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

If the buyer paid the seller any stated interest accrued, but not yet due at the date of the sale, that amount is recovered tax-free as a return of capital.⁹

Gain in excess of tax-exempt interest will generally be capital gain, including gain from any premium paid on call (see Q 7666). See Q 702 regarding the treatment of capital gains and losses.

If the bond was bought on the market at a discount reflecting a decline in value of the obligation after issue, this market discount does not represent tax-exempt interest paid by the issuer.¹⁰ Market discount is the amount by which the purchase price is less than the face value of the bond (or, in the case of a bond originally issued at a discount, less than the issue price plus the amount of original issue discount apportioned, as above, to the previous holders).

With respect to tax-exempt bonds purchased after April 30, 1993, market discount recovered on sale is treated as taxable interest instead of capital gain.¹¹ For tax-exempt bonds purchased before May 1, 1993, gain attributable to market discount has generally been treated by the Service as capital gain.¹² Capital gain is not exempt from federal income tax, but is currently taxed at lower rates if the gain is long-term capital gain.¹³

If a loss is realized on the sale or on a redemption, it is a capital loss. However, if “substantially identical” obligations were acquired (or a contract to acquire them was made) within 30 days before or 30 days after the sale, the loss will be subject to the “wash sale” rule discussed in Q 7537.

The IRS concluded that a modification of tax-exempt revenue bonds constituted a deemed exchange under IRC Section 1001 because the modified bonds, which had been issued in an exchange, were materially different from the original bonds. Thus, the modified bonds would be treated as newly issued securities for federal income tax purposes.¹⁴

The installment method for recognizing and taxing gain is not available for securities traded on an established securities market. As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year.¹⁵

If the bond traded “flat” because interest was in default, see Q 7671.

Bonds issued after June 30, 1983, must be in registered form in order to deduct loss on sale or to treat gain as capital (as opposed to ordinary) gain (see Q 7698, Q 7699).

If the bond was held as part of a tax straddle, see Q 7593 to Q 7614. If the bond was held as part of a conversion transaction, the additional rules discussed in Q 7615 and Q 7616 will apply.

If the transfer is between spouses, or between former spouses and incident to divorce, see Q 789.