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Tax treatment of accreted market discount


I just discovered your site and find it very interesting. But with regard to your “Lessons in Laddering” article, my understanding is that accreted market discount is taxable at ordinary income rates when a bond is sold, even for municipal bonds. In your example, when the discounted bonds bought in the swap at 50 mature at 100, ordinary income tax will be owed on the $100,000 gain. Therefore the tax loss of $100,000 resulting from the swap will be offset by $100,000 of accreted market discount at maturity. If the tax loss is used to offset capital gains, then the investor is only saving 15% ($15,000) in taxes at the time of the swap, but will owe anywhere up to 35% ($35,000) taxes on the accreted market discount at maturity, presumably 20-plus years after the swap. You state: “Best of all, the investor’s new bonds regained all of their lost market value in the following years,” but you don’t mention this tax liability. Admittedly, if the investor reinvested the $15,000 tax savings, and his tax rate were less than the maximum 35%, he might still come out ahead, but it pretty much seems a wash. Am I missing something?



James A. Klotz responds:

Your understanding is correct regarding the tax treatment of the “accreted market discount.”

In our article you refer to above, we described a transaction that occurred in the early 1980s. During this period, the market discount was taxed as a capital gain when a bond was sold or matured above the original purchase price.

After reviewing your e-mail, we realized that we should have explained that the tax code was changed in May 1993 to treat this type of gain as ordinary income. Thank you for bringing this to our attention.

Aug 2, 2007

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