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Zero Coupon Municipal Bonds: Tax Treatment

If you sell the bond before maturity, you may also incur a capital gain, depending on how the price at which you sell compares to the adjusted issue price, plus accrued market discount. For example, suppose you bought a bond whose adjusted issue price was 80, for 76. You have four points of market discount. Suppose the bond has four years until maturity, and you decide to accrue one point of market discount per year.

After two years, the adjusted issue price of your bond would be 89.44, and you would have accrued an extra two points of market discount. If you sold the bond for more than 91.44, the two points would be taxable as ordinary income and the difference between 91.44 and the price you got is capital gain.

If, on the other hand, you sold at 90.44, you have to recognize only the one point of market discount as ordinary income.

A final wrinkle. If you buy a zero-coupon bond for more than its adjusted issue price, you get to reduce your annual accrual by a fraction each year. The fraction is the amount of premium you paid divided by the size of the original issue discount. So if you paid four points over the adjusted issue price for a zero-coupon bond that had been issued at a price of 60 (with an original issue discount of 40), you would reduce your annual accrual by 10% a year. For taxable bonds, that reduction would lower your tax bill. For municipals, there's no tax bill to begin with, so there's no benefit.

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TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.
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