Great information on your site, especially the laddering truths, which most people don't understand. I have a few questions: 1) Capital losses, for example: Buying zeros (at a bit of a premium over accreted value) and a short time later they are called at accreted value. Is there a capital loss to report on one's 1040 schedule D? If yes, do you accrete them up to expected value based on your purchase price, then subtract for the loss? 2) Zero munis accrete, as we know. Does one report the accretion on the 1040 with other exempt interest? If yes, does one figure the accretion from one's purchase price to maturity (not the bond's original accretion)? If the bond was bought at a discount or premium to accreted value at the time of purchase, one would create a new schedule on a spreadsheet. 3) Similar to the first question above: Do zeros, if sold before maturity, ever create a cap gain or loss? If yes, is it based on one's own accretion table (as in question two above)?
Your question is a good one. It addresses issues that are often misunderstood or ignored by taxpayers as well as many tax professionals.
Tax-exempt interest earned on zero coupon bonds should be reported on your 1040, along with all other tax-exempt interest received. The interest reported is based on the original issue price and yield or, as you stated, "the bond's original accretion."
Your adjusted basis in the bonds at any time after purchase would be your actual purchase price plus any accretion that, once again, is based on the original issue price and yield. Additionally, for tax-free zeros purchased at a premium to accreted value, the premium must be amortized using the constant interest method. This will serve to lower the adjusted basis, but is not allowed to lower the interest (accretion), which should be reported.
A subsequent sale of a tax-free zero will result in ordinary income to the extent there was a market discount to accreted value at the time of purchased, and a capital gain to the extent that sale proceeds are greater than the bond's original accreted value at the time of sale. It will result in a capital loss if the bond is sold at a price lower than adjusted basis.
Here are some examples:
Purchase price 30.
Accreted value at time of purchase 33.
Bond held to maturity (Proceeds 100)
Adjusted basis would be 97. Ordinary income would be 3.
Same as above except:
Bonds sold at 73 when accreted value is at 70.
Adjusted basis would be 67. Ordinary income 3 and Capital gain 3.
Same as above except:
Bonds sold at 65 when accreted value is at 70.
Adjusted basis would be 67. Capital loss would be 2.