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Series 7 practice questionmediumTax Implications — Municipal Bond Taxation

An investor buys a municipal bond at a premium ($1,050 for a $1,000 par bond with 10 years to maturity). How must the premium be handled?

  1. AThe premium can be deducted as a loss at maturity
  2. BThe premium must be amortized annually, reducing the cost basis and the tax-exempt interest reported✓ Correct answer
  3. CThe premium is ignored for tax purposes
  4. DThe premium is deducted immediately as a current-year expense
Explanation

Why B — The premium must be amortized annually, reducing the cost basis and the tax-exempt interest reported

For municipal bonds purchased at a premium, the investor must amortize the premium over the remaining life of the bond. Each year, the amortized amount reduces the bond's cost basis and the amount of tax-exempt interest income reported. At maturity, the basis equals par value ($1,000), so there is no capital loss. This is mandatory for municipal bonds, unlike corporate bonds where amortization is elective.

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