FINRA Series 7Investment Information and Suitable RecommendationsHard
A client purchases a municipal bond at a discount in the secondary market. The bond has a par value of $1,000, pays a 4% coupon semi-annually, and was purchased for $950 with 5 years to maturity. Which of the following statements regarding the tax treatment of this bond is TRUE?
- AAll interest payments are fully taxable at the federal level.
- BThe annual interest income and the discount accretion are both tax-exempt at the federal level.
- CThe annual interest income is tax-exempt at the federal level, but the discount accretion is taxable as ordinary income at maturity.
- DThe discount accretion is considered a capital gain and is taxable only upon sale or maturity.
Show answer & explanationAnswer & explanation
Correct answer: B. The annual interest income and the discount accretion are both tax-exempt at the federal level.
For municipal bonds purchased at a discount in the secondary market, the annual interest income is tax-exempt, and the discount must be accreted. This accretion increases the cost basis and is also considered tax-exempt interest income, not a capital gain, if held to maturity.
Why the other options are wrong
- A. Municipal bond interest is generally federal tax-exempt.
- C. The discount accretion on original issue discount (OID) municipal bonds and secondary market discount municipal bonds (if held to maturity) is treated as tax-exempt interest, not ordinary income.
- D. The discount accretion on a municipal bond is treated as tax-exempt interest, not a capital gain. If sold prior to maturity, any gain above the accreted basis would be a capital gain.
Municipal Secondary Market Discount Tax
For municipal bonds bought at a discount in the secondary market, the discount must be accreted annually. Both the annual interest income and the accreted amount are generally federal tax-exempt.
- Accretion increases cost basis annually.
- No phantom income is created for tax-exempt bonds.
- If sold prior to maturity, any gain above the accreted basis is a capital gain.
Memory trick: Buying a muni cheap in the secondary market means both the coupon and the 'catch-up' discount are usually tax-free hugs from Uncle Sam.