A Series 7 customer just emailed me to question the tax treatment for original issue discount (OID) municipal bonds. To be honest, I've never felt 100% comfortable teaching on this topic and should have done some research on it a long time ago. So, no matter how dry an email about the veracity of taxation on original issue discount municipal securities might seem, I was actually quite pumped to dive in. Luckily, I've been doing so much searching at http://www.irs.gov/ lately that I was able to find what I needed in less than one minute. And, luckily, all I needed was Publication 550. That, plus a handful of Excedrin, the reading skills of an attorney, and the patience of Job. But, in the end I was rewarded by knowing that the way I teach taxation on discounted municipal bonds is, apparently, exactly right. I also noticed that I do, apparently, provide a useful service for Series 7 candidates by taking nearly incomprehensible English and making sense of it. In my Pass the 7 book, I try to keep it simple. In the book, my job is to tell you that an original issue discount (OID) municipal bond is treated differently from a STRIP. Since the interest on a STRIP is taxable, you have to report some interest income you haven't actually received on 1099-OID each year and pay tax on it. But, a muni is tax-exempt; therefore, you don't have to pay tax on anything and don't have to file anything. If you sell the bond before maturity, you get to step up your cost-basis to help reduce or eliminate a capital gain on the bond. I also then point out that when you buy a tax-exempt (muni) bond at a discount from an investor, things are wholly different. Now, that discount is taxable . . . as ordinary income!
Turns out, that is exactly right, no matter how strange it seems. But what really struck me is how difficult it is to get that all from the orginal bureaucratic, legalistic version. This is how the IRS explains what I just wrote above (From Publication 550) :
Original issue discount. Original issue discount (OID) on tax-exempt state or local government bonds is treated as tax-exempt interest. If the bonds were issued after September 3, 1982, and acquired after March 1, 1984, increase the adjusted basis by your part of the OID to figure gain or loss.
Discounted tax-exempt obligations. OID on tax-exempt obligations is generally not taxable. However, when you dispose of a tax-exempt obligation you must accrue OID on the obligation to determine its adjusted basis. The accrued OID is added to the basis of the obligation to determine your gain or loss.
Market discount. Market discount on a tax-exempt bond is not tax-exempt. If you bought the bond after April 30, 1993, you can choose to accrue the market discount over the period you own the bond and include it in your income currently, as taxable interest. If you do not make that choice, or if you bought the bond before May 1, 1993, any gain from market discount is taxable.
I guess what also struck me was how much I enjoyed reading Publication 550 and how much I, apparently, need to find myself a hobby.