4.11.1. Original Issue Discount Municipal Bonds
Original issue discount (OID) bonds are issued at a discount to par and do not pay any interest. The amount of the discount is treated, by the IRS, as interest over the life of the bond. The discount will be divided by the total number of years to calculate the annual phantom interest. For most municipal bonds this interest is tax-free on the federal level, but it may be taxed at the state level depending on the bond. It may also be taxed at the federal level if it is a private activity bond. The annual phantom interest, which is the same as an OID bond’s yearly accretion amount, must always be reported as interest income by the taxpayer each year until maturity. This requirement holds whether the interest is taxable or not.
Example: Andre purchases a 10-year $5,000 bond at its issue price of $3,000. Thus, the bond’s original issue discount is $2,000 ($5,000 – $3,000). The annual accretion for the bond will be $200 ($2,000 discount / 10 years). Since this is an OID bond, Andre must report the $200 as tax-free interest income, or phantom interest, each year until the bond reaches maturity.
To determine taxes due for an investor who bought an OID bond when it was first issued and later sells the bond on the secondary market, simply subtract the bond’s compound accreted value (CAV), which is the bond’s original issue price plus its total accretion, from its sale price. Note that in the case of an OID bond, annual accretion is calculate