Tax Free Zero Coupon Bonds and Taxes

Question

I am an investor in Municipal bonds, including tax free zero coupon bonds. Imagine an investor buys a tax free zero coupon bond at 20 and then keeps the bond for 3 years and sells the bond at 15. He has a capital loss. For tax purposes, can he add to the basis of the bond the interest he "received" on an accrual basis? If so, then he should have a loss more like 7 points.

Answer 1

A zero-coupon bond does not accrue, or pay, interest. Muni bond exemption only applies to interest, so if there is no interest there is no exemption.

Are you perhaps thinking of Original Issue Discount (OID)? As a US taxpayer if you buy a (long-term) bond issued at a (non-minimal) discount from par value, you are required to treat a portion of that discount as imputed interest each year you hold the bond, and in most cases pay tax on the imputed interest. For a stripped tax-exempt bond you only pay tax on the part that exceeds what the tax-exempt coupon would have been, but for a zero that's all of it. See chapter 1 of Publication 550 current year online here (all years downloadable in PDF from the Forms&Pubs tab)

If you buy through a broker, they will provide this information on form 1099-OID in your end-of-year tax package; if you have to do it yourself see Publication 1212 (in places similar to 550) and weep.

This basic rule applies to all bonds, zero or stripped or normal, although zeros and strips essentially always sell at a discount while coupon-paying bonds only sometimes do; sometimes they sell at a premium, in which case for a taxable bond you have the option to amortize the premium against the interest received. Similarly if you buy in the secondary market, at (additional) discount due to e.g. higher competitive rates or increased issuer risk, you have the option whether to amortize that or defer it, but if you defer it on disposition you must treat it as interest (rather than capital gain).

In all cases you do add imputed OID to basis, as well as market discount if you elected to amortize (and subtract amortized market premium). See the items 'Market discount on bonds' and 'Original Issue Discount (OID) on debt instruments' under (several pages under!) Basis of Investment Property - Stocks and Bonds. And yes this does result in decreasing your taxable gain or increasing your loss on disposition.