified and non-bank-qualified securities, with the latter being less attractive to banks and other corporations due to the higher rates required for profitability.
Bank-qualified tax-exempt obligations are issued by qualified small issuers, who issue less than $10 million in total debt during a calendar year. These obligations are often municipal bonds, which offer a major tax advantage as the interest may be exempt from federal taxes and, depending on the state, state taxes as well.
The 2009 Recovery Act's exception for non-bank-qualified tax-exempt securities issued in 2009 or 2010 provided a temporary reprieve from the full disallowance of interest expenses for financial institutions, allowing them to invest in these securities without incurring the usual tax consequences.
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The Tax Reform Act of 1986 created two types of tax-exempt obligations: bank qualified and non-bank qualified
The Tax Reform Act of 1986 created two types of tax-exempt obligations: bank-qualified and non-bank-qualified. This act introduced a provision that required banks to add back a portion of their interest expense on municipal bonds or loans, impacting the demand for these bonds.
Prior to the Tax Reform Act of 1986, banks could deduct the carrying cost of tax-exempt obligations, which was calculated using a formula based on the ratio of average tax-exempt assets to average total assets. However, the 1986 Act eliminated this tax-exempt benefit for banks, making municipal obligations less attractive for investment.
To mitigate the impact on smaller communities, an exception was created for "qualified small issuers." A qualified small issuer is defined as an entity that issues no more than $10 million of tax-exempt bonds in a calendar year. These obligations are referred to as "bank-qualified bonds."
Non-bank-qualified obligations, on the other hand, often require higher rates to be profitable, making them less appealing compared to bank-qualified bonds. The interest expense attributable to carrying non-bank-qualified tax-exempt securities is generally not deductible, resulting in a 100% disallowance for financial institutions.
It's important to note that the 2009 Recovery Act provided a temporary exception for non-bank-qualified tax-exempt securities issued in 2009 and 2010, allowing up to 2% of the average assets of financial institutions to be excluded from the 100% disallowance rule.
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Municipal bonds: the interest may be exempt from federal taxes and sometimes state taxes, depending on the state laws
Municipal bonds are generally assumed to be tax-free, but this is not always the case. The interest on municipal bonds is usually exempt from federal income taxes, but other taxes may apply. Municipal bonds are issued by state, city, and local governments, and the income from these bonds is generally free from federal taxes. However, this income must be reported when filing taxes. While municipal bond income is usually free from state tax in the state where the bond was issued, some states do tax interest on their own bonds. In some cases, a state may exempt specific bonds from taxation at the time of issuance.
The tax implications of municipal bonds can vary depending on the specific state tax laws. If an investor buys municipal bonds from another state, their home state may tax the interest income from those bonds. On the other hand, if an individual invests in a bond issued by their home state, state tax is rarely charged. Municipal bonds are often exempt from local taxes as well, particularly when the bond's investor lives in the state where the bond was issued.
It is important to note that capital gains realized from selling municipal bonds are generally subject to federal and state taxes. Additionally, municipal bonds purchased at a discount on the secondary market may be subject to capital gains tax upon redemption. While municipal bonds are often exempt from federal income taxes, the IRS includes the income from these bonds in the modified adjusted gross income (MAGI) when determining the taxability of an individual's Social Security benefit. If the MAGI, including tax-exempt municipal bond interest, exceeds certain thresholds, a portion of the Social Security benefits may become taxable.
In terms of tax-exempt obligations, there are two types: bank-qualified and non-bank-qualified, which were created following the Tax Reform Act of 1986. Bank-qualified tax-exempt obligations are issued by "qualified small issuers," who issue a limited amount of debt during a calendar year. Non-bank-qualified tax-exempt obligations, on the other hand, may approach taxable obligation rates, making them less attractive for banks and other corporations. The interest expense deduction allocable to non-bank-qualified tax-exempt securities is generally disallowed for financial institutions.
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Frequently asked questions
A "qualified small issuer" is an issuer that issues no more than $10 million of tax-exempt bonds during a calendar year.
The interest expense attributable to carrying tax-exempt securities is generally not deductible. The nondeductible amount varies depending on whether the security is bank qualified (20% disallowance) or non-bank qualified (100% disallowance).
Financial institutions that are C corporations are subject to the TEFRA limitation for both bank-qualified and non-bank-qualified securities. Financial institutions that are S corporations are subject to the TEFRA limitation for non-bank-qualified securities and only the first three years of electing S-corporation status for bank-qualified securities.
The Act included a provision requiring banks to add back a portion of their interest expense on municipal bonds/loans, effectively eliminating the tax-exempt benefit. This led to a decline in demand for these bonds.
Municipal bonds are a type of tax-exempt obligation. State and local governments use the tax-exempt financing from these bonds to raise capital for public capital improvements and other projects, such as infrastructure facilities.
