While you don't have to pay ordinary income tax on it, the IRS wants to know how much tax-exempt municipal bond interest you are receiving, and in some cases it can be used to limit your qualification for certain other tax breaks. Therefore, tax-exempt interest from state and local municipal bonds, including mutual funds that invest in these bonds, must be listed on the dotted lines provided for detailed information under Line 1 on the Schedule B, but it is not included in the "Amount" column on the right side of the page.

Reporting. The IRS requires payors of tax-exempt interest of $10 or more to furnish an annual report to the recipient of the interest and to the IRS. The payor may be the issuer or a corporate paying agent hired by the issuer. Either Form 1099-INT or a substitute form may be used. If a substitute is used, it must provide the following information:

• Payor's name, address, phone number, and EIN
• Payee's name, address, TIN (if available), and account number
• Amount of tax-exempt interest paid
• Amount of tax-exempt AMT interest, if it can be reasonably determined
• Federal income tax withheld, if any

Work Smart To clearly differentiate your tax-exempt interest, some tax practitioners recommend splitting the "dotted line" area into two columns labeled "tax-exempt" and "taxable," to make it very clear how much of which types of interest you've received. Or, you may want to add a separate page to your return that clearly details these amounts.

The total amount of tax-exempt interest you receive during the year must also be carried over to the front of your tax return, on Line 8b of both Form 1040 and 1040A.