Zero Coupon Municipal Bonds: Tax Treatment

I have been trying to determine whether zero-coupon municipal bonds are subject to market discount rules for taxation purposes. In short, is the buyer of a zero-coupon muni held to maturity ever subject to federal taxes (other than the alternative minimum tax)?

-- William Duke

William,

Ah, tax time.

In short, yes, buyers of zero-coupon municipal bonds may incur a tax liability, but that liability does not have to be recognized until the bond is redeemed or sold.

Before I go on, let me explain your question to other readers.

The question concerns tax-exempt zero-coupon municipal bonds.

A regular bond pays interest on its face value, or principal, twice a year at a rate determined by its coupon. A bond with a face value of $1,000 and a 6% coupon pays $60 a year in two installments until it matures and the principal is returned. Most coupon-bearing bonds are originally sold at face value.

Zero-coupon bonds don't have coupons, so they don't make annual interest payments. Instead, they are originally sold at a steep discount to face value, also known as an OID (original issue discount). For example, a bond with a face value of $1,000 may be sold for $500. So while zero-coupon bonds don't make interest payments, they do offer an interest rate that is a function of the difference between the purchase price and face value, and the time remaining until maturity. For example, a 10-year zero-coupon bond sold at a price of 50 (or $500 for a $1,000 bond) offers an interest rate, or yield, of 7.05%.

As explained to me by Michael Decker of the Bond Market Association, the tax rules for zero-coupon bonds bought as new issues and held to maturity are fairly simple.

Whether the bond is taxable or tax exempt, you have to accrue interest on the bond. That means you have to calculate the portion of the difference between the purchase price and face value that accrued to you each tax year, even though you didn't receive any payment. The interest accrues at the interest rate you obtained when you bought the bond. Using the earlier example, if you paid $500 for a 10-year, $1,000 bond getting an interest rate of 7.05%, you would accrue $35.25 of interest in the first year.

$500 x 0.0705 = $35.25

Your adjusted issue price, or cost basis, in the bond, would then become $535.25.

$500 + $35.25 = $535.25

The following year, you would accrue $37.74 of interest.

$535.25 x 0.0705 = $37.74

And so on.

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.

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.

RELATED STORIES:

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.

More from Rates and Bonds

What Is Inflation (In 60 Seconds)?

What Is Inflation (In 60 Seconds)?

Jerome Powell's Testimony Isn't Changing This Strategist's 3,000 S&P 500 Target

Jerome Powell's Testimony Isn't Changing This Strategist's 3,000 S&P 500 Target

Bond Yields to Slide for Rest of Year Amid Trade Turmoil, Morgan Stanley Says

Bond Yields to Slide for Rest of Year Amid Trade Turmoil, Morgan Stanley Says

Benchmark 10-Year Yield Pulls Back After Touching 3% on Fed Rate Hike

Benchmark 10-Year Yield Pulls Back After Touching 3% on Fed Rate Hike

HSBC CEO: It's Time to Kick Into Growth Mode

HSBC CEO: It's Time to Kick Into Growth Mode