Original Issue Discount (OID) Municipal Bonds: Annual Accretion and Taxation
An investor buys an Original Issue Discount (OID) municipal bond at issuance for 80 ($800 per bond) with a 10-year maturity. If the investor holds the bond until maturity and redeems it at par ($1,000), what is the tax treatment of the $200 discount?
Original Issue Discount (OID) on municipal bonds must be accreted annually. Because the accretion is treated as tax-exempt interest, holding to maturity produces $0 capital gain.
Complete Analysis & Legal Rationale
For Original Issue Discount (OID) municipal bonds, IRS rules require annual accretion using the constant yield method. The annual upward adjustment to the bond's cost basis is treated as tax-free interest income (not capital gain). Over 10 years, the cost basis increases by $20 per year from $800 to $1,000. When redeemed at par ($1,000) at maturity, cost basis equals redemption price, resulting in $0 capital gain or loss.
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:
Original Issue Discount (OID) on municipal bonds must be accreted annually. Because the accretion is treated as tax-exempt interest, holding to maturity produces $0 capital gain.
Fails to adhere to municipal bond rules regarding B.
Fails to adhere to municipal bond rules regarding C.
Fails to adhere to municipal bond rules regarding D.
Official Standard: For Original Issue Discount (OID) municipal bonds, IRS rules require annual accretion using the constant yield method. The annual upward adjustment to