4.26 Tax-Exempt Bonds Bought at a Discount

Original issue discount (OID) on tax-exempt obligations is not taxable, and on a sale or redemption, gain attributed to OID is tax exempt. Gain attributed to market discount is capital gain or ordinary income depending on whether the bond was purchased before May 1, 1993, or on or after that date; see below.

Original issue discount tax-exempt bond.

This arises when a bond is issued for a price less than the face amount of the bond. The discount is considered tax-exempt interest. Thus, if you are the original buyer and hold the bond to maturity, the entire amount of the discount is tax free. On a disposition of a tax-exempt bond issued after September 3, 1982, and acquired after March 1, 1984, you must add to basis accrued OID before determining gain or loss. OID must generally be accrued using a constant yield method; see IRS Publication 1212.

When bonds issued after June 8, 1980, are redeemed before maturity, the portion of the original issue discount earned to the date of redemption is tax-free interest; the balance of the OID, the “unearned” part is capital gain. Bonds issued with an intention to redeem before maturity are not subject to this rule; all interest is tax exempt.

Market discount tax-exempts.

A market discount arises when a bond originally issued at not less than par is bought at below par because its market value has declined. If before May 1, 1993, you bought at a market discount a tax-exempt bond which you sell for a price exceeding your purchase price, the excess is capital gain. If the bond was held long term, the gain is long term. A redemption of the bond at a price exceeding your purchase price is similarly treated.

However, for market discount tax-exempt bonds purchased after April 30, 1993, the ordinary income rules (4.20) apply.

Stripped tax-exempt obligations.

OID is not currently taxed on a stripped tax-exempt bond or stripped coupon from the bond if you bought it before June 11, 1987. However, for any stripped bond or coupon you bought or sold after October 22, 1986, OID must be accrued and added to basis for purposes of figuring gain or loss on a disposition. Furthermore, if you bought the stripped bond or coupon after June 10, 1987, part of the OID may be taxable; see Publication 1212 for figuring the tax-free portion.