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Tax exempt bonds after RRA '93.

RRA '93 mandates that gain attributable to market discount on tax-exempt securities bought on the secondary market after April 30, 1993, be taxed as ordinary income when the security is sold, redeemed, or otherwise disposed of. Market discount is defined differently for ordinary bonds and stripped coupon bonds.

RRA '93 does not affect bonds purchased at original issue regardless of the date of purchase or to bonds purchased on the secondary market prior to May 1, 1993. Also exempt from treating market discount as ordinary income are bonds issued before July 19, 1984.

For ordinary tax-exempt bonds (nonzero-coupon bonds), market discount is the difference between the stated redemption price and the price paid for the bond when purchased on the secondary market.

For stripped coupon tax-exempt bonds (zeros) purchased on the secondary market, market discount is the difference between the purchase price and the revised issue price. The revised issue price is defined as the original issue price plus accreted tax-exempt interest on the bond from date of issue to date of purchase using the "constant interest rate method" (compounding). The rate to be used for compounding is the yield rate of the bond when first issued. Revised issue prices are computed annually and are available from brokerage firms dealing in zeros.

A de minimus rule exempts treating market discount as ordinary income if the discount on the bond is one cent less than .0025 x the face value of the bond x the number of complete years between the bond's acquisition date and its maturity date. For example, the de minimus amount for a $1,000 face value bond with 10 complete years remaining to maturity is 1[cent] less than $25, i.e., $24.99.

Investors can elect to report market discount annually on a pro rata basis, but there are disadvantages for making such an election.

Investors in municipal bonds may have a portfolio of bonds falling into a variety of categories requiring different tax treatment. A recent bill introduced by Representative B. Cardin (D-MD) to repeal the complicated rules has a slim chance of passage according to the Public Securities Association.

The categories with explanations of the various types of municipal bonds are as follows:

1. Ordinary bonds or zeros bought at original issue and held to maturity. The discount on bonds in this class is tax exempt. At maturity the disposition is reported in Schedule D. The selling price and the basis are equal to the face amount of the bond. (IRC Sec. 1272(a)(2)(A); Rev. Rul. 72-587, 1971-2CB-74)

2. Ordinary bonds bought at original issue and called or sold prior to maturity. For obligations in this class issued prior to June 9, 1980, discount is amortized between the period held (earned) and the periods not held (unearned). For the period held, the discount is tax exempt. For the period not held, the discount is taxed as a capital gain. (Rev. Rul. 80-143, 1980-1CB-19)

Example: A 20-year, $1000 bond is bought for $900 and sold for $975 when 10 complete years remain until maturity. The discount of $100 is amortized at the rate of $5 per year. The Schedule D computation is as follows:
Selling price                           $975
Basis:
a) Cost                        $900
b) Earned tax exempt
interest/discount for the
10-year period held at
$5 per year                      50
Total basis                              950
Capital gain                             $25


(Note: If the above bond is sold for less than $950, a capital loss
will be sustained equal to the difference between $950 and the
selling price.)


3. Zeros bought at original issue and sold prior to maturity. For zeros in this category, capital gain is realized to the extent that the selling price exceeds the revised issue price as of the date of sale. A capital loss is sustained if the selling price is less than the revised issue price. An adjustment is required to the revised issue price if the bond is sold on a date which differs from the date the revised issue price is published.

4. Ordinary bonds bought at a discount on the secondary market prior to May 1, 1993, and a) held to maturity or b) sold prior to maturity. For ordinary bonds in this category, capital gain is realized to the extent that the redemption price or sales price exceeds the bond cost. (Bonds purchased at a premium require amortization of the premium, over the period from purchase date to date of sale or call, to reduce its basis. If there is no call date, amortization is extended to the maturity date.)

5. Zeros bought on the secondary market prior to May 1, 1993, and held to maturity. Gain attributable to market discount on bonds in this category is capital gain.

Example: Investor buys a 20-year, $1,000 face value zero-coupon bond for $500 when 10 complete years remain to maturity. The revised issue price at the time of purchase is $560. The market discount is $60, which is taxed as capital gain. The computation for Schedule D is as follows:
Redemption amount at
maturity                                  $1,000


Basis:
a) Cost                          $500
b) Accreted tax exempt
interest from purchase
date to date of maturity
($1,000-$560)                     440


Total basis                                  940
Capital gain (equal to market
discount)                                   $ 60


6. Zeros bought on the secondary market prior to May 1, 1993, and sold prior to maturity. Gain attributable to market discount in this category is considered to be capital gain.

Example: Same facts as in 5 above, except the bond is sold for $800, five complete years from date of purchase. At time of sale the revised issue price is $750:
Selling price                               $800


Basis:
a) Cost                          $500
b) Accreted tax exempt
interest for the five-year
period held which is
the difference between
the revised issue
price at time of sale
($750) and time of
purchase ($560)                   190


Total basis                                  690
Capital gain $60 discount +
($800-$750)                                 $110


7. Ordinary bonds bought on the secondary market after April 30, 1993, and a) held to maturity or b) sold prior to maturity. For bonds bought after May 1, 1993, on the secondary market, market discount is ordinary income.

Example A: A 20-year bond is bought for $800 with 10 years remaining to maturity. At maturity the $200 discount is a Schedule B entry. Selling price is $1,000. Basis is $1,000 ($800 + $200). Gain or loss is zero.

Example B: Assume the same facts, except the bond is sold exactly five years from date of purchase for $950. The computation for Schedule D is as follows:
Selling price                           $950


Basis:
(a) Cost                       $800
(b) Accreted discount
for five years at $20 per
year taxed in Schedule B        100


Total basis                              900
Capital gain                            $ 50


Example C: Same facts, except the bond is sold for $850:
Selling price                           $850


Basis:
(a) Cost                       $800
(b) Discount taxed
in Schedule B                   100


Total basis                              900
Capital loss                            ($50)


(Note: Although the overall gain is $50, $100 is ordinary income and
$50 is a capital loss). This interpretation of RRA '93 is based on
the statement of the managers for H.R. 2264 to extend the same
market discount rules to tax-exempt bonds as they apply to taxable
bonds (except that market discount on tax exempts may be reported
upon disposition rather than annually).


8. Zeros bought on the secondary market after April 30, 1993, and held to maturity. Gain attributable to market discount is ordinary income.

Example: Investor buys a $1,000 20-year, zero-coupon bond for $500, when the revised issue price is $560, with 10 complete years remaining to maturity. The market discount of $60 is amortized over 10 years at $6 per year.
Redemption amount at
maturity                             $1,000


Basis:
a) Cost                      $500
b) Tax-exempt interest
($1,000 - $560)               440
c) Market discount
to Schedule B
($560 - $500)                  60


Total basis                           1,000
Schedule D gain/loss                    -0-


9. Zeros bought on the secondary market after April 30, 1993, and sold prior to maturity. The gain attributable to market discount on the sale of a zero-coupon bond prior to maturity is ordinary income for bonds purchased on the secondary market after April 30, 1993.

Example A: Investor buys a $1,000 zero-coupon bond for $500, at which time 10 complete years remain to maturity. The revised issue price on date of purchase is $560. The discount is $60. The bond is sold five complete years after purchase for $850 at which time the revised issue price is $750:
Selling price                          $850


Basis:
a) Cost                      $500
b) Accreted discount
for five years at $6 per
year taxed as ordinary
income in Schedule B           30
c) Accreted tax
exempt interest
($750-$560)                   190
Total basis                             720
Capital gain                           $130


Example B: Same facts, except that the bond is sold for $675. The discount is still ordinary income. A Schedule D loss of $45 is reported (selling price $675, basis $720). But see the note under example 7.
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Title Annotation:Federal Taxation; Revenue Reconciliation Act of 1993
Author:Bercher, I. Stanley
Publication:The CPA Journal
Date:Jun 1, 1995
Words:1489
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