Market Discount of Municipal Bonds

How would market discount of tax exempt bonds be calculated in the case of a tax-exempt bonds that was originally issued at a discount?

For example, the tax exempt bond that was discussed in section 2 (Original Issue Discount or OID) was issued at $4,628 on July 1, 2003, had a coupon rate of 5.00%, and a yield to maturity of 6.00%. On July 1, 2004, the original holder would have accrued $28.10 in original issue discount or OID (calculated by multiplying the issue price by 3%, reducing that amount for the actual interest paid, and repeating the calculation for two semi-annual periods). Thus, the "adjusted issue price" would be $4,656.10 ($4,628, plus the accrued OID).

Assume the tax exempt bond holder sells the tax exempt bond for $4,456.10 ($200 less than the adjusted issue price). In that case, the new tax exempt bonds holder has $200 of market discount. The new tax exempt bond holder will continue to accrue the tax exempt OID at the same rate as the prior holder (and for this purpose should consult IRS Publication 1212 for the appropriate amount of OID that accrues each period). Those amounts of OID will equal, in the aggregate, $343.90 by the time the bond matures ($5,000 face amount minus the adjusted issue price of $4,656.10). When the second tax exempt bond holder adds that amount to his cost basis of $4,456.10, he will have a final basis of $4,800 in the bond. If the second tax exempt bonds holder holds to maturity, he or she will thus recognize a gain of $200 ($5,000 proceeds on maturity minus $4,800 basis). Since this gain is wholly attributable to the market discount, the gain will be taxed as ordinary income.

What if the second tax exempt bonds holder sold the tax exempt bond prior to maturity? In that case, he would have to determine his adjusted basis by starting with his cost basis ($4,456.10), and adding to that the amount of OID that has accrued (based on the original discount on the tax exempt bond). If the tax exempt bonds holder would sell after two years, the amount of OID that would accrue in the above example would be $61.42 in those two years. Thus, the second tax exempt bonds holder's basis would increase to $4,517.52. If he sold the tax exempt bond for $4,600, he would have a gain of $82.48. Part of that gain is attributable to the $200 market discount at the time he bought the bond. That market discount accrues on a straight-line basis at the rate of ($200 divided by 9 years) or $22.22 per year. Since he has held the tax exempt bond for two years, $44.44 of his gain is ordinary income and the remaining $38.04 is long term capital gains.

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