Amortization of Municipal Bond Premiums: Mandatory Basis Reduction
An investor purchases a municipal bond at 108 ($1,080) with 8 years remaining until maturity. The investor holds the bond until maturity and receives par ($1,000). For federal income tax purposes, which statement is TRUE?
For all municipal bonds purchased at a premium, amortization of the premium is MANDATORY. Cost basis is reduced annually to par, resulting in $0 capital loss at maturity.
Complete Analysis & Legal Rationale
Under IRS rules, amortization of bond premium is MANDATORY for all municipal bonds. The premium paid ($80 over 8 years = $10 per year) must be amortized annually, reducing the bond's adjusted cost basis by $10 each year. At maturity, the adjusted cost basis reaches exactly $1,000. When redeemed for $1,000, there is NO capital loss. The amortized amount is not deductible because the underlying interest is already tax-exempt.
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:
For all municipal bonds purchased at a premium, amortization of the premium is MANDATORY. Cost basis is reduced annually to par, resulting in $0 capital loss at maturity.
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: Under IRS rules, amortization of bond premium is MANDATORY for all municipal bonds. The premium paid ($80 over 8 years = $10 per year) must be amortiz