Chapter 4 Practice Question Answers
1. Answer: C. Sally’s cost basis is $4,000. The bond’s annual accretion is $375 (($10,000 – $2,500) / 20). Since the bond is five years old, its compound accreted value is $4,375 ($2,500 + 5 years x $375) at the time Sally purchased it. So Sally purchased the bond at a discount of $375 to its accreted value. However, the $375 discount is below the bond's de minimis amount of $500 (0.0025 x $10,000 x 20). This means that if Sally holds the bond to maturity, she will have to pay taxes on the discount at her long-term capital gains rate.
2. Answer: C. Since she purchased the bond for $4,800 and sold it for $5,100, Lynn realizes a $300 gain ($5,100 – $4,800). We must then calculate how much of that gain is taxable income and how much is capital gains. In purchasing a $5,000 face value bond for $4,800, Lynn received a $200 discount ($5,000 – $4,800). The bond had five years to maturity when she bought it, so we divide the discount by five to calculate the annual accretion on the bond, which is $40 ($200 / 5). Thus Lynn’s adjusted cost basis increases by $40 each year, and when she sells her bond two years later, that adjusted cost basis is $4,880 ($4,800 + $40 + $ 40). She will pay ordinary income on any gain up to her adjusted cost basis when the bond is sold, meaning that she will pay for $80 profit at her regular tax rate ($4,880 – 4,800). The remainder of her $300 profit, which is $220, will be taxed at her capital gains rate ($300 – $80).
3. Answer: B. General obligation (GO) bonds are typically the safest kinds of bonds because they are backed by the full faith and credit of the municipality, so they receive the lowest yield. Revenue bonds can be divided into two different kinds of taxable bond. A public purpose bond is one that finances projects that serve the local population in general. Public purpose bonds are tax-exempt and therefore