Gains and Losses on Municipal Bonds

Although interest from municipal bonds is exempt from the federal income tax, the IRS doesn't ignore the gain or loss that results when you sell the bonds. If you sell a bond for more than your basis, the profit is a capital gain; if you sell it for less, it's a deductible capital loss.

In general, your basis is figured the same way as for taxable bonds. However, if you buy a tax-exempt bond at a premium (you pay a premium when the interest rate of the bonds you purchase is higher than the current rate on comparable bonds), you must amortize the premium over the period you own the bond. This amortization reduces your basis in the bond, but unlike a taxable bond, you can't deduct the amortized amount. The premium amortization is not deductible because the interest is not taxable.

If you buy a bond originally issued at a discount, you increase your basis each year as is required with taxable bonds, but you don't have to report the annual portion of the discount as income. It, along with interest paid on the bond, is tax-free. You buy bonds at a discount when the interest rate on the bond at the time it is issued is lower than the current rate on comparable bonds.

Things are different, though, if you buy a municipal bond at a market discount. This can happen when you purchase a bond on the secondary market and the rate on the bond is lower than the current rate on comparable bonds. And, different rules apply depending on when you buy the bond. For those purchased before May 1, 1993, you don't amortize the market discount. Rather, your basis remains stable, and when you redeem the bond at face value, the difference between what you paid and what you receive is a taxable capital gain. When Congress hiked the top tax bracket to 39.6 percent but kept lower rates for capital gains taxes, however, the lawmakers decided this rule was too generous.

When you sell a market-discount tax-exempt acquired after April 30, 1993, gain attributable to the discount is treated as ordinary income and the remainder is capital gain. Rather than report the full amount at the time you dispose of the bond, you can choose to report a portion of the discount annually as it accrues.

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