This is educational content, not investment, tax, or legal advice. Consult an adviser for personalized guidance.
I'm pleased to welcome Elie Rozner back for a guest appearance at Tax Alpha Insider. We've teamed up before, including a piece about how tax-loss harvesting municipal bond ETFs within 6 months could mean some losses are permanently disallowed. He and I also co-authored Managing Concentrated Public Stock Positions by Seeding an Exchange-Traded Fund, which was recently published in The Journal of Wealth Management.
The Internet scrambled to their dictionaries after Treasury Secretary Scott Bessent called Elizabeth Warren's letter sciolistic. It quickly became a meme.
I don't care about their food fight. I care about the word sciolist, which I looked up and learned meant "pretended expertise" and shares the same root as the word science. Fun!
Anyway...
While municipal bonds are popular among high-income investors for their tax benefits, they have a hidden cost investors rarely consider.
The sciolist may suggest they could be ideal collateral for, say, a tax-aware long/short strategy, though that's probably a bit harsh.
Sadly, but for sound reasons, under IRC Section 265 ("expenses and interest relating to tax-exempt income"), taxpayers cannot deduct interest on debt that’s attributable to holding tax-exempt bonds.
This explains why many tax-aware long/short asset managers do not allow munis as collateral for long/short overlays. We have a numerical example below for the curious.
There are also cases where debt could be “attributable” to munis in surprising ways, and remove an interest deduction investors would normally expect.