Original Issue Discount

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.

Client Adaeze Nwosu holds Treasury STRIPS in her TAXABLE brokerage account, purchased at a deep discount and maturing in eighteen years. She tells her IAR she likes them because they pay nothing until maturity, so there is nothing to report each year. Which statement is correct?

1. A.She is correct: because no cash is received before maturity, no federal income is reportable until the STRIPS mature.Incorrect. Original issue discount accretes and must be included in federal taxable income annually, notwithstanding the absence of any cash payment.
2. B.She is mistaken: the annual accretion of original issue discount is federally taxable each year even though no cash is received, which is why zeros suit tax-deferred accounts; the interest is, however, exempt from state and local tax.Correct. Phantom income makes a taxable account the wrong home for a zero, while Treasury status still exempts the interest from state and local tax.
3. C.She is mistaken, because the annual accretion is taxable at both the federal and the state level, exactly as corporate zero-coupon interest is.Incorrect as to the state treatment. STRIPS are Treasury obligations, so the interest is exempt from state and local income tax.
4. D.She is correct, and the STRIPS also carry less interest rate risk than a coupon Treasury of the same maturity.Incorrect on both counts. Annual OID is reportable, and a zero has the LONGEST duration for its maturity, so it carries the most interest rate risk.

Why: STRIPS are created when an eligible Treasury note or bond is separated through the book-entry system so that each interest payment and the final principal payment becomes its own zero-coupon security. Each piece is a direct obligation of the United States government, so credit risk is negligible, and like other Treasury obligations the interest is exempt from state and local income tax. Because a zero pays no cash before maturity, it carries no reinvestment risk on interim coupons, and it has the longest duration of any bond of a given maturity, so its price is unusually sensitive to changes in interest rates. Her belief about reporting is wrong. The discount accretes as original issue discount, and the holder must include the accreted amount in federal taxable income EACH year even though no cash is received. That phantom income problem is precisely why zero-coupon instruments are usually better held inside a tax-deferred account.

An investor buys an ORIGINAL ISSUE DISCOUNT municipal zero-coupon bond at issue and holds it to maturity. The accreted discount is:

1. A.Tax-exempt interest that increases her basis to par by maturityCorrect. OID accretion on municipals keeps its tax-exempt character.
2. B.Taxable ordinary income each yearWrong-but-tempting. Annual ordinary taxation describes CORPORATE zeros (and muni MARKET discount), not muni OID.
3. C.A capital gain recognized at maturityWrong. Basis reaches par by maturity, so no gain arises.
4. D.Deferrable until she sells the bondWrong. Accretion happens annually - it is simply tax-exempt.

Why: Original issue discount on a tax-exempt bond is treated as tax-exempt interest that accretes annually and increases basis, so redemption at par produces no taxable gain. Citation: IRC Sec. 1288 (OID on tax-exempts); contrast Sec. 1276 (market discount). Takeaway: muni OID = tax-free accretion; muni market discount = taxable.