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Profit on zero-coupon bonds
Q
I am in a bit of turmoil and confused. In 1990, I bought a zero coupon tax-free muni for $9,155 and last year (2005), it reached its maturity and I cashed it in for $25,000. It was a Pennsylvania bond, and 10 years ago, I moved to South Carolina. I thought that no tax would be owed on this bond since it was a zero-coupon muni, but I’ve been informed that I will owe federal taxes on the profit made in those 19 years. Is that right?
A
James A. Klotz responds:
If your zero-coupon bond was purchased at the time of issuance, the tax-free interest earned on the zero coupon municipal bond acts to increase your cost basis in the security. Your adjusted cost at maturity would then be equal to the redemption price, which indicates no tax is due.
If the zero coupon bond is purchased after issuance, below its accreted value, the difference between the adjusted cost basis and the redemption price could be subject to capital gains tax.
Please consult your tax advisor for a definitive answer regarding your specific situation.
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