Muni bond premium - state issue

[ttbtaxes]

Client bought non-NYS municipal bonds at a premium and the interest is reported on Schedule B. The year-end brokerage statement also lists out the bond premium accretion amount. That amount gets subtracted from the total muni interest on Schedule B. The brokerage house reports the municipal interest to the IRS and and the taxpayer's resident state (NYS in this case). The bond accretion is NOT reported to the IRS nor to NYS.

When the taxpayer files his resident NYS tax return the muni interest is shown as income (through an addback) because all of the bonds are non-NYS bonds. The brokerage house has reported the full amount of the muni interest but the addback should be the full amount LESS the bond premium accretion.

How does the taxpayer avoid getting a tax notice from NYS in the future for interest income not fully reported?

[Kram BergGold]

Bond Premium

Muni bond premium unlike taxable bond premium can't be subtracted from the interest. It has to be amoritized down as a reductioon of basis every year. So client pays tax on 100% of the non NY muni bond interest.

[buzzardbreath]

Agree with KramGold

The stated interest is the only item non-taxable with a municipal bond. Original issue discount, and gains/losses are taxable.

Amortization of a premium is not periodically taken as deductible expense. Upon redemption or sale, the taxpayer is instead allowed a deduction for the initial unadjusted basis in the bond.

[ttbtaxes]

I thought the same thing until I came across Example 4 (and its conclusion in part iv) in Reg 1.171-2(c) which shows the premium accretion offseting the interest payment received.

Am I reading it wrong?

[buzzardbreath]

Changing my tune

Thanks for setting me on the right track. I've read the regulation and come away with the same thing you have.
Looks like a bond premium is not a tax-friendly thing. Not only does it offset tax-free income (which does the investor no good), but it also reduces the basis such that you can't take a loss when the bond is redeemed.

Moving the discussion into state income tax, and you have told us the bond is not from the resident state.

Appears the tax-free interest (adjusted downward for the premium accretion) is tax free for federal only. However, the interest is not free to the resident state to begin with. So the premium accretion would reduce the other-wise taxable interest for the resident state.

To answer your original question about the "matching" of the reporting to the state taxability: I agree there is no correct match. I can only hope tax exempt bonds do not have matching sophisticated enough to detect the problem, or that the state recognizes that differences do exist. Outside of this, I have no practical solution other than to disclose the discrepancy on the state return (which could cause more problems than it solves).

Under any condition, I would report the lesser amount as taxable to the state of residence.