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:

D. 4 points taxable interest income; 1 point capital gain

Explanation:

The complete question should come with the following choice of answers

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.

For discount bonds bought in the secondary market, taxable interest income is charged on the market discount. The taxable interest income fee could be paid on discount left to accumulate annually or it could paid when the bonds are sold or redeemed.

From the question, the bonds were valued at cost, therefore the discount will not accumulate. Hence, when the 10 year bonds are sold after 4 years, tax will be paid on market discount earned (4/10 or value at 10years). The bonds was sold for 95 indicating a total 5point gain after 4 years, so 4 parts of the bond value will be taxed as interest income while tax on capita gain is collected on the remaining 1 part

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