Municipal bond fund regulation

According to the Tax Reform Act of 1976 a fund must hold a minimum of 50% tax exempt bonds in order to qualify to pass tax exempt income to its shareholders.

Section 2137(c) of the Tax Reform Act of 1976, I.R.C. § 852(b)(5), provides in pertinent part: "If, at the close of each quarter of its taxable year, at least 50 percent of the value... of the total assets of the regulated investment company consists of [state and local government] obligations . . . such company shall be qualified to pay exempt-interest dividend . . . to its shareholders." The section provides further that an exempt-interest dividend "shall be treated by shareholders. . . as an item of interest excludable from gross income."

In late 1976 mutual fund companies introduced funds investing in municipal bonds.

A balanced fund holding municipal bonds can hold a maximum of 50% stocks, and still qualify for the pass-through of tax exempt interest. These regulations account for the allocation policy of the Vanguard Tax-Managed balanced fund, which has a policy of maintaining a 50/50 target asset allocation between stocks and municipal bonds.