Investing Tax Free
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Original Issue Discount (OID) of Municipal Bond

Constant Yield To Maturity

In order to avoid this result, the Internal Revenue Code (the "Code") provides that the holder's basis will increase over time based on a "constant yield to maturity" (CYM) method. Because this CYM method is also utilized for other purposes related to tax-exempt bonds, including the treatment of premium and "market discount," we will calculate the CYM on the above bond to demonstrate how the holder's basis is increased.

In order to determine the constant yield to maturity on a municipal bond, it is necessary to determine a constant discount rate that must be applied to each and every payment on the municipal bond (principal and interest) in order to produce an aggregate value (as of the issue date) that is equal to the issue price of the municipal bond. Using the above example (a bond that will pay $125 semi-annually for 10 years, with a final principal payment of $5,000 at the end of such ten year period), the discount rate that must be applied to each of those payments to produce a value of $4,628 is 6.00%, compounded semi-annually.

Thus, even though the stated interest rate is 5%, the municipal bond actually produces a yield to the municipal bond holder of 6% due to its being issued at a discount. This 6% CYM will enter into the accretion of the holder's basis and such basis will increase each year by an amount equal to the excess of

  1. the accreted issue price at the beginning of each semi-annual period multiplied by the 3% yield (6% annual yield divided by 2 to reflect interest payments), over
  2. the amount of interest actually paid on the municipal bond during such period.

For instance, assume the municipal bond holder purchased the municipal bond upon issuance on July 1, 2003. The holder's basis six months later on January 1, 2004 would be equal to the opening basis of $4,628 plus ($4,628 x 3% or $138.84) minus ($125 of interest), which will produce a basis of $4,641.84 as of January 1, 2004. Because this calculation is only necessary to determine the municipal bond holder's basis, it need not be done by the municipal bond holder until sale or other disposition of the municipal bond and, if the municipal bond holder holds the municipal bond until maturity, it need never be done. The basis of a municipal bond purchased at issuance and held to maturity will equal the principal amount of the municipal bond at maturity.

In the case of a taxable bond, if the OID is less than one-fourth of one percent (1/4%) of the principal amount of the bond multiplied by the number of full years until the bond's maturity, the OID is treated as de minimis and is ignored. This rule does not apply in the case of a tax-exempt bond in order to ensure that the full amount of OID is treated as tax-exempt interest to the holder and that the holder does not have an "artificial" gain on the sale of the bond.

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