With all of the states trying to raise revenues to deal with their budget shortfalls, the District of Columbia is not immune. One of the hidden gems of D.C.’s tax law has recently been changed. Until recently, DC did not have an “add-back” of any interest income that was considered tax-exempt for federal tax purposes (these are generally reported in Box 8 or 9 of Form 1099-INT or Box 10 or 11 of Form 1099-DIV).

Earlier this year, DC passed a legislation change related to the taxability of income from obligations of a state or municipality other than the District of Columbia, the Metropolitan Washington Regional Airport Authority, Puerto Rico, Guam, Virgin Islands, or American Samoa acquired on or after January 1, 2012. Income from such obligations will be taxable for DC income tax purposes beginning for tax years beginning after December 31, 2011 (for most taxpayers, this will be for their 2012 tax returns). Any securities purchased before January 1, 2012, or if they were issued by DC or the other exempt jurisdictions named above will continue to be exempt from DC income tax as long as it is held by the taxpayer. Most investment statements include details of the issuers of the bonds, including the issuing governmental authority.

For investments in mutual funds (or other types of funds), income from state and municipal bond funds is exempt from DC taxation to the extent that the mutual fund provides you with written or electronic substantiation of the income from bonds acquired prior to January 1, 2012. Without such information only the proportion of income that is income from DC bonds or the other exempt jurisdictions named above would be exempt from taxation. Most mutual fund investment statements include an allocation by percentage of the amount of income allocable to the different states.

Realistically, DC is just aligning itself to how other states treat income from of tax-exempt obligations. Its neighbor states of VA and MD have already been treating non-instate tax-exempt interest income as an add-back for years.

And on the bright side, DC still allows an exemption of taxable interest from U.S. Treasury bonds and other obligations. Also, DC does not impose income tax on non-residents, which virtually all other states do. So, hopefully, those two benefits will endure the test of time.

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE WOLF GROUP TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.