Investing Tax Free
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Market Discount of Municipal Bonds

In general, the effect of the election is to slightly decrease the rate at which the market discount of municipal bonds is deemed to accrue, which will generally produce a beneficial result for the municipal bond holder by reducing the amount of ordinary income recognized on a sale of the municipal bond prior to maturity. If the municipal bond holder retains the bond until maturity, both methods will produce the same result with the entire amount of market discount taxed as ordinary income.


In the above example, the market discount accrued ratably over the remaining term to maturity of the municipal bond, i.e., on a straight-line basis. Alternatively, a municipal bonds holder can elect to accrue market discount using the same method that is used for OID (i.e., using a constant yield-to-maturity method).


If the market discount is below a certain "de minimis" amount, it is treated as zero. In the case of tax exempt bonds, this is beneficial to the tax exempt bond holder because, although the discount will be taxable when the bond matures, it will be taxed as capital gains tax instead of ordinary income. Market discount is treated as de minimis if it is less than one-fourth of one percent (1/4%) of the redemption amount of the tax exempt bond (typically the par value) multiplied by the number of complete years until the tax exempt bond matures, measured from the date it is acquired by the holder.


For example, if an individual acquires in the secondary market a $10,000 face amount tax exempt bond (issued at par) on January 1, 2004 for a price of $9,800, and the tax exempt bond matures on January 1, 2014, the $200 market discount of the tax exempt bond is de minimis. This result occurs because the face amount of the tax exempt bond $10,000 multiplied by 1/4 of one percent, multiplied by 10 years until maturity, equals $250. Thus, any market discount of tax exempt bonds less than $250 is de minimis. If the purchase price had been exactly $9,750, the market discount would not have been de minimis and would have been treated as ordinary income upon maturity of the tax exempt bond.

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