Taxes and Market Discount on Tax-Exempts

The U.S. tax code contains a provision governing the tax treatment of bonds, including municipal securities, purchased at a market discount. Given recent market conditions, specifically a rising interest rate environment, questions regarding the treatment of market discount have become particularly relevant for many municipal bond investors, and some confusion has arisen over the application of this provision. This memo answers some frequently asked questions related to the treatment of market discount on municipal securities.

Market discount generally exists when a bond is purchased on the secondary market at a price below par. Market discount is the difference between the purchase price of a bond and its stated redemption price at maturity. In the case of a bond sold with original issue discount (OID), such as a zero-coupon bond, market discount is the difference between the purchase price and the issue price of the bond plus accreted OID. (See Q&A 7.) Accreted market discount is taxed as ordinary interest income in the year a bond is sold, redeemed or transferred.

Before May 1993, market discount on municipal securities was treated as capital gain, not as ordinary income. Under current law, accreted market discount is taxed as ordinary income at the time a bond is sold or redeemed. (A taxpayer may elect to include accreted market discount in taxable income on a current basis during the period he or she holds the bond. In most cases, however, this would not be advantageous.) The new rules for the taxation of market discount on municipal bonds apply to instruments acquired after April 30, 1993. Market discount bonds acquired before May 1, 1993 are still subject to the old rules.

The de minimis rule governs the treatment of small amounts of market discount. Under the de minimis rule, if a bond is purchased with a small amount of market discount—an amount less than 0.25 percent of the face value of a bond times the number of complete years between the bond’s acquisition date and its maturity date—the market discount is considered to be zero. If the market discount is less than the de minimis amount, the discount on the bond is generally treated as a capital gain upon disposition or redemption rather than as ordinary income.

No. OID exists when a bond is issued at a price below its redemption value. OID represents interest paid by the issuer and, for municipals, is generally treated as taxexempt interest. Market discount exists when a bond falls in value after it has been issued. Market discount is not treated as tax-exempt interest because it does not represent an interest expense of the issuer. An OID bond may be subject to the market discount rules if purchased after original issue at a time when the price of the bond reflects a market discount, i.e., if the bond is purchased at a price below its revised, or adjusted, issue price. (See below.)

OID and market discount are taxed differently. For taxable OID bonds, accrued OID must be recognized annually as taxable interest income. For tax-exempt municipal OID bonds, this income is not subject to the ordinary income tax, although it is required to be reported for informational purposes in the same manner as other tax-exempt bond interest. Accrued OID on municipal bonds is also potentially subject to the alternative minimum tax in the same manner as other municipal bond interest. Unlike OID, market discount is not subject to taxation annually. Accreted market discount only becomes taxable in the year the bond is sold or redeemed. Also unlike OID, market discount is taxable income regardless of the tax-exempt nature of a bond’s interest income.

For bonds acquired after April 1993, the amount of a bond’s market discount is accreted between the bond’s date of acquisition and its date of maturity. Accreted market discount must be included as ordinary, taxable income in the year a bond is sold, redeemed or otherwise disposed of. An investor may choose to accrete market discount on a daily basis using the ratable, or straight-line method, or using the constant interest rate method. The constant interest rate method corresponds to the economic accrual of interest based on the yield on a market discount bond at the time it is purchased.

For example, suppose an investor buys a tax-exempt bond—originally issued at par—in the secondary market at a price of 90 with ten years left until maturity. Five years later, he or she sells the bond at a price of 95. Assuming the discount is amortized on a straight-line basis, the investor must treat the five-point gain as ordinary income in the year the bond is sold. (Total market discount at the time the bond is purchased is ten points, accreted on a straight-line basis over the ten years until maturity. After five years, accreted market discount totals five points.) Suppose under the same circumstances, the investor sells the bond after five years at a price of 96. Five points (the total accreted market discount) are taxed as ordinary income and one point is taxed as a capital gain. Suppose, again under the same circumstances, that the investor holds the bond to maturity. Ten points (the entire amount of market discount) are taxed as ordinary income in the year the bond is redeemed. Finally, suppose the investor sells the bond after five years at a price of 88. In this case, the investor would recognize no market discount income and would recognize a capital loss of two points.

In another example, suppose the investor buys the bond at a price of 98 with ten years left until maturity. Because the amount of market discount, two points, is less than the de minimis amount (which in this case is 2.5 points, or 0.25 percent of the face value of a bond times the number of years between the bond’s acquisition and its maturity), the market discount is considered to be zero and the difference between purchase price and sales price or redemption is generally treated as a capital gain upon disposition or redemption.

For OID bonds, market discount arises when a bond is purchased on the secondary market at a price below the revised issue price of the bond (the bond’s issue price plus accrued OID). The revised issue price for tax-exempt OID bonds is calculated annually using the constant interest rate method and is equal to the original issue price plus accrued OID through the date of purchase. (The constant interest rate method corresponds to the economic accrual of interest based on the yield on an OID bond at the time it is issued.) For OID bonds, market discount is the excess, if any, of the revised issue price over the purchase price. As with other tax-exempt securities, market discount on OID bonds is accreted from the date the bond is purchased to the maturity date. Accreted market discount is taxed as ordinary income at the time a bond is sold or redeemed.

For example, suppose an investor purchases a 20-year, zero-coupon municipal bond at an original issue at a price of 50. Suppose further that after ten years, the revised issue price of the bond using the constant interest rate method is 70 (the original issue price of 50 plus 20 points of accrued OID) and the investor sells the bond to a second investor at a price of 60. When the bond matures, the second investor must include as ordinary, taxable income ten points of gain (the revised issue price at acquisition of 70, less the purchase price of 60). The remaining gain on the taxexempt bond attributable solely to OID (30 points) is not taxed.