How to Calculate Taxes on Municipal Bonds

 

Bonds and Taxes

 

In our last article we told you how to tell if a specific municipal bond is tax free.  There are still scenarios where you will have to pay taxes on municipal bonds however, even when those bonds are labeled as tax free.

Lets look at an example of each of the primary scenarios where this could happen:

 

Taxes on Municipal Bonds – Quick Jump Links

Scenario 1: Municipal Bond Bought at Initial Offering and Held to Maturity

Scenario 2: A Municipal Bond Bought at Original Issue and Sold Before Maturity

Scenario 3: For a Municipal Bond which is Bought After Original Issue and Held to Maturity

Scenario 4: For a Municipal Bond Which is Bought After Original Issue and Sold Before Maturity

 

Other Information:

How to Calculate the Tax/Cost Basis on a Municipal Bond
Long Term vs. Short Term Capital Gains, “de minimus” rule, and where to find original discount/premium

A Municipal Bond Bought at Initial Offering and Held to Maturity

Assuming you buy a triple tax-free municipal bond during the initial offering period (when its first sold to the public), and hold the bond to maturity, you will not have to pay any taxes related to the bond.  This is true even if the bond is sold to you during the initial offering period at a discount to face value.

If you buy a bond at a premium to its face value during the initial offering period, you will receive less money back at maturity than your initial purchase price.  However, this “loss” of principal as the bond moves towards its face value at maturity, is compensated by the bond paying a higher coupon interest rate than it would have, had it not been sold to you at a premium. In this case, the decrease in value from the purchase price to face value is considered a deduction in interest, and as a result there is no capital gain or loss associated with it.

A Municipal Bond Bought at Original Issue and Sold Before Maturity

In the secondary market, a municipal bond’s price fluctuates when interest rates change, or the market’s opinion of the amount of risk involved with the bond changes.  If you are not familiar with this concept, you can learn more about it in our article on Yield to Maturity.

If you buy a municipal bond during the initial offer period and sell it before maturity, you will generate a capital gain or loss on the bond which is not tax exempt.  If the bond was originally sold at the same price as its face value, then its easy: The capital gain or loss will be the price you sell the bond for, minus the price you paid for it.

Many municipal bonds are sold during the initial offer period at a discount or premium to their face value.  In these cases value is added to or subtracted from the purchase price over time, to reflect the value of the original discount or premium that has been “used up” during the time you’ve held the bond.  In these cases when calculating your capital gain or loss for tax purposes, part of the difference in price will be attributed to the original discount or premium.  In order to calculate your capital gain or loss on the bond you need to first include this in your purchase price which will give you your tax basis.

Calculating the Tax Basis on a Municipal Bond

With bonds that are bought at a discount, the tax basis will rise over time in relation to your initial purchase price, at a rate where it reaches face value at maturity.  Bonds that were originally sold at a premium will have their tax basis fall over time, also at a rate where it reaches the face value of the bond at maturity.

Tax Basis Example

Lets say you bought some municipal bonds for $9500 when they were first issued, which had a face value of $10,000 and a 10 year original maturity (the bonds were offered at a discount).

To find out how much the purchase price should be adjusted, so you can calculate your tax basis, divide the discount ($500) by the original term of the bond (10 years). In this case it would be $500 / 10 = $50.  Each year the tax basis for this bond increases by $50. Every year (or pro-rata portion of a year) $50 would be added to your purchase price in order to get the tax basis.

For example, if you were the original buyer and held the bond for five years, your tax basis would be your $9500 purchase price + ($50 x 5) for a total of $9,750. If you sold it for more than $9,750, you would have a capital gain. Below that level, a capital loss.  The amount of the capital gain or loss would be the price you sold the bond for minus $9,750.

If the bond was originally sold at a premium to the face value, the tax basis would decrease by a fixed amount every year. Other than that the calculation would be the same.

For a Municipal Bond which is Bought After Original Issue and Held to Maturity

When a municipal bond is bought after the original issue things get a little more complicated.  As long as the bond is held to maturity, there will be no capital gain or loss associated with the bond.

If the bond is purchased either at a premium to it face value, or at price higher than its tax basis, then there is no income tax. However, if a bond is purchased at a price below the tax basis and a discount to face value, then the holder with have to pay ordinary income taxes.

Example:

Lets say you bought the same municipal bonds described in the first example ($10,000 Face Value, 10 Year original maturity bond originally sold at a discount for $9500).  In this example however, you bought the bonds in the secondary market, 2 years after the original issue.  Interest rates had risen over the 2 years since the bonds were issued, so the price of the bond has dropped to $9000 when you buy it.

Since you are two years into the life of the bonds when you bought them, $100 of the $500 in original discount has already accrued.  That leaves $400 in interest which is associated to the original issue discount, and is therefore tax free.  There is still $600 of discount left to account for however, which is the discount resulting from price movements in the secondary market, and therefore is taxable just like interest on a regular bond.  Under current law it is your choice as to whether you recognize this interest in each tax year, or wait until you sell the bond or it reaches maturity, whichever comes first.

For a Municipal Bond Which is Bought After Original Issue and Sold Before Maturity

This adds another level of complexity, as in this example you will have some tax free interest which is associated with the original issue, some taxable interest which is associated to the market discount or premium that is “used up” while you hold the bond, and some capital gain or loss which is the portion of the discount or premium which is not allocated to interest. Keep in mind that in this case the premium that you are amortizing is your purchase premium, not the the original purchase premium.

Example:

Lets say you bought the same bonds described in the examples above ($10,000 Face Value, 10 Year original maturity bond issued at a discount for $9500).  In this example however you bought the bonds in the secondary market 2 years after the original issue and then sold them after another 2 years.  Interest rates had risen over the 2 years since the bonds were issued, so the price of the bond had dropped to $9000 when you bought the bonds.  Interest rates continued to rise during the 2 years you held onto the bonds so the price had dropped to $8500 when you sold the bonds after holding them for 2 years.

In this example we will first need to calculate the interest that is attributed to the original issue discount of $500 and then the portion of the discount that is counted as taxable interest. What’s left over after that is our capital gain or loss on the bond.

First Calculate Your Tax Basis

To calculate your tax basis in this example, you will need to account for the interest that is attributed to the original issue discount of $500.  Since you held the bond for 2 years, you “used up” $200 of the $500 in original issue discount.  Add this $200 to the purchase price of the bond $9000 to get your tax basis of $9200.

Next Calculate the Taxable Interest Resulting from the Market Discount

Start by subtracting your tax basis of $9200, from the $10,000 face value of the bond.  This remaining $800 is the discount left to account for until maturity which is associated with movement in the secondary market and therefore taxable interest.

As you only held the bond for 2 years you are only taxed on the portion of the discount that accrues during those years.  To find out how much that is you take the $800 of discount calculated above and divide it by the 8 years that were left until maturity, when you bought the bond.  This gives you $100 a year in taxable interest.  Multiply that by the 2 years you held the bond and you get 2 years of taxable interest which in this case is $200.

Lastly Calculate your Capital Gain or Loss on the Bond

Start by subtracting the price you sold the bond for ($8500) from your tax basis ($9200). This gives you -$700.   Next subtract the $200 of taxable interest which we calculated above to get your total capital loss of $900.

You’re finished!  Your tax bill on this bond would be $200 in interest taxed at your ordinary income rate and a capital loss of $900 which you can count against capital gains made on other investments.

Longterm/Short Term capital Gains, “de minimus” rule, and Where to Find Original Issue Discount or Premium

The current long term capital gains rate, which is the rate for investments held for longer than 12 months is 15%.  If you do not hold an investment for longer than 12 months, you will be taxed at the short term capital gains rate which is generally the same as your ordinary income tax rate (as high as 35%).

If the market discount on the bond is less than 0.25% of the value of the face value of the bond per year left to maturity (ie a bond with 10 years to maturity would be 2.5% of face value), the discount can be treated as a capital gain when the bond matures or is sold.  This is referred to as the  “de minimis” rule.

Lastly if you do not know the original discount or premium for a municipal bond that you hold you can find it by searching the CUSIP number of the bond on EMMA, clicking on the bond’s name, and looking in the column that says “initial offering price” (%).

Disclaimer:

While we do our best to provide high quality information we do not guarantee the accurateness of any of the information above. We are not CPA’s here at LearnBonds so you should consult a tax professional before making any decisions.

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Comments

  1. MuniNewComer says

    Not sure about tax basis. 10000 issued at 9500 means $500 over 10 years, the accretion should be $50 per year, held for 2 years then the basis should go up by $100 ($9100), not $200. Can anyone clarify this?

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