Market Discount of Municipal Bonds

What is market discount of municipal bonds?

Market discount on municipal bonds or any tax exempt bonds can arise if:

• the municipal bonds are issued at par or at a premium and is later purchased in the secondary market at a price that is less than par or

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• the municipal bonds are issued at a discount and is later purchased in the secondary market at a price that is less than the original issue price plus accrued original issue discount (OID)through the date of purchase.

What is the tax treatment for market discount of municipal bonds?

Market discount of municipal bonds, unlike original issue discount or OID, is not treated as tax-exempt interest to the municipal bond holder when recognized because it arises as a result of market forces, not through the action of the issuer.

The effect of this rule is that a taxpayer who purchases tax exempt bonds subsequent to their original issuance at a price less than its stated redemption price at maturity (or, if issued with OID, at a price less than its accreted value), either because interest rates have risen or the obligator's credit has declined since the municipal bond was issued, and who thereafter recognizes gain on the disposition of such municipal bond will have part or all of the "gain" treated as ordinary income.

Market Discount of Municipal Bonds Example

For example, if a $5,000 tax exempt bond (issued at par on January 1, 2003) with a 20-year maturity were purchased five years after its issuance (on January 1, 2008) at a price of $4,400, the market discount would be $600. If that bond were sold on January 1, 2013 at a price of $4,700, one-third (5 years of owning the bond divided by 15 years from purchase to maturity) of the market discount would have accrued. Thus, $200 (1/3 x $600) of market discount would have accrued and that portion of the holder's $300 gain would be treated as ordinary income. The remaining $100 of the holder's gain would be taxed as long term capital gains.

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