Secondary Market Discount Municipal Bonds: Ordinary Income Tax Treatment
A municipal bond with an original par value of $1,000 was originally issued at par. Five years later, due to rising interest rates, an investor purchases the bond in the secondary market at 92 ($920). The investor holds the bond to maturity and receives $1,000. How is the $80 discount treated for federal income tax purposes?
Unlike OID bonds, a market discount on a municipal bond purchased in the secondary market is taxed as ORDINARY INCOME (or capital gain if de minimis) upon redemption, NOT tax-exempt interest.
Complete Analysis & Legal Rationale
A critical tax distinction on the Series 7: While original issue discount (OID) interest is tax-exempt, market discounts on municipal bonds purchased in the secondary market are NOT considered tax-exempt interest. Instead, the discount represents taxable income: under IRC Section 1276, the market discount ($80) is taxed as ordinary income upon redemption at maturity (or as a capital gain if within the de minimis threshold).
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:
Unlike OID bonds, a market discount on a municipal bond purchased in the secondary market is taxed as ORDINARY INCOME (or capital gain if de minimis) upon redemption, NOT tax-exempt interest.
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: A critical tax distinction on the Series 7: While original issue discount (OID) interest is tax-exempt, market discounts on municipal bonds purchased