36 MARCH / APRIL 2017 The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. In a rising rate environment, bonds priced at a discount become more prevalent; therefore, it is imperative that municipal bond investors consider the tax implications of purchasing municipal bonds at a discount. Discounts that occur in the secondary market are known as “market discounts,” and those that occur at issuance are known as “original issue discounts.” The nature of the discount is key to determining the after-tax yield. Market Discount If the discount is due to market factors, then the difference between the accrued discount price at the disposal date and par is taxed as ordinary income. Examples of market factors include changes in yield levels and credit risk. Original Issue Discount If the bond was issued at a price less than par, then the discount is treated as interest. For a tax-exempt municipal bond, the discount would not be taxed. Zero coupon bonds have an original issue discount (OID), but there can be an OID for coupon-paying bonds, as well. As time progresses, the accrued interest is added to the issue price to adjust the tax basis of the bond. If an OID bond is purchased in the secondary market, then a market discount may also be present if the discount is deeper than the OID adjusted for accreted interest since the issue date, also known as the “revised issue price.” The market discount is taxed as ordinary income, and the OID is taxed as interest. The process of determining the tax implications of discount municipal bonds is summarized in Exhibit 1. Example 1 – Bond Issued at Par and Purchased at a Discount Issue price: $100 Purchase price: $99 The purchase price is less than the issue price; therefore, the discount is a market discount. The difference between the purchase price and the issue price is taxed as ordinary income. Example 2 – OID Bond Purchased Below the Revised Issue Price Issue price: $60 Revised issue price: $65 Purchase price: $64 The purchase price of $64 is less than the revised issue price of $65, so there is a market discount present in addition to the OID. The market discount of $1 ($65 - $64) is taxed as ordinary income, while the remainder of the discount is taxed as interest. Understanding the Tax Treatment of discount municipal bonds Article author Dana Sparkman Municipal Analyst The Baker Group dana@gobaker.com DIRECTORS / SENIOR MANAGEMENT Exhibit 1
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