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Series 7 practice questionhardTax Implications — Municipal Bond Taxation

An original issue discount (OID) municipal bond is purchased at issuance for $900 with a par value of $1,000 and 10 years to maturity. How is the $100 discount treated?

  1. ATaxed as a capital gain at maturity
  2. BTaxed as ordinary income at maturity
  3. CAccreted annually and treated as tax-exempt interest, increasing the cost basis each year✓ Correct answer
  4. DIgnored for tax purposes
Explanation

Why C — Accreted annually and treated as tax-exempt interest, increasing the cost basis each year

For OID municipal bonds purchased at issuance, the discount is accreted (added to basis) annually over the life of the bond and treated as tax-exempt interest income. Each year, the cost basis increases by the accretion amount ($100/10 years = $10/year). At maturity, the basis equals par ($1,000), so there is no capital gain. This differs from market discount bonds purchased in the secondary market.

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