Question

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 gain.

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.

Which of the following statements is true regarding municipal discount bonds and premium bonds?
1) Discount bonds are accreted at the option of the bondholder
2) Premium bonds must be amortized
3) Discount bonds must be amortized
4) Premium bonds are accreted at the option of the bondholder

Answer 1

The true statements regarding municipal bonds are that discount bonds can be accreted at the bondholder's option and premium bonds must be amortized; options 1 and 2 are correct.

Step-by-step explanation:

When it comes to municipal bonds, understanding the tax implications of discount and premium bonds is essential. Discount bonds, which are purchased below their face value, can be accreted at the bondholder's option. This means that the bondholder can choose to gradually increase the bond's value on their books to reach par by the maturity date, reflecting income rather than a capital gain. On the other hand, premium bonds, which are bought above their face value, must be amortized, which means their value is reduced over time to match the face value at maturity, preventing any capital gain or loss. This particular accounting treatment affects how gains are taxed for investors.

Considering these facts, the correct statement regarding municipal discount bonds and premium bonds is that: 1) Discount bonds are accreted at the option of the bondholder and 2) Premium bonds must be amortized. The other statements are incorrect as discount bonds do not have to be amortized and premium bonds cannot be accreted at the option of the bondholder; they must be amortized.