Original Issue Discount (OID) Accretion and Tax Treatment
An investor buys a newly issued municipal bond at an Original Issue Discount (OID) for $800 with a 10-year maturity. If the investor holds the bond to maturity, what are the federal tax consequences of the $200 discount?
For municipal Original Issue Discount (OID) bonds, the discount is treated as additional tax-exempt interest. The discount must be accreted annually to adjust cost basis upward, resulting in an adjusted basis of $1,000 at maturity and ZERO capital gain.
Complete Analysis & Legal Rationale
In contrast, for secondary market discount municipal bonds, the discount is taxed as ordinary income at maturity. OID municipal discounts are treated as tax-free interest over the holding period.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
OID accretion is treated as tax-exempt interest, bringing cost basis to par with no capital gain at maturity.
Capital gains do not apply when OID basis accretes to par at maturity.
Ordinary income taxation applies to secondary market discounts, NOT municipal OID debt.
Accretion is mandatory under IRS rules.
Official Standard: Accretion of OID on tax-exempt municipal bonds increases basis without creating taxable gain.