Tax reporting zero coupon municipal bonds

Introduction to Zero-Coupon Municipal Bonds

  1. How Are Municipal Bonds Taxed?
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  4. Municipal Bonds Basics |

You buy the bond at a substantial discount from its face value, then collect the full value years later. You can buy a zero-coupon bond to pay for college bills ten years down the road, sock it away, and forget about it until you withdraw the money.

Which Bonds Are Tax Exempt?

You're paying tomorrow's bills today, at a big discount. There's one big gotcha, though. Even though you receive no annual interest, the IRS requires that you report the phantom payments just as if you were getting the checks. You owe tax each year on the prorated difference between what you paid for the bond and what you'll receive when it matures.

How Are Municipal Bonds Taxed?

This makes zeros attractive chiefly to people with IRAs, on which they needn't pay tax until they take the money out. Zeros are available as municipal bonds, which also spare you the annual reporting chore.

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Most are Treasury issues, which escape state income taxes. Zeros are also an attractive way to give financial gifts to kids, who will probably be taxed at a lower rate than you would be. Zeros carry the usual market risks for investors, with this added kicker: The company that issues a zero could conceivably default without ever having paid you a penny of interest.

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Whether taxable or not, the accrued income is added to the taxable basis of the underlying bond. If a taxpayer buys the bond from the issuer and holds it to maturity redeemed by the issuer , then the annual basis adjustment would eliminate the discount, causing no gain or loss on the receipt of the principal. If the bond is bought at par, no further computations are needed upon its sale; the sales price over the adjusted tax basis is all capital gain. The holding period will determine if it is short-term or long-term. If a taxpayer buys a bond at a market discount, when the price of the bond is below its adjusted tax basis, he or she will report the discount as ordinary income.

If a taxpayer buys a bond at a premium, for which the cost is greater than the adjusted tax basis, then the premium will be amortized during bond ownership.

Zero Coupon Bonds

The amortization reduces the municipal income, which is generally irrelevant, and also reduces the tax basis of the bond, which is always relevant. The adjusted tax basis is used to compute the capital gain.

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Municipal income will not determine the amount one receives as social security benefits, but it will affect the computation of how much of those benefits are taxable. Low-income taxpayers will not include any social security benefits in their taxable income. However, the threshold to be considered a low-income taxpayer can be easily surpassed, resulting in as much as 85 percent of the benefits one receives to be treated as taxable income.

The factor determining taxation is the total other sources of income reported on the tax return, specifically including municipal income. Therefore, despite the lack of taxation on the municipal income itself, taxpayers may potentially incur taxes indirectly on other sources of income.

Municipal Bonds Basics |

Taxpayers should consult with both a financial advisor and tax accountant to weigh the pros and cons of municipal bonds or any investment to ensure it meets with their short- and long-term needs. About the Author: Jeffrey M. Lauderdale office at or via email at info bpbcpa. Berkowitz Pollack Brant has cultivated a diverse client base that includes companies of all sizes.