Pub. 8 2017 Issue 1

www.wvbankers.org 8 West Virginia Banker Understanding the Tax Treatment of Discount Municipal Bonds By Dana Sparkman, The Baker Group I n a rising rate environment, bonds priced at a discount become more prevalent; therefore, it is imperative that municipal bond investors consider the tax implications of purchasing municipal bonds at a discount. Discounts that occur in the secondary market are known as “market discounts” and those that occur at issuance are known as “original issue discounts.” The nature of the discount is key to determining the after-tax yield. Market Discount If the discount is due to market factors, then the difference between the accrued discount price at the disposal date and par is taxed as ordinary income. However, in some cases the market discount may be small enough so that it is taxed as a capital gain. This is known as the “de minimis rule.” Specifically, if the discount is less than .25% multiplied by the number of full years until maturity times the par value, then the discount is considered small. The difference between the discount price and the par value may be treated as a capital gain and taxed at the corresponding capital gain rate rather than the ordinary income tax rate. Original Issue Discount (OID) If the bond was issued at a price less than par, then the discount is treated as interest. For a tax-exempt municipal bond, the discount would not be taxed. Zero coupon bonds have an OID, but there can be an OID for coupon-paying bonds as well. As time progresses, the accrued interest is added to the issue price to adjust the tax basis of the bond. If an OID bond is purchased in the secondary market, then a market discount may also be present if the discount is deeper than the OID adjusted for accreted interest since the issue date, also known as the “revised issue price.” If the price is within the de minimis rule’s limit, then the difference between the price and the revised issue price is taxed as a capital gain, and the remainder of the discount is taxed as interest. Otherwise, the market discount is taxed as ordinary income and the OID is taxed as interest. Example 1 – Bond issued at par and purchased within the de minimis limit Issue Price: $100 Purchase Price: $99 Years to Maturity: 8 The purchase price is less than the issue price; therefore, the discount is a market discount. However, the amount of discount allowed by the de minimis rule is $2 (.25% x 8 x 100). Since the purchase price of $99 is within the de minimis limit of $98 ($100-$2), the discount is taxed as a capital gain.