If and when President Donald Trump unveils his latest tax plan, which could be as early as Wednesday, financial advisors working with wealthy clients may want to pay particular attention to the treatment of municipal bonds.
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Many wealthy investors own municipal bonds or municipal bond funds because the interest on those bonds are exempt from federal, state and local income taxes. Those clients would benefit from cuts in the top marginal income tax rates, but the value of their muni holdings could drop if tax deductions on itemized returns are capped and if the deduction for state and local income taxes from federal taxes is eliminated.
Demand for munis could also decline if marginal corporate tax rates are cut since banks and insurance companies have been buyers of munis, according to Christopher Ryon, a municipal bond fund portfolio manager at Thornburg Investment Management.
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There’s also the possibility that municipal bonds could lose their tax-exempt status, but that appears less likely than the loss of the state and local tax deduction from federal returns.
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There’s no specific proposal yet, but Trump’s various tax plans to date and the most recent Republican tax plan “imply that they would get rid of most tax deductions,” says Howard Gleckman, senior fellow at the Urban-Brookings Tax Policy Center, a nonpartisan think tank based in Washington. “The assumption that everyone makes is that the state and local deduction will be on the block, and they’re probably right.”
Deductions would be eliminated or capped to help make up for the revenue lost from personal and corporate income tax cuts, and that would likely affect the muni market in states and cities that levy income taxes.
“If the state and local tax deduction is ended, it will be much more difficult for states and localities to raise taxes to pay their bills,” says Gleckman.
Those governments could turn more to revenue bonds, whose interest payments are tied to revenues collected from tolls or user fees, but there are no revenues for many of the projects that muni bonds pay for such as schools.