WASHINGTON — The District of Columbia’s budget vote last Wednesday jolted local municipal bond investors who could see their taxes jump on Oct. 1 as a result of a provision to tax the interest earnings from munis issued outside the district.

By Friday, some District Council members were scrambling to stop the tax from applying to outstanding munis, saying it would hurt seniors who traditionally invest in them for security and tax-free income.

The budget comes up for a final vote on June 14 before it is sent to Congress for approval. Council member Jack Evans said he will introduce an amendment to “grandfather” the exemption for outstanding municipal bonds, meaning the tax will not apply to investors’ current holdings of munis issued outside the district.

The budget initially introduced Wednesday by council chairman Kwame Brown had a grandfather clause to keep the exemption for outstanding munis. But during the budget debate, council members voted 7 to 6 for an amendment sponsored by council member Tommy Wells that would make the tax effective on Oct. 1, the beginning of the district’s fiscal year, for both outstanding and new munis issued elsewhere.

The tax is estimated to raise $13 million in fiscal 2012 and could eventually generate up to $30 million a year, according to district chief financial officer Natwar Gandhi. The tax is one of the provisions council members enacted to close the city’s $322 million shortfall for fiscal 2012. If the interest exemption is grandfathered, it would not raise any new revenue because investors in the district would shy away from new bonds issued elsewhere, Evans said.

The Wells amendment would remove the muni tax from a list of contingency priorities — programs that would not be cut if more revenues are found to close the district’s budget shortfall. The programs include spending for homeless shelters, affordable housing, and mental health services, among others.

Evans said his amendment will be aimed at getting the muni tax back on that list.

“If we get additional revenues in June and-or September, it will be enough to cover the grandfathering-in of people who have purchased” municipals, Evans said in an interview Friday. The district forecasts its revenues quarterly.

The district taxes individuals with incomes above $40,000 at a rate of 8.5%. Evans said he has received e-mails from anxious seniors who want to avoid the muni tax. If the muni tax becomes law, “that’s a lot of money if you weren’t expecting it,” Evans said.

Wells will oppose Evans’s amendment if its “goal is to prioritize a tax exemption before restoring cuts” to social services,  Charles Allen, his chief of staff wrote in an e-mail Friday. The prospect of the muni tax puts district investors in a conundrum: sell their out-of-district portfolio or take the tax hit. Investors who sell the munis and replace them with the district’s bonds expose themselves to greater credit risk, local wealth managers said.

The proposed muni tax “puts investors in a tight spot because basically if they don’t want that tax increase, they are going to be forced to buy the D.C. bonds,” said Scott E. Beck, president of district-based Chesapeake Investment Management LLC. “I don’t think [the district’s bonds] are looked on all that favorably,” he added.

Clients “are in a tough situation,” said Adrian Kutko, managing director for district-based Lepercq Lynx Investment Advisory. Many of his district clients have just about 15% of their muni portfolios in D.C. bonds.

“It’s an unfortunate situation for the D.C. clients,” he said. The district “doesn’t really have that many high-quality credits.” The firm expects to buy some additional district bonds if the law passes, he said.

The district’s general obligation bonds are rated A1 by Moody’s Investors Service and A-plus by Standard & Poor’s and Fitch Ratings. The district has a AAA rating from Standard & Poor’s on its income tax-secured bonds, which are rated Aa2 by Moody’s.

The tax would not have the impact for investors today that it would have had five years ago because munis are not as attractive an investment — “a reflection of what’s going on in the municipal bond market in general,” said Elizabeth Larson, a principal with district-based Evermay Wealth Management. The firm manages about $290 million, including $16 million of munis, she said.

The tax would “put another nail in the coffin for why not to buy municipal bonds for D.C. residents,” she said.

With the budget vote, the district joins 42 states that are taxing each others’ municipal bonds. Eight states do not collect income taxes.

At the beginning of the year, Indiana and the district were the last two jurisdictions with income taxes to exempt munis issued outside their borders. In April, Indiana passed a law to tax muni interest on out-of-state bonds with a grandfather clause so that the tax would only apply to munis purchased after Dec. 31, 2011.

Bond issued by Guam, Puerto Rico, and the Virgin Islands are unique in that they are not taxed by any states or the district.

The muni tax idea has been considered before in the district. In 2004, the provision was introduced but eventually dropped when the district received an unexpected $50 million of sales tax revenues. Then-Mayor Anthony Williams had also introduced a similar plan in 2002, but that was dropped following a public outcry.


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