Accretion

Accretion of an original issue discount (OID) bond:

1. A.Only matters at saleThis treats accretion like an ordinary capital gain, recognized only on disposition. Accretion instead runs every year the bond is held, adjusting basis annually whether or not the holder sells anything.
2. B.Has no tax effectThe accreted amount is generally reported as interest income each year, which is the defining feature of an OID bond: the holder is taxed on income not yet received in cash. Declaring no tax effect erases the reason the accretion rule exists.
3. C.Decreases the basis to zeroBoth the direction and the destination are wrong. Accretion raises basis toward par rather than lowering it, and it stops at par rather than running to zero. A zero basis would imply the entire redemption amount was gain.
4. D.Increases the cost basis toward par over timeCorrect - the discount is accreted to par.

Why: Accretion increases the bond's cost basis over time toward par, and the accreted amount is generally taxed annually as interest.

Treasury STRIPS (zero-coupon Treasuries) are taxed:

1. A.As capital gains onlyTreating the entire increase in value as capital gain misreads what the growth represents. The climb from the discounted purchase price toward par is accreted interest, and it is reported as interest income rather than gain.
2. B.On imputed interest annually (phantom income)Correct - taxed each year without cash.
3. C.Never (they are tax-free)Treasury securities are exempt from state and local income tax, which is likely the source of the tax-free impression. Federal tax still applies, and for STRIPS it applies each year on the accreted amount.
4. D.Only at maturityThis is the most understandable answer, since not a dollar of cash reaches the holder until the security matures. Tax follows the accretion rather than the cash, so the owner reports imputed interest every year, the phantom income problem that makes STRIPS awkward outside a retirement account.

Why: STRIPS accrete imputed interest that is taxed annually, despite paying no current cash interest.

For a bond bought at a discount and held to maturity, the discount is:

1. A.IgnoredThe discount cannot be ignored. It is accreted over the life of the bond, raising the adjusted cost basis each year until it reaches par at maturity.
2. B.A capital loss at maturityThis reverses the direction of the economics. The investor paid less than par and receives par, which is a benefit, not a loss; accretion recognizes it along the way so basis equals par at maturity.
3. C.Amortized to zeroAmortization is the term for writing a PREMIUM down toward par. A discount moves the other way and is accreted upward, and it stops at par rather than running to zero.
4. D.Accreted up to par by maturityCorrect - basis rises to par.

Why: A market discount is accreted so the basis reaches par by maturity.

Hollis pays 700 dollars for a zero-coupon corporate bond with a 1,000 dollar face value and 10 years to maturity, held in a taxable account. Using straight-line accretion, what is his adjusted cost basis after four years?

1. A.700 dollarsThis assumes no accretion occurs until maturity. On a taxable OID bond the discount is accreted and taxed each year.
2. B.1,000 dollarsThis jumps to the full face value. Basis reaches face only at maturity, after all ten years of accretion.
3. C.820 dollarsCorrect. 300 / 10 = 30 dollars per year, and 700 + (30 x 4) = 820 dollars.
4. D.760 dollarsThis accretes for only two years. The stem asks for the basis after four years.

Why: The discount is 1,000 minus 700, or 300 dollars, spread over 10 years, so 30 dollars accretes each year. After four years 120 dollars has been accreted and reported as taxable interest income, and the basis rises correspondingly to 700 plus 120, or 820 dollars. The rising basis is what prevents that income from being taxed a second time as gain. Review original issue discount accretion in the debt securities topic.