How does the IRS treat municipal bond income?

Municipal bond income is treated by the IRS as generally tax-exempt at the federal level when the bonds are issued by governmental entities to finance public projects. This means that the interest earned from municipal bonds is not subject to federal income tax, reinforcing the idea that it is completely excluded from taxable income for federal purposes.

However, there are particular cases where municipal bond income may be subject to state or local taxes depending on the state in which the bondholder resides or from which the bond was issued. Moreover, certain types of municipal bonds, such as those issued for private purposes, might not enjoy the same level of tax-exemption.

Ultimately, while municipal bond interest is typically excluded from federal taxable income, the nuances of tax treatment can lead to situations where taxpayers must consider other factors regarding state taxation or specific bond types. This might give rise to the perspective that only parts of the income could be subject to tax in certain contexts, which aligns with the answer choice that mentions partial exclusion under specific circumstances.