Original Issue Discount of Municipal Bond

If tax exempt bonds are originally issued at a price less than par (as distinguished from a subsequent sale of a previously-issued bond), the difference between the issue price of such tax exempt bonds and the amount payable at the maturity of the bond is considered " original issue discount " ( or OID).

For instance, if a $5,000 face amount tax exempt bond (with a maturity of 10 years and a stated interest rate of 5%, payable semi-annually) is issued for $4,628, the tax exempt bond is treated for federal tax purposes as issued with $372 of original issue discount (OID) ($5,000 minus $4,628). From the bondholder's perspective, original issue discount (OID) is simply additional interest that the municipal bond holder will receive on the municipal bond, except that it is paid at maturity instead of annually throughout the life of the municipal bond. In the case of a tax-exempt bond, such OID is treated as tax-exempt interest.

Although the OID or original issue discount of municipal bonds is treated as tax-exempt to the municipal bond holder, it will increase the holder's tax "basis" in the municipal bond (over the life of the municipal bond) for purposes of calculating capital gains or capital loss if the municipal holder disposes of the municipal bond prior to maturity.

In the example above, the value of the municipal bond on the day it is issued is $4,628; at maturity, the municipal bond will be worth $5,000 (assuming it is not in default). If interest rates remain stable, the value of the municipal bond will increase over time from $4,628 to $5,000. If the OID, original discount issue, did not increase the holder's tax basis during the period the municipal bond is outstanding, a sale of the municipal bond for an amount in excess of $4,628 would produce taxable capital gain to the bondholder, even if the increase in value arose solely as a result of the accretion of OID, original discount issue.

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.

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