Municipal Bonds

March 13, 2024

7664 / Is premium paid for a tax-exempt bond deductible? Must basis in a tax-exempt bond be reduced by bond premium?

<div class="Section1">An individual who owns any fully tax-exempt interest bearing bond (or debenture, note, certificate, or other evidence of indebtedness) must amortize any premium paid for the bond, but the part of the premium allocable to the year is not deductible.<a href="#_ftn1" name="_ftnref1">1</a> (The premium paid, in effect, reduces the annual interest; therefore, because the tax-free interest received each year represents in part a tax-free return of premium, the premium is not deductible.) Regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998) provided substantially similar rules. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7665">7665</a> for an explanation of the effective date for final regulations under IRC Section 171. The individual must reduce his or her basis each year by the amount of premium allocable to the year.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> For an explanation of how the annual amount of amortization is calculated, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7665">7665</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 171; Treas. Reg. § 1.171-1(c). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1016(a)(5). </div></div>

March 13, 2024

7666 / Is premium paid on call of a tax-exempt bond before maturity tax-exempt interest?

<div class="Section1">No, it is a capital payment taxable as capital gain.<a href="#_ftn1" name="_ftnref1">1</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7663">7663</a> if the bond was originally issued at a discount. For the treatment of capital gains and losses, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>.<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 72-587, 1972-2 CB 74; GCM 39309 (11-28-84); see also Rev. Rul. 74-172, 1974-1 CB 178; District Bond Co. v. Comm., 1 TC 837 (1943); Bryant v. Comm., 2 TC 789 (1943), acq. 1944 CB 4. </div></div>

March 13, 2024

7670 / If the interest on an obligation issued by a state or local government is not tax-exempt, how is it taxed?

<div class="Section1">Short-term obligations issued on a discount basis and payable without interest at a fixed maturity date of one year or less are treated like U.S. Treasury bills (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7624">7624</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7626">7626</a>).<a href="#_ftn1" name="_ftnref1">1</a> Other bonds are treated like U.S. Treasury notes and bonds (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7630">7630</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7633">7633</a>).<a href="#_ftn2" name="_ftnref2">2</a><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1271(a)(3); IRC § 454(b). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC §§ 1271 and 1272. </div></div>

March 13, 2024

7669 / Are interest and expense deductions limited because of ownership of municipal bonds?

<div class="Section1">If interest is paid on loans by an individual who owns tax-exempt municipal bonds, deduction of the interest may be partly or entirely denied (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8044">8044</a>). In addition, some expense deductions may be denied to individuals holding obligations – the interest on which is tax-exempt (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8050">8050</a>).</div>

March 13, 2024

7667 / Is interest on a tax-exempt municipal bond paid by a private insurer because of default by the state or political subdivision tax-exempt?

<div class="Section1">Yes, interest that would have been tax-exempt if paid by the issuer will be tax-exempt if paid by a private insurer on the issuer’s default.<a href="#_ftn1" name="_ftnref1">1</a> It makes no difference whether the issuer or the underwriter pays the premium on insurance obtained by the issuer covering payment of the principal and interest or whether the individual investors obtain their own insurance.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> A bondholder, however, may not exclude from gross income interest paid or accrued under an agreement for defaulted interest if the agreement is not incidental to the bonds or is in substance a separate debt instrument or similar investment when purchased. If, at the time the contract is purchased, the premium is reasonable, customary, and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds, then the agreement will be considered both incidental to the bonds and not a separate debt instrument or similar investment. Under these circumstances, a bondholder may exclude interest paid or accrued under an agreement for defaulted interest.<a href="#_ftn3" name="_ftnref3">3</a> If the interest or principal is guaranteed by the federal government, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7668">7668</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 72-134, 1972-1 CB 29. <a href="#_ftnref2" name="_ftn2">2</a>.   Rev. Rul. 72-575, 1972-2 CB 74; Rev. Rul. 76-78, 1976-1 CB 25. <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 149(b)(1); Treas. Reg. § 1.149(b)-1. </div></div>

March 13, 2024

7660 / Is interest on obligations issued by state and local governments taxable?

<div class="Section1">Interest paid on certain bonds issued by or on behalf of state or local governments is not tax-exempt. These are generally private purpose bonds (such as industrial development bonds and “private activity” bonds) and arbitrage bonds. For tax purposes, such non-exempt issues are government bonds taxed like Treasury bonds (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7630">7630</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7633">7633</a>).<div class="Section1"> Interest on certain categories of private purpose bonds is tax-exempt, although tax-exempt interest on some private activity bonds is a tax preference item for both the individual and corporate alternative minimum tax (note that the corporate AMT was repealed for tax years beginning after 2017, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7662">7662</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>).<a href="#_ftn1" name="_ftnref1">1</a> Interest on general purpose obligations of states and local governments (i.e., states, territories, possessions of the United States, or political subdivisions of any of them, or the District of Columbia) issued to finance operations of the state, local government, or instrumentality is generally tax-exempt. In addition, some obligations are tax-exempt under special legislation. In a case of first impression, the issue in Department of Revenue of Kentucky v. Davis was Kentucky’s system of exempting from state income taxes the interest on bonds issued by Kentucky or its political subdivisions, but not on bonds issued by other states and their subdivisions—and specifically, whether that differential tax treatment violated the Commerce Clause of the United States Constitution. After paying state income tax on out-of-state municipal bonds, the taxpayers (George and Catherine Davis) sued for a refund claiming that Kentucky’s differential taxation of municipal bond interest impermissibly discriminated against interstate commerce in violation of the Commerce Clause. The trial court granted judgment for the Commonwealth of Kentucky, but the Kentucky Court of Appeals reversed the trial court’s ruling, finding that Kentucky’s system of taxing only extraterritorial bonds ran afoul of the Commerce Clause. (The Supreme Court of Kentucky denied the motion for discretionary review by the Commonwealth of Kentucky.) The Supreme Court of the United States (in a plurality opinion) reversed the judgment of the Kentucky Court of Appeals, and remanded the case. Relying primarily on recent precedent,<a href="#_ftn2" name="_ftnref2">2</a> the Court stated that issuing debt securities to pay for public projects is a quintessentially public function with a venerable history, likely motivated by legitimate objectives distinct from simple economic protectionism. The Court determined that Kentucky’s tax exemption system favored a traditional government function, without any differential treatment favoring local entities over substantially similar out-of-state interests and, thus, concluded that this type of law does not impermissibly discriminate against interstate commerce for purposes of the dormant Commerce Clause.<a href="#_ftn3" name="_ftnref3">3</a> Whether a particular issue meets the requirements for tax exemption can involve complex legal and factual questions. Law firms specializing in municipal debt offerings, often called “bond counsel,” provide legal opinions concerning the validity of bond issues that generally include the exemption of interest from federal income tax. These opinions are customarily printed on the bonds. It has been held that where bonds issued by a city as tax-exempt were later found invalid under state law, the interest on them was not excludable from gross income under IRC Section 103(a).<a href="#_ftn4" name="_ftnref4">4</a> Where a county housing authority refused to pay a rebate to the federal government relating to bonds that were ruled to be arbitrage bonds by the Service and not tax-exempt, the interest was not excludable from the gross income of bondholders under IRC Section 103(a).<a href="#_ftn5" name="_ftnref5">5</a> Where tax-exempt bonds trade “flat” because interest is in default, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7671">7671</a>. Bonds issued after June 30, 1983, must be in registered form in order to be tax-exempt (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7698">7698</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7699">7699</a>). Tax-exempt interest is included in the calculation made to determine whether Social Security payments are includable in gross income. It has been determined that although this provision may result in the indirect taxation of tax-exempt interest, it is not unconstitutional (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="677">677</a>).<a href="#_ftn6" name="_ftnref6">6</a> (The direct-indirect distinction probably does not matter anyway. The Supreme Court held in 1988 that there is no constitutional requirement that interest on state and municipal bonds be excluded from the federal income tax base.)<a href="#_ftn7" name="_ftnref7">7</a> Every person who receives tax-exempt interest (and who is required to file an income tax return) must report for informational purposes the amount of tax-exempt interest received during the tax year on that return.<a href="#_ftn8" name="_ftnref8">8</a> The Code requires the reporting of tax-exempt interest paid after December 31, 2005.<a href="#_ftn9" name="_ftnref9">9</a> The Service released transitional guidance regarding the information reporting requirements for payments of tax-exempt interest on state or local bonds.<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 57(a)(5). <a href="#_ftnref2" name="_ftn2">2</a>.   United Haulers Assn, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 550 U.S. 330 (2007). <a href="#_ftnref3" name="_ftn3">3</a>.   Department of Revenue of Kentucky et al. v. Davis et ux., 553 U.S. 328 (2008), reversing, 197 S.W.3d 557. <a href="#_ftnref4" name="_ftn4">4</a>.   Rev. Rul. 87-46, 1987-2 CB 44. <a href="#_ftnref5" name="_ftn5">5</a>.   Harbor Bancorp v. Comm., 115 F.3d 722 (9th Cir. 1997). <a href="#_ftnref6" name="_ftn6">6</a>.   Goldin v. Baker, 809 F.2d 187 (2d Cir.), cert. denied, 484 U.S. 816 (1987). <a href="#_ftnref7" name="_ftn7">7</a>.   South Carolina v. Baker, 485 U.S. 505 (1988). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 6012(d). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 6049(b). <a href="#_ftnref10" name="_ftn10">10</a>.   Notice 2006-93, 2006-2 CB 798. </div></div>

March 13, 2024

7662 / Is tax-exempt interest treated as an item of tax preference for purposes of the alternative minimum tax?

<div class="Section1">The answer is generally no. However, except as noted below with respect to private activity bonds issued in 2009 and 2010, tax-exempt interest on private activity bonds other than qualified 501(c)(3) bonds is a tax preference item for both the individual and corporate alternative minimum tax (prior to 2018, the corporate AMT was repealed for tax years beginning after 2017, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>). The interest may be reduced by any deduction not allowable in computing regular tax that would have been allowable if the interest were includable in gross income (e.g., amortizable bond premium).<a href="#_ftn1" name="_ftnref1">1</a> The preference item includes exempt-interest dividends paid by a mutual fund to the extent attributable to such interest.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> The alternative minimum tax applies to such bonds issued after August 7, 1986 (or on or after September 1, 1986, in the case of bonds covered by the “Joint Statement on Effective Dates of March 14, 1986”). Interest on bonds issued to refund immediately pre-August 8, 1986, bonds is not an item of tax preference.<a href="#_ftn3" name="_ftnref3">3</a> Temporary modification of AMT limits on tax-exempt bonds issued in 2009 and 2010. The American Recovery and Reinvestment Act of 2009 (ARRA 2009) provided a temporary tax break for private activity bond interest. For private interest activity bonds issued during 2009 and 2010, interest from such bonds was not treated as a tax preference item for alternative minimum tax purposes.<a href="#_ftn4" name="_ftnref4">4</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 57(a)(5)(A). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 57(a)(5)(B). <a href="#_ftnref3" name="_ftn3">3</a>.   See the Conference Report, TRA ’86, page 333). IRC § 57(a)(5)(C). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 57(a)(5)(C)(vi), as added by ARRA 2009; § 1503 of ARRA 2009. </div></div>

March 13, 2024

7668 / Is interest on municipal bonds tax-exempt if payment is guaranteed by the United States or corporations established under federal law?

<div class="Section1">Interest on bonds issued by states, territories, and possessions (or their political subdivisions), which would otherwise be exempt from federal income tax, may not be exempt if payment of interest or principal is federally guaranteed.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> Generally, an obligation issued after 1983 is federally guaranteed if payment of principal or interest (in whole or in part, directly or indirectly) is guaranteed by: the United States, any U.S. agency, or, under regulations to be prescribed, any entity with authority to borrow from the United States (the District of Columbia and U.S. possessions are usually excepted); or if proceeds of the issue are to be used in making loans so guaranteed.<a href="#_ftn2" name="_ftnref2">2</a> Exceptions to this rule include certain bonds guaranteed by the Federal Housing Administration, the Department of Veterans Affairs, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Government National Mortgage Association, and the Student Loan Marketing Association. Some housing program obligations and qualified mortgage bonds and veterans’ mortgage bonds are also excepted, provided proceeds are not invested in federally insured deposits or accounts. Bonds issued or guaranteed by Connie Lee Insurance Company are not considered “federally guaranteed.”<a href="#_ftn3" name="_ftnref3">3</a> Some state and local obligations are secured by certificates of deposit federally insured by the Savings Association Insurance Fund (SAIF–formerly the Federal Savings and Loan Insurance Corporation (FSLIC)) or the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per bondholder. Bonds issued after April 14, 1983, other than any obligations issued pursuant to a binding contract in effect on March 4, 1983, are denied tax-exempt status if 5 percent or more of the proceeds of the issue is to be invested in federally insured deposits or accounts.<a href="#_ftn4" name="_ftnref4">4</a> The IRS ruled that interest on refunding bonds that were issued in an advance refunding of previously issued private activity bonds would be excludable from gross income under IRC Section 103(a).<a href="#_ftn5" name="_ftnref5">5</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 149(b)(1); Treas. Reg. § 1.149(b)-1. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 149(b). <a href="#_ftnref3" name="_ftn3">3</a>. Notice 88-114, 1988-2 CB 449. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 149(b)(2)(B). <a href="#_ftnref5" name="_ftn5">5</a>. Let. Rul. 200139007. </div>

March 13, 2024

7661 / What are Build America Bonds and how are they taxed?

<div class="Section1">ARRA 2009 created the Build America Bond program (under IRC Section 54AA), which authorized state and local governments to issue Build America Bonds as taxable governmental bonds in 2009 and 2010 to finance any governmental purpose for which tax-exempt governmental bonds could be issued. The 2017 tax reform legislation repealed Section 54AA, which governed Build America Bonds for 2009 and 2010. State and local governments could, at their option, issue two general types of Build America Bonds and receive federal subsidies for a portion of their borrowing costs. The subsidies took the form of either tax credits provided to holders of the bonds (tax credit type) or refundable tax credits paid to state and local governmental issuers of the bonds (direct payment type).<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> “Build America Bond” means any taxable state or local governmental bond (excluding a private activity bond) that meets the following requirements: (1) the interest on such bond would (but for IRC Section 54AA) be excludable from gross income under IRC Section 103; (2) the bond was issued before January 1, 2011; and (3) the issuer made an irrevocable election to have IRC Section 54AA apply.<a href="#_ftn2" name="_ftnref2">2</a> In general, Build America Bonds (tax credit type) could be issued to finance any governmental purpose for which tax-exempt governmental bonds (excluding private activity bonds) could be issued and must have complied with all requirements applicable to the issuance of tax-exempt governmental bonds.<a href="#_ftn3" name="_ftnref3">3</a> If a taxpayer holds a Build America Bond on one or more interest payment dates of the bond during any taxable year, a credit is allowed against the regular income tax liability in an amount equal to the sum of the credits determined under IRC Section 54AA(b) with respect to those dates.<a href="#_ftn4" name="_ftnref4">4</a> The amount of the credit determined under IRC Section 54AA(b) with respect to any “interest payment date” for a Build America Bond is 35 percent of the interest payable by the issuer with respect to such date.<a href="#_ftn5" name="_ftnref5">5</a> “Interest payment date” means any date on which the holder of record of the Build America Bond is entitled to a payment of interest from such bond.<a href="#_ftn6" name="_ftnref6">6</a> Accordingly, the tax credit that a taxpayer may claim with respect to a Build America Bond (tax credit) is determined by multiplying the interest payment that the bondholder is entitled to receive from the issuer (i.e., the bond coupon interest payment) by 35 percent.<a href="#_ftn7" name="_ftnref7">7</a> The credit allowed under IRC Section 54AA(a) for any taxable year cannot exceed the excess of (1) the sum of the regular tax liability plus the alternative minimum tax liability, over (2) the sum of the credits generally allowable against the regular income tax (excluding the refundable credits and the Build America Bond tax credit).<a href="#_ftn8" name="_ftnref8">8</a> Any excess is carried over to the succeeding taxable year and added to the credit allowable under IRC Section 54AA(a) for the taxable year.<a href="#_ftn9" name="_ftnref9">9</a> Unused credit may be carried forward to succeeding taxable years.<a href="#_ftn10" name="_ftnref10">10</a> Original issue discount (OID) is not treated as a payment of interest for purposes of determining the credit.<a href="#_ftn11" name="_ftnref11">11</a> Interest on any Build America Bond is includable in gross income.<a href="#_ftn12" name="_ftnref12">12</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 54AA(d), as added by ARRA 2009. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref3" name="_ftn3">3</a>. Notice 2009-26, 2009-16 CB 833. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 54AA(a), as added by ARRA 2009. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 54AA(b), as added by ARRA 2009. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 54AA(e), as added by ARRA 2009. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref7" name="_ftn7">7</a>. Notice 2009-26, 2009-1 CB 833. See H.R. Conf. Rep. 111-16, 111th Cong., 1st Sess. (February 12, 2009). <a href="#_ftnref8" name="_ftn8">8</a>. IRC § 54AA(c)(1), as added by ARRA 2009. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 54AA(c)(2), as added by ARRA 2009. Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref10" name="_ftn10">10</a>. H.R. Conf. Rep. 111-16, 111th Cong., 1st Sess. (Feb. 12, 2009). Notice 2009-26, 2009-1 CB 833. <a href="#_ftnref11" name="_ftn11">11</a>. Notice 2009-26, 2009-1 CB 833. See H.R. Conf. Rep. 111-16, 111th Cong., 1st Sess. (Feb. 12, 2009), n. 146. <a href="#_ftnref12" name="_ftn12">12</a>. IRC § 54AA(f)(1), as added by ARRA 2009. </div>

March 13, 2024

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

<div class="Section1">The seller may recover an amount equal to the seller’s adjusted basis tax-free. If the bond was purchased at a premium, the seller’s basis for determining gain or loss is adjusted to reflect the amortization of the premium (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7664">7664</a>).<div class="Section1"> 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).<a href="#_ftn1" name="_ftnref1">1</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>), except that discounts of less than ¼ of 1 percent (.0025) times the number of years to maturity are accounted for.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> Gain in excess of tax-exempt interest will generally be capital gain, including gain from any premium paid on call (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7666">7666</a>). See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> 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.<a href="#_ftn10" name="_ftnref10">10</a> 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.<a href="#_ftn11" name="_ftnref11">11</a> For tax-exempt bonds purchased before May 1, 1993, gain attributable to market discount has generally been treated by the Service as capital gain.<a href="#_ftn12" name="_ftnref12">12</a> Capital gain is not exempt from federal income tax, but is currently taxed at lower rates if the gain is long-term capital gain.<a href="#_ftn13" name="_ftnref13">13</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7537">7537</a>. 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.<a href="#_ftn14" name="_ftnref14">14</a> 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.<a href="#_ftn15" name="_ftnref15">15</a> If the bond traded “flat” because interest was in default, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7671">7671</a>. 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7698">7698</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7699">7699</a>). If the bond was held as part of a tax straddle, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7593">7593</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a>. If the bond was held as part of a conversion transaction, the additional rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> will apply. If the transfer is between spouses, or between former spouses and incident to divorce, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="789">789</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1288(a)(2). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1288(b)(1). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1288(b). <a href="#_ftnref4" name="_ftn4">4</a>.   TAM 8541003. <a href="#_ftnref5" name="_ftn5">5</a>.   Rev. Rul. 73-112, 1973-1 CB 47. <a href="#_ftnref6" name="_ftn6">6</a>.   Rev. Rul. 80-143, 1980-1 CB 19; Rev. Rul. 72-587, 1972-2 CB 74. <a href="#_ftnref7" name="_ftn7">7</a>.   Notice 94-84, 1994-2 CB 559. <a href="#_ftnref8" name="_ftn8">8</a>.   Rev. Rul. 95-70, 1995-2 CB 124. <a href="#_ftnref9" name="_ftn9">9</a>.   Rev. Rul. 69-263, 1969-1 CB 197. <a href="#_ftnref10" name="_ftn10">10</a>.   Rev. Rul. 73-112, above; Rev. Rul. 60-210, 1960-1 CB 38; Rev. Rul. 57-49, 1957-1 CB 62. <a href="#_ftnref11" name="_ftn11">11</a>.   IRC §§ 1276(a), 1278(a)(1). <a href="#_ftnref12" name="_ftn12">12</a>.   Rev. Rul. 60-210, above; Rev. Rul. 57-49, above. <a href="#_ftnref13" name="_ftn13">13</a>.   Willcuts v. Bunn, 282 U.S. 216 (1931); U.S. v. Stewart, 311 U.S. 60 (1940); Rev. Rul. 81-63, 1981-1 CB 455. <a href="#_ftnref14" name="_ftn14">14</a>.   FSA 200116012. <a href="#_ftnref15" name="_ftn15">15</a>.   IRC § 453(k). See Rev. Rul. 93-84, 1993-2 CB 225. </div></div>