This Day On The Street
Continue to site right-arrow
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Zero Coupon Municipal Bonds: Tax Treatment

If the bond is taxable, the annual accruals will be reported to you on a 1099-OID form and you have to pay income tax on them. That's why many people opt to hold taxable zero-coupon bonds in tax-deferred accounts. If the bond is a tax-free municipal, the accruals aren't taxable and they won't be reported to you. Simple as that.

Where it Gets Complicated

It gets more complicated when a zero-coupon bond is either bought in the secondary market (as opposed to being bought as a new issue), sold before maturity, or both.

Let's start with the sold-before-maturity scenario.

If you sell a zero-coupon bond before it matures, you may incur a capital gain or loss. That depends on how the price at which you sell compares to the adjusted issue price, which you've been calculating each year for tax purposes (see the example above). If you sell for more than the adjusted issue price, you have a capital gain. If you sell for less, you have a loss. It doesn't matter whether the bond is taxable or tax exempt.

On to buying in the secondary market, the subject of your question.

If you buy a zero-coupon bond in the secondary market, and the price you pay for it happens to be the adjusted issue price, you're golden. You just follow the same rule you would have followed had you bought it new.

But in all likelihood, the price you paid will be either lower or higher than the adjusted issue price.

If it was lower, you've got what's called a market discount. That's the difference between the adjusted issue price and the price you paid. Eventually, you'll have to pay ordinary income tax on it, whether the bond is taxable or tax exempt -- but not until the bond matures or you sell it.

In the meantime, you accrue the market discount using the same formula used to accrue the original issue discount, described above. Or you can use a so-called straight-line formula. Under the straight-line formula, if you have 10 price points of market discount and 10 years till maturity, you would accrue one point of market discount a year.

If you hold the bond to maturity, you pay income tax on the full amount of market discount at that point, whether the bond is taxable or tax-exempt.

2 of 3

Select the service that is right for you!

Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!


DOW 17,959.44 +154.64 0.87%
S&P 500 2,078.54 +7.89 0.38%
NASDAQ 4,781.4240 +16.0440 0.34%

Brokerage Partners

Rates from

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs