6.3.3. Compound Accreted Value
As discussed in Chapter 1, some bonds pay out in the form original issue discounts (OIDs) instead of coupon payments, and these OIDs are treated as interest for tax purposes. The IRS requires that this “phantom interest” be reported each year even if it is tax-free, as is the case for most municipal bonds. Much of the math involving OIDs is too complex to be on the exam. However, you should understand the concepts involved.
Even though an OID does not actually pay out until maturity, for tax purposes the OID is broken up and part of it allocated to each year of the bond’s life, either as taxable interest, or in the case of most municipal bonds, as non-taxable but reportable interest. How much is allocated to each year? In the 1980s and ’90s, there were several rule changes that complicated this question.
The old method was called the ratable method, and it divided up the dollar amount of the OID equally throughout the life of the bond. So if a 10-year