Chapter 6 Practice Question Answers
1. Answer: A. 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). This is a $375 market discount that will be taxed at her ordinary income rate. Since she holds the bond to maturity, she will incur no capital gains or losses.
2. Answer: A. Lynn’s bond had a 5% coupon rate that paid out $250 in interest each year. Lynn’s bond accretes by $40 each year ($5,000 – $4,800 / 5). Lynn sells her tax-exempt bond in year seven. Her adjusted cost basis is $4,880 ($4,800 + 2 years x $40). Since the difference between the sale price and her adjusted cost basis is $220 ($5,100 – $4,880), she has incurred a capital gain of $220. Lynn reports this as a capital gain on her tax returns, because investors must report capital gains and losses and pay taxes on capital gains. At sale, she will also be taxed at her ordinary income rate on the $200 discount she incurred at purchase. This is not considered a capital gain.
3. Answer: A. When the proceeds from the sale of a municipal security are greater than the adjusted cost basis, the investor has incurred capital gains. Capital gains incurred on the sale of municipal securities must be paid by the investor. Only the interest earned on municipal securities is tax-exempt.
4. Answer: A. For municipal OID bonds that are bought and held to maturity, the appreciation on the investment is considered interest on the bond and will have to be reported as tax-exempt interest.
5. Answer: A. While the interest on municipal securities is tax-exempt, capital gains realized on the sale of a municipal security are taxed. Because the security was held for one year or less, it will be taxed as a short-term capital gain. Short-term capital gains are taxed at a taxpayer’s ordinary income rate.
6. Answer: