Investors have several buying options and may purchase municipal bonds at prices above, below, or at par value. We will examine three scenarios here:
- Bonds purchased at a market discount.
- Bonds purchased as an original issue discount.
- Bonds purchased at a premium.
Municipal Bond Purchased at Market Discount
Market discounts can occur due to an increase in interest rates or a reduction in the credit worthiness of the issuer. The IRS has ruled that if an investor buys a tax-exempt bond at a market discount to par after May 1, 1993, the investor must pay ordinary income tax on the value of the discount just as if it were a taxable bond. This can be paid over the life of the bond or at maturity.
Municipal Bond Purchased at Original Issue Discounts
When an issuer issues a municipal bond below par, the entire discount is considered tax-exempt. The IRS considers this an issuer-based discount as opposed to a market-based discount. A common example of this is the zero-coupon municipal. The investor can incur a capital gain or loss upon sale of these bonds if the difference between what is paid is more or less than the original issue discount.
Municipal Bond Premiums
If an investor buys a tax-exempt bond at a premium, he must amortize the premium over the period he owns the bond. This amortization reduces his basis in the bond, but unlike a taxable bond, he can't deduct the amortized amount. The premium amortization is not deductible because the interest is not taxable.
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