Quick Answer
A premium paid at purchase must be amortized (mandatory, non-deductible) down to par; an original issue discount is accreted (tax-free) up to par. A discount bought later in the secondary market is market discount. It is generally ordinary income when recognized, unless the de minimis exception gives capital-gain treatment; it is not tax-free like original issue discount (OID).
Now that you understand how municipal bonds are priced, let's look at what happens to the cost basis when you buy a bond above or below par. The tax treatment of premiums and discounts is one of the most tested areas in municipal bond math.
How Does Premium Amortization Work?
When a tax-exempt municipal bond is purchased at a premium (above par), the premium must be amortized. This is mandatory, not optional.
Think of it this way: You paid extra for a bond that will only pay back par at maturity. Each year, a portion of that "overpayment" is written off, gradually walking your cost basis down to what you will actually receive at the end.
Key rules:
- Amortization reduces the cost basis annually toward par over the remaining life of the bond
- The amortized premium is not deductible against income (unlike taxable bonds)
- At maturity, the adjusted cost basis equals par, so there is no capital loss at redemption
- Straight-line amortization (for Series 7): premium / years to maturity
What Does a Premium Amortization Calculation Look Like?
Buy a 5% municipal bond at 108 (10 years to maturity):
- Purchase price: $1,080
- Par value: $1,000
- Premium: $80
- Annual amortization: $80 / 10 = $8 per year
| Year | Adjusted Cost Basis |
|---|---|
| Purchase | $1,080 |
| After 1 year | $1,072 |
| After 5 years | $1,040 |
| At maturity (year 10) | $1,000 (no gain or loss) |
If sold before maturity, gain or loss is calculated against the amortized cost basis, not the original purchase price.
Exam Tip: Gotchas
- Premium amortization on tax-exempt munis is MANDATORY (not optional) and the amortized amount is NOT tax-deductible.
- If you sell a premium bond before maturity, use the amortized basis (not original cost) to calculate gain or loss.
How Does OID Accretion Work?
When a municipal bond is issued at an original issue discount (below par at issuance), the discount is accreted (added to basis) over the life of the bond.
Key rules:
- OID on a tax-exempt bond is treated as tax-free interest (not taxable income)
- Annual accretion (straight-line): OID / years to maturity
- At maturity, the adjusted cost basis equals par, so there is no capital gain at redemption
- If sold before maturity for more than the accreted value, the excess is a capital gain
What Does an OID Accretion Calculation Look Like?
Buy a new-issue municipal bond at 92 (20 years to maturity):
- Purchase price: $920
- Par value: $1,000
- OID: $80
- Annual accretion: $80 / 20 = $4 per year
| Year | Adjusted Cost Basis |
|---|---|
| Purchase | $920 |
| After 5 years | $940 |
| After 10 years | $960 |
| At maturity (year 20) | $1,000 (no gain) |
If sold at $960 after 5 years: $960 - $940 (accreted basis) = $20 capital gain
How Does Market Discount Differ from OID?
When a municipal bond is purchased in the secondary market at a discount (below par for bonds originally issued at par, or below the current accreted value for OID bonds), the discount is a market discount.
Critical distinction from OID:
| Feature | OID (Original Issue Discount) | Market Discount |
|---|---|---|
| When it occurs | At original issuance | Secondary market purchase |
| Tax treatment on munis | Tax-free (treated as tax-exempt interest) | Generally ordinary income; capital gain if de minimis |
| When recognized | Accreted annually (adjusts basis) | At sale or maturity (or annual election) |
- Market discount on municipal bonds is generally ordinary income when recognized, unless the de minimis exception applies
- For non-de minimis market discount, the investor may elect to include it annually or defer recognition until sale or maturity
De minimis exception: A market discount smaller than 0.25% of the bond's face value times the number of full years remaining to maturity is treated as zero under the market-discount rules. Gain on that small discount is capital gain, not tax-exempt interest. For a $1,000 bond with ten full years left, the threshold is $25; a $50 discount exceeds it.
Exam Tip: Gotchas
- Original issue discount accretion on a tax-exempt muni is tax-free interest. Market discount is taxable: generally ordinary income, or capital gain if below the de minimis threshold.
- Original issue discount arises at issuance; market discount arises on a later purchase. The full tax treatment also depends on the size of the market discount.
What Drives Bond Price Sensitivity?
Why does this matter? When interest rates change, not all bonds react equally. Two characteristics determine how much a bond's price moves: how long until maturity and how large the coupon is.
- Longer maturity = greater price volatility for a given change in interest rates (more duration)
- Lower coupon = greater price volatility for a given change in interest rates
- A zero-coupon bond has the highest price volatility of any bond with the same maturity
- With market yields and credit quality unchanged, a bond's price converges toward par as maturity approaches (the "pull to par" effect). Rate changes can interrupt that trend; repayment at maturity assumes no default
Exam Tip: Gotchas
- Zero-coupon bonds have the highest price sensitivity to interest rate changes of any bond with the same maturity. No coupon payments means all value is in the final payment, so duration is maximized.
- Lower coupon = more volatility. A 2% bond moves more in price than a 6% bond when rates change by the same amount.
What Should You Check on Exam Day?
- Confirm whether a scenario describes a premium (amortize, mandatory, no deduction) or an original issue discount (accrete, tax-free).
- Distinguish original issue discount (tax-free accretion) from secondary-market discount, then check the de minimis threshold before assigning ordinary-income or capital-gain treatment.
- Use the amortized or accreted basis, not the original purchase price, when calculating gain or loss on an early sale.
- Identify which bond has the highest price sensitivity: longest maturity, lowest coupon, or zero coupon.