7663 / How is gain or loss taxed on sale or redemption of tax-exempt bonds issued by a state or local government?

With respect to a bond both issued after September 3, 1982, and acquired after March 1, 1984, the owner’s basis is increased by the amount of tax-exempt original issue discount that accrued while owning the bond (subject to an adjustment if the owner purchased the bond at a price in excess of the issue price plus original issue discount accrued up to the time of acquisition).¹ Original issue discount accrues daily at a constant rate as it does generally for taxable original issue discount bonds issued after July 1, 1982 (see Q 7650), except that discounts of less than ¼ of 1 percent (.0025) times the number of years to maturity are accounted for.² For obligations with a maturity of one year or less, discount will accrue daily on a ratable basis, as it does for taxable short-term government obligations (that is, by dividing discount by the number of days after the day the taxpayer acquired the bond up to and including the day of its maturity); however, the taxpayer apparently may make an irrevocable election to use a constant rate (under regulations) with respect to individual short-term obligations.³

With respect to any bond acquired on or before March 1, 1984, or any bond issued on or before September 3, 1982, whenever acquired, the seller’s basis is not adjusted to reflect annual accrual of original issue discount. Consequently, loss on sale is determined without regard to original issue discount accrued up to the date of sale.⁴ Nonetheless, to the extent there is gain on sale or redemption, an amount equal to original issue discount allocable to the period the investor held the bond is excludable as tax-exempt interest that accrued over the period it was held. The amount of tax-free discount apportioned to any holder is the amount that bears the same ratio to the original issue discount as the number of days the holder held the bond bears to the number of days from the date of original issue to the date of maturity, assuming there was no intention at issue to call the obligation before maturity.⁵ If the bond is redeemed before maturity, any unaccrued original issue discount realized is taxable as capital gain, not excludable interest, except that in the case of a bond issued before June 9, 1980, it is recovered tax-free as tax-exempt interest.⁶

Stated interest that is unconditionally payable at maturity on short-term tax-exempt bonds may be treated as includable in the stated redemption price at maturity or as qualified stated interest, at the choice of the taxpayer, provided all short-term tax-exempt bonds are treated in a consistent manner. This guidance is effective for tax-exempt bonds issued after April 4, 1994, and until the Service provides further guidance.⁷ Scheduled interest payments are not unconditionally payable when, under the terms of a debt instrument, the failure to make interest payments when due requires that the issuer forgo paying dividends, or that interest accrue on the past-due payments at a rate that is two percentage points greater than the stated yield.⁸