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The Coming Boom in Municipal Bonds

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However the "fiscal cliff" nonsense ends, it's likely to mean a hike in the tax on investment income.

How high is the question.

A CBS Moneywatch story in November figured capital gains rates could go to 20%, from the current 14%.This seems to be the Obama administration's latest proposal to avert the cliff, and even if it's accepted, that is an increase of over 30%.

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What happens if you go "cliff-diving?" Rick Ferri calls what would then happen a "tax mountain" with rates as high as 43% on some dividends, for folks earning over a quarter-million dollars per year.

But there is a bit of fine print in even Ferri's dire warning. "Tax-exempt interest from municipal bonds is excluded."

It's one of those things that make you go, "Hmmm."

While there have been some high-profile municipal defaults in recent years -- Stockton and Bakersfield, Calif., and Birmingham, Ala., are three that come to mind right away -- the fact is that, as BHJ Advisors noted in August,

The default rate of municipalities is much lower over every time period than the default rate of corporations. In fact, over the past 10 years, the default rate for AAA-rated corporate bonds is actually greater than the rate for Baa rated municipal bonds.

Municipal bond issuance has jumped in 2012, but that is mainly in relation to a slack 2011, which was also a peak for defaults, notes The Bond Buyer. Bill Gross of PIMCO is snapping them up by the armload, writes Forbes.

If you're interested, there is something you ought to know. The tax treatment of a municipal bond differs depending on where you live, and whether your state imposes an income tax. Currently eight states have no state income taxes, Wikipedia notes, and another seven have flat rates, the same for all income levels.

Thus, the best way to invest in munis is to stick close to home, where you can actually see the results of your investment and where you can avoid the maximum in taxes.

I live in Atlanta, Ga., where I like to ride my bicycle. Municipalbonds.com tracks bond sales, and my city recently issued some bonds that run until 2039 to build a bike trail around the city known as the Beltline. It's got a 5% coupon, and it's presently trading near par value. Part of the trail has even been built.

That's a yield of 5% exempt from federal and state income taxes for as far out as I'm likely to live. Chances are, you have some projects like that in your city you can invest in. You'll pay a tax on the capital gains if you sell them, and I think you're very likely to have some because, as noted earlier, tax-free is about to beat taxable by a country mile.

This also means that cities and states are going to be encouraged to issue a lot more bonds next year, assuming these higher tax rates hold. It means a lot of infrastructure projects around you that have been delayed for many years may finally get done. It means new roads, schools, and bridges. It means an opportunity for you to make some money tax-free, too. Win-win.

Tax law changes always impact upon investment trends. We forget that when taxes go up, that favors some investments. I don't think investors have yet caught on to the great deals they can get on municipal bonds. If you buy before the end of the year, you can beat them to it.

At the time of publication, the author had no investments in municipal bonds.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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