Taxation of Municipal Bonds Flashcards
(34 cards)
Which of the following statements are TRUE regarding municipal bonds trading in the secondary market
I Municipal market discount bonds must be accreted
II Municipal market discount bonds may be accreted
III Municipal market premium bonds must be amortized
IV Municipal market premium bonds may be amortized
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
The discount on market discount municipal bonds is treated as taxable interest income earned. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not?
The holder can either accrete the discount annually as taxable interest income earned and adjust the cost basis of the bond upwards by this amount; or can wait until the bond is sold or matures to reported the accumulated “earned” discount as taxable interest income at that point (this is the better choice from a tax standpoint).
The premium on market premium municipal bonds must be amortized over the bond’s life. It is reported annually as a reduction of municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted downwards by this amount. If the bond is held to maturity, the entire premium has been amortized and there is no capital gain or loss at maturity.
Regarding municipal discount bonds, which statements are TRUE?
I Municipal original issue discount bonds must be accreted
II Municipal original issue discount bonds may be accreted
III Municipal market discount bonds must be accreted
IV Municipal market discount bonds may be accreted
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
The discount on original issue discount municipal bonds must be accreted annually. It is reported annually as municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted upwards by this amount. If the bond is held to maturity, the entire discount has been accreted and there is no capital gain or loss at maturity.
The discount on market discount municipal bonds is treated as taxable interest income earned. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not? The holder can either accrete the discount annually as taxable interest income earned and adjust the cost basis of the bond upwards by this amount; or can wait until the bond is sold or matures to report the accumulated “earned” discount as taxable interest income at that point (this is the better choice from a tax standpoint).
Which of the following statements are TRUE regarding original issue municipal bonds?
I Municipal original issue discount bonds must be accreted
II Municipal original issue discount bonds may be accreted
III Municipal original issue premium bonds must be amortized
IV Municipal original issue premium bonds may be amortized
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
The discount on original issue discount municipal bonds must be accreted annually. It is reported annually as municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted upwards by this amount. If the bond is held to maturity, the entire discount has been accreted and there is no capital gain or loss at maturity.
The premium on original issue municipal premium bonds must be amortized over the bond’s life. It is reported annually as a reduction of municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted downwards by this amount. If the bond is held to maturity, the entire premium has been amortized and there is no capital gain or loss at maturity.
Regarding municipal premium bonds, which statements are TRUE?
I Municipal original issue premium bonds must be amortized
II Municipal original issue premium bonds may be amortized
III Municipal market premium bonds must be amortized
IV Municipal market premium bonds may be amortized
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
The premium on both original issue and market premium municipal bonds must be amortized over the bond’s life. It is reported annually as a reduction of municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted downwards by this amount. If the bond is held to maturity, the entire premium has been amortized and there is no capital gain or loss at maturity.
All of the following statements are true regarding the tax treatment of municipal bonds EXCEPT:
A. primary discount bonds must be accreted
B. primary premium bonds must be amortized
C. secondary discount bonds must be accreted
D. secondary premium bonds must be amortized
The best answer is C.
The discount on original issue discount municipal bonds must be accreted annually. It is reported annually as municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted upwards by this amount. If the bond is held to maturity, the entire discount has been accreted and there is no capital gain or loss at maturity.
The discount on market discount municipal bonds is treated as taxable interest income earned. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not? The holder can either accrete the discount annually as taxable interest income earned and adjust the cost basis of the bond upwards by this amount; or can wait until the bond is sold or matures to report the accumulated “earned” discount as taxable interest income at that point (this is the better choice from a tax standpoint).
The premium on both original and secondary issue premium municipal bonds must be amortized. It is reported annually as a reduction of municipal interest income earned (non-taxable), and the cost basis of the bond is adjusted downwards by this amount. If the bond is held to maturity, the entire premium has been amortized and there is no capital gain or loss at maturity.
A customer buys a municipal bond in the primary market at a discount. Which of the following statements are TRUE regarding the discount and the tax consequence?
I The discount must be accreted
II The discount may be accreted at the option of the bondholder
III If the bond is held to maturity there is no taxable capital gain
IV If the bond is held to maturity, there is taxable capital gain
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
If a customer buys a new issue municipal bond at a discount, the discount must be accreted. Every year, a portion of the discount is “earned” and is taxed as interest income. In this case, since municipal issues are exempt from Federal income tax, no tax is due. As the bond is accreted, its cost basis is increased yearly by the accretion amount. At maturity, the bond’s cost basis has been accreted to par. Since it is redeemed at par, there is no capital gain or loss at maturity.
A customer buys 100M of a newly issued municipal bond in the primary market at 90. The bond has 20 years to maturity. If the bond is held to maturity, the customer will have:
A. no taxable gain or loss
B. a $1,000 capital gain
C. a $10,000 capital gain
D. a $100,000 capital gain
The best answer is A.
The customer is buying a new issue of bonds at a discount. The discount on original issue discount bonds must be accreted. Every year, a portion of the discount is “earned” and is taxed as interest income. In this case, since municipal issues are exempt from Federal income tax, no tax is due. As the bond is accreted, its basis is increased yearly by the accretion amount. At maturity, the bond’s cost basis has been accreted to par. Since it is redeemed at par, there is no capital gain or loss at maturity.
Which of the following statements are TRUE regarding municipal bonds purchased at a discount in the secondary market?
I Annual accretion of the discount is mandatory
II Annual accretion of the discount is optional
III The discount amount is taxed as interest income
IV The discount amount is not subject to tax
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
The discount on market discount municipal bonds is treated as taxable interest income earned. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not? The holder can either accrete the discount annually as taxable interest income earned and adjust the cost basis of the bond upwards by this amount; or can wait until the bond is sold or matures to report the accumulated “earned” discount as taxable interest income at that point (this is the better choice from a tax standpoint).
A $10,000 par municipal bond is purchased in the secondary market with a .25 mark-down. If the bond is held to maturity, the tax consequence is:
A. $25 capital gain
B. $25 taxable interest income
C. $250 capital gain
D. $250 taxable interest income
The best answer is B.
If a municipal bond is purchased in the secondary market for less than par, the market discount is treated as “taxable interest income.” So, in this case, tax-free municipal bonds are not so tax free! The holder has the choice of accreting the market discount annually and paying tax each year; or waiting until maturity or sale to pay the tax (the better option).
This bond is purchased at $10,000 less a .25 mark-down, which is a mark-down of .25% of $10,000 = $25. The bond is purchased for $9,975. If the bond is held to maturity, the $25 gain is taxable interest income.
A $100,000 municipal bond is purchased by a financial institution in the secondary market at 90. For tax purposes, the institution opts to not accrete the bond. The bond has 10 years to maturity. The bond is sold after 4 years at 95. The tax consequence is:
A. no gain or loss
B. 1 point capital gain
C. 1 point capital loss
D. 4 points taxable interest income; 1 point capital gain
The best answer is D.
Since these discount bonds are purchased in the secondary market, the market discount that is earned over the life of the bonds is treated as taxable interest income. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not? The holder has the option of either accreting the discount annually, and paying tax on the portion of the market discount earned; or of waiting until the bonds are sold or redeemed to pay the tax (the better option).
Since the bonds are valued at cost, there was no annual accretion of the discount. Thus, when the 10 year bonds are sold after 4 years, 4/10ths of the 10 point market discount has been “earned” and will be taxable as interest income at that point. The bonds were bought at 90; and sold for 95. Of the 5 point gain, 4 points (4% of $100,000 = $4,000) are taxed as interest income, with the remaining 1 point (1% of $100,000 = $1,000) taxed as capital gain.
A municipal bond dealer quotes an 8 year 4% bond trading in the secondary market on a 6% basis. After considering all taxes, the customer’s yield will be:
A. less than 4%
B. 4%
C. more than 4% but less than 6%
D. 6%
The best answer is C.
Even though the coupon rate earned from a municipal bond is free of federal income tax, any market discount is taxed as interest income earned. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not? The discount can be accreted annually and tax paid, or the tax can be paid at maturity or sale date.
There are two components to the yield earned on a discount security - the coupon rate and the annual earning of the discount. With this bond the customer is earning 4% per year in annual interest plus 2% per year in annual gain (which equals the 6% basis.) The 4% interest earned is not taxable, however, the annual 2% accretion of the discount is taxed at ordinary income tax rates. Therefore, the after tax yield will be more than 4% but less than 6%.
Municipal bonds purchased in the secondary market at a premium to par:
A. may be amortized
B. must be amortized
C. must be accreted
D. may be accreted
The best answer is B.
Secondary market premium municipal bonds must be amortized on a straight line basis over the life of the bond. Each year, the amortization amount reduces non-taxable interest income received; and reduces the bond’s cost basis. If the bond is held to maturity, the bond’s cost basis has been adjusted to par and since it is redeemed at par, there is no tax deductible capital loss. Amortization is required for both new issue premium and market premium municipal bonds.
A municipal bond is purchased at a premium in the secondary market. If the bond is held to maturity, what is the tax consequence?
A. There is no capital gain or loss if held to maturity
B. There is a loss which is deductible as a long term capital loss
C. There is a loss which is deductible as interest expense
D. There is a long term capital gain
The best answer is A.
Both new issue premium municipal bonds and municipal premium bonds purchased in the secondary market must be amortized. If they are held to maturity, the full premium has been amortized and the adjusted basis is par. Since the bonds are redeemed at par, there is no capital gain or loss.
A $10,000 municipal bond with 5 years to maturity is purchased in the secondary market at 105. The bond is sold after 2 years at 105. The taxable gain or loss is:
A. 0
B. a 2 point capital gain
C. a 2 point capital loss
D. a 5 point capital loss
The best answer is B.
All municipal premium bonds, whether original issue premium or trading market premium bonds, are subject to straight line amortization. The 5 point premium must be amortized over 5 years, so 1 point per year is amortized (with no tax deduction allowed for the annual amortization amount). After 2 years, the bond has an adjusted cost basis of 103 (105 purchase - 2 points total amortization). Since the bond is being sold at 105, the capital gain is 2 points.
A $10,000 municipal bond with 5 years to maturity is purchased in the primary market at 105. The bond is sold after 2 years at 103. The taxable gain or loss is:
A. 0
B. a 2 point capital gain
C. a 2 point capital loss
D. a 5 point capital loss
The best answer is A.
All municipal premium bonds, whether original issue premium or trading market premium bonds, are subject to straight line amortization. The 5 point premium must be amortized over 5 years, so 1 point per year is amortized (with no tax deduction allowed for the annual amortization amount). After 2 years, the bond has an adjusted cost basis of 103 (105 purchase - 2 points total amortization). Since the bond is being sold at 103, there is no taxable gain or loss.
A $10,000 municipal bond with 10 years to maturity is purchased in the primary market at 105. The bond is sold after 2 years at 105. The taxable gain or loss is a:
A. 1 point capital gain
B. 2 point capital gain
C. 2 point capital loss
D. 4 point capital loss
The best answer is A.
All municipal premium bonds, whether original issue premium or trading market premium bonds, are subject to straight line amortization. The 5 point premium must be amortized over 10 years, so 1/2 point per year is amortized (with no tax deduction allowed for the annual amortization amount). After 2 years, the bond has an adjusted cost basis of 104 (105 purchase - 1 point total amortization). Since the bond is being sold at 105, there is a 1 point capital gain.
A municipal bond dealer quotes an 8 year 6% bond trading in the secondary market on a 4% basis. After considering all taxes, the customer’s yield will be:
A. 6%
B. less than 6% but more than 4%
C. 4%
D. less than 4%
The best answer is C.
There are two components to the yield earned on a premium security - the coupon rate and the annual loss of the premium. With this bond the customer is earning 6% per year in annual interest minus 2% per year in annual loss (which equals the 4% basis.) The 6% interest earned is not taxable, and the 2% annual amortization of the premium is not deductible, so the net return is 4% after considering all taxes.
Thus, after considering all taxes, the basis quoted for a municipal premium bond will be the return received by the investor. In contrast, for a municipal discount bond, after considering all taxes, the return received by the investor will be lower than the stated basis because the portion of the investment return attributable to the market discount is taxable.
A customer buys a 6.5% municipal bond with 20 years left to maturity in the secondary market priced at 120 to yield 5.00%. After taking taxes into consideration, the customer’s yield will be:
A. less than 5.00%
B. 5.00%
C. between 5.00% and 6.50%
D. more than 6.50%
The best answer is B.
The premium on municipal premium bonds must be amortized over the bond’s life, but is not deductible for tax purposes. The yield on this bond consists of 2 components: the annual 6.50% coupon rate and the annual 1% loss of the premium (20 point premium amortized over 20 years = 1 point loss per year). Since there is no tax deduction for the annual loss, the net return each year, after tax, is 5.50% (6.50% coupon - 1.00% annual loss = $55 per year). The bond’s average value over its life is $1,100 ($1,200 purchase price + $1,000 redemption price / 2). The after-tax yield to maturity is: $55 / $1,100 = 5.00%.
Thus, after considering all taxes, the basis quoted for a municipal premium bond will be the return received by the investor. In contrast, for a municipal discount bond, after considering all taxes, the return received by the investor will be lower than the stated basis because the portion of the investment return attributable to the market discount is taxable.
An investor buys a 10% municipal bond in the secondary market on an 8% basis. If the bond is held to maturity, considering income and capital gains taxes, the investor’s after-tax yield will be:
A. 8%
B. 10%
C. more than 8% but less than 10%
D. less than 8%
The best answer is A.
Municipal bonds purchased at a premium, whether in the primary or secondary market, are subject to amortization of the premium. Every year, the investor’s non-taxable interest income is reduced by the amortization amount. At the same time, the bond’s cost basis is reduced by the amortization amount. At maturity, there is no capital gain or loss on the bond since the adjusted cost basis has been amortized to $1,000 and the bond is redeemed at $1,000. Thus, the after-tax yield on the bond will simply be the 8% yield to maturity that was quoted.
Thus, after considering all taxes, the basis quoted for a municipal premium bond will be the return received by the investor. In contrast, for a municipal discount bond, after considering all taxes, the return received by the investor will be lower than the stated basis because the portion of the investment return attributable to the market discount is taxable.
A customer buys $100,000 face amount of G.O. bonds in the secondary market at 90 and $100,000 face amount of Revenue bonds in the secondary market at 110. The investor opts not to accrete the G.O. bonds. If the bonds are held to maturity, the tax consequences are:
A. capital gains tax on the G.O. bonds; capital loss on the Revenue bonds
B. a gain taxed as interest income on the G.O. bonds; no gain or loss on the Revenue bonds
C. capital loss on both the G.O. and Revenue bonds
D. no gain or loss on both the G.O. and Revenue bonds
The best answer is B.
Investors that purchase municipal discount bonds in the secondary market have the option of accreting the bonds. If there is no accretion, the bonds are valued at cost. If they are held to maturity, there is a taxable gain at that point (with no accretion). The gain is taxed as interest income, though, and not as a capital gains.
Municipal premium bonds purchased in the secondary market must be amortized. If they are held to maturity, the full premium has been amortized and the adjusted basis is par. Since the bonds are redeemed at par, there is no capital gain or loss.
The term for the annual reduction of cost basis of a premium municipal bond performed according to IRS rules is:
A. compound amortization
B. straight line amortization
C. economic accrual accretion
D. straight line accretion
The best answer is B.
Under IRS rules, the premium on municipal bonds must be amortized on a straight line basis over the life of the bond.
All of the following are needed to determine the annual accretion amount on an original issue municipal discount bond EXCEPT:
A. Dated date
B. Maturity date
C. Acquisition cost
D. Sale price
The best answer is D.
The annual accretion amount on an original issue discount bond is based on the difference between the original acquisition cost of the bond and par value at maturity. The sale price is used to compute gain or loss, but is not needed to compute the annual accretion amount. The dated date is needed since accretion starts from this date. The maturity date is needed since accretion stops at this date.
The amount of accretion to be reported for tax purposes on an original issue discount bond requires the use of all of the following EXCEPT:
A. purchase price
B. market value
C. redemption price
D. maturity
The best answer is B.
Annual accretion of an original issue discount bond for tax purposes is based upon the difference between the issue price and redemption price, accreted over the number of years to maturity. The market value has no bearing on the annual accretion amount that must be reported as interest income earned.
All of the following are needed to determine the annual accretion amount on an original issue municipal discount bond EXCEPT:
A. Dated date
B. Maturity date
C. Acquisition cost
D. Market value
The best answer is D.
The annual accretion amount on an original issue discount bond is based on the difference between the original acquisition cost of the bond and par value at maturity. The current market value is not needed to compute the annual accretion amount. The dated date (the legal issuance date) is needed since accretion starts from this date. The maturity date is needed since accretion stops at this date.
