Series 7 practice questionmediumTax Implications — Municipal Bond Taxation
A municipal bond purchased in the secondary market at a discount is subject to the de minimis rule. If a bond with a par value of $1,000 and 10 years to maturity is purchased at $960, how is the discount treated?
- AThe entire $40 discount is tax-exempt
- BThe $40 discount is taxed as a capital gain at maturity
- CThe $40 discount is taxed as ordinary income at maturity because it exceeds the de minimis threshold✓ Correct answer
- DThe discount is ignored for tax purposes
Explanation
Why C — The $40 discount is taxed as ordinary income at maturity because it exceeds the de minimis threshold
The de minimis rule states that if a market discount exceeds 0.25% of par per year to maturity (0.25% x $1,000 x 10 years = $25), the entire discount is taxed as ordinary income at maturity rather than as a capital gain. Since the $40 discount exceeds the $25 de minimis threshold, all $40 is ordinary income. If the discount were $25 or less, it would be taxed as a capital gain.
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