zero coupon muni bond

[Bjorn]

Fact Pattern:
Bought zero coupon muni bond many years ago for $20,000.00.
In 2003 the tax payer received $49,000.00 when it was sold.

The transaction was issued on a 1099B when it was sold.

Question:
Is this "muni interest" or is this a capital gain? It was not reported on the tax return and now the IRS is asking questions.

The person is a resident of California and it is a California bond.
What is the proper reporting to get the IRS off the tax payer?

Can we just report the proceeds and basis as the same since the interest, we feel, is exempt from federal tax?

[Nancy]

IRS Publication 550, page 50

If the bond was redeemed before maturity the following paragraph will apply:

Redeemed before maturity. If a state or local bond that was issued before June 9, 1980, is
redeemed before it matures, the OID is not taxable to you.
If a state or local bond issued after June 8, 1980, is redeemed before it matures, the part of
the OID that is earned while you hold the bond is not taxable to you. However, you must report the unearned part of the OID as a capital gain.

[Mark Goldberg]

Sale of Bond

If the Bond was held to maturity it is safe to assume that there is little or no capital gain.
At least not enough to spend hours seeking the correct answer. So to report you just say sold for $49,000 and cost $49,000. However if it was sold or called before maturity you need to add to the $20,000 cost all the non taxable interest earned while your client owned the bond. The sum o fthese two numbers relative to the sale price is the gain or loss.

[Snaggletooth]

Myth

Again, here is a classic case of a myth out on the street, and commonplace even among sellers of securities.

Only the interest for a "tax-free" bond will be exempt. In general, if there is amortization of discount and/or gain/loss upon disposition (including redemptions) these items are taxable.

In the situation posted, probably the big problem is that someone assumed the transaction was not reportable at all, in spite of the 1099-B for $49,000. It is quite possible there is zero income, and overwhelmingly probable that if income exists, it is small.

Obviously, the interest was accumulated into the redemption value, rather than being paid to the bondholder in periodic payments. The basis of the bond when redeemed would be the original purchase price plus all the STATED interest accumulated into the bond, even though the interest was exempt. Additionally, since there was also OID amortized, the total of this should be added to the basis as well.

[Joe Bfstplk]

Zero Coupon bonds

An OID instrument accrues interest and is reported on Form 1099-OID if it is a taxable bond. The taxable OID accrual is taxable. By the same token, I would assume that the OID on a muni bond would accrue as non-taxable income.

However, if the bond is bought in the secondary market, the OID would need to be adjusted which could make the amount of the adjustment a taxable gain or loss. This sounds somewhat complicated, but if you read IRS publication 1212 you will find that it is the most mind-boggling tax computation ever devised. No tax preparer or IRS agent is ever likely to make such a calculation, so, for all practical purposes, I would say that the OID could be treated as non-taxable. To do otherwise would be to say such muni bonds are 100% taxable which woud obviously make them unmarketable unless they carried a far higher interest rate than a municipal or state bond issuer would want to offer.