Caveat emptor -- let the buyer beware! If ever that old Latin phrase had meaning, it certainly should be applied now when purchasing municipal bonds. Congress, in its own inimitable way, has managed to throw a large monkey wrench into the municipal-financing apparatus: On Dec. 17, the House passed HR 3838, the Tax Reform Act of 1985. Certainly, the true spirit of tax-free financing was being abused by the proliferation of "private purpose" bonds -- student loan securities, industrial development bonds, stadium bonds and so forth. But the House passed a massive "tax reform" bill with many new provisions that have made it virtually impossible for issuers to be certain that the bonds are within the provisions of HR 3838, and for buyers to know that an issue is fully within the provisions of HR 3838.

When a municipal bond is issued, it is accompanied by a legal opinion printed on the bond. There are two main reasons for a legal opinion. First, the bond counsel of the issuer must make sure that the bonds are binding obligations of the issuer according to state and local statutes. Next, the bond counsel must verify the tax-exempt status of the interest payments that investors will be receiving according to federal and local laws. Congressional aides see no problems with legal opinions. Because HR 3838 is binding from Jan. 1, 1986, aides feel that a legal opinion stating that the new issue is in compliance with the new bill is sufficient. More reasonable persons have suggested that the effective date be changed from Jan. 1, 1986, to July 1, 1986, or even Jan. 1, 1987, so that all of the ambiguities may be ironed out. But senior senators denied this request, because they did not want to lose any revenue. So it is advisable, at best, to obtain a "qualified" legal opinion from congressional aides, but under no circumstances should one purchase a municipal issued after Jan. 1, 1986, that does not have a legal opinion.

However, HR 3838 includes changes that easily could render the true tax-exempt status uncertain. For example, in the issuance of an "essential-function" or a "governmental" bond (most public-facility financings that are secured by general obligation pledges of state and local governments), 5 percent of the proceeds must be spent within 30 days of issuance, and the remaining 95 percent within three years. If these requirements are not met, the interest can be deemed taxable retroactively to the date of issuance by the IRS. Many state and local governments are simply unable to act with such speed, and many operate under old laws that prohibit any action on their part until the proceeds of the bond sale are in the bank. This new provision is included to force the state and local entities to streamline and speed up their operations. Great, but how would you like to buy a tax-exempt bond and find out four years later that it is now taxable because the local government was unable to spend all its bond proceeds within three years?

There are many other items that should be written about: the alternative minimum tax of 25 percent; limits, or caps, on "nongovernmental" or "nonessential function" bonds, and so forth. But already the marketplace has begun to differentiate between pre-Jan. 1, 1986 and post-Jan. 1, 1986 bonds. There is a 30-basis-point spread between pre-1986 Washington Suburban Sanitary District bonds of Maryland and their 1986 "sisters." In other words, where the new 2005 maturity is offered at 7.90 percent, the old 2014 maturity is offered at 7.60 percent. (A basis point is one one-hundredth of a percentage point.)

Lastly, because HR 3838 is only "half a bill," there are serious doubts as to the outcome once the Senate and the conference committee have worked it over. For one thing, HR 3838 calls for lower tax brackets. But the furor over Gramm-Rudman-Hollings could lead to a tax increase. So remember caveat emptor, until more definitive and sensible guidance is forthcoming from Congress, and if you must buy tax-exempts, purchase pre-1986 issues. Lebherz has 26 years' experience in fixed-income investments.