A:
An investor bought a new full faith and credit bond issued by the city of Limrock. The bond had a twenty-year maturity, a coupon 4.35 and was purchased for $900. Ten years later, the investor sold the bond for $950. What are the tax implications for this investor?
I. The investor has paid taxes on a total accretion of $50
II. The investor will have a $50 capital gain
III. The investor has accreted the bond, but has paid no taxes on the accretion
IV. The investor will realize no gain; no loss

a) I, IV
b) I, II
c) II, III
d) III, IV

The correct answer is d.
There are two problems in this question. The first is to recognize the fact that this bond is an Original Issue Discount Bond (OID). All discount bonds, including OID municipals, must be accreted, but the tax rules allow the accretion to be treated as municipal interest—tax exempt. The amount of accretion is $50 ($100 discount ÷20 years = $5/year × 10 years = $50). The original basis of the bond, $900 is accreted by $50 to $950, so when the bond is sold for $950 there is no capital gain or loss.

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