Monday, January 25, 1999


Tax-free bonds not always thus

        Question: Is a tax-free interest municipal bond subject to the capital gains tax?

        — J.M. in Cincinnati.

        Answer: Tom Cooney, a tax partner with Cincinnati's Rippe & Kingston, says interest on state and local government obligations is ex empt from federal income tax, but you may have a taxable gain on the sale or redemption of the bonds.

        If you bought the bonds on their issue date at a discount from face value, you received an Original Issue Discount (OID). Your basis in an original issue bond is increased over time as the discount is earned. If you sell the bond at maturity, you would not realize a gain because your basis would equal face value.

        For bonds issued after June 8, 1980, the portion of the OID that has not been earned is treated as a capital gain. OID on bonds issued before June 9, 1980, is considered tax-exempt interest.

        For bonds bought after original issue, the difference be tween your purchase price and the face value of the bond is called a market discount. For bonds bought after April 30, 1993, market discount recovered on sales is treated as taxable interest and not capital gain. For tax-exempt bonds bought before May 1, 1993, the gain attributable to market discount generally will be treated as a capital gain.

        You may elect to treat market discount as income as it is earned. If you do, the discount recognized will increase your tax basis.

        Your gain also could be attributable to a call premium, which allows the issuer to redeem the bonds early. The amount they pay for this option is called the call premium. The difference between a call premium and the basis is treated as a taxable gain.

        The gain you realized on the redemption of your bonds could be a combination of market discount, original issue discount and call premium.

        For more information, consult IRS Publication 555, Investment Income and Expenses.

        — Compiled by Perry Brothers

        Readers should consider the advice from the Money Panel as general information only. Investors should seek the help of professionals on questions regarding their own portfolios because circumstances might vary.


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