Municipal bonds aren't always tax-free. While the interest income you earn from tax-free municipal bonds isn't subject to federal tax and is also exempt from state tax if you buy a bond from a state where you reside, the Internal Revenue Services treats your proceeds from trading municipal bonds differently. When you trade the bonds, you pay capital gains taxes and get to claim capital loss offsets.
Capital Gains and Losses
Capital gains and losses are calculated based on your after-commission cost of buying an asset and your after-commission proceeds from selling it. If you pay $10,000 plus $50 commission to buy a bond and you end up selling it for $9,750 and paying $50 commission on the sale, you'd have a $350 loss ($10,050 minus $9,700). You can use capital losses to offset capital gains, and if you end up with a net loss for the year you can write off up to $3,000 of it -- $1,500 if you're married and file separately -- against your regular income.
Municipal Bond Trading
When you buy and sell municipal bonds, you could be subject to losses and gains. These won't come into play when you buy newly issued bonds and hold them to maturity, though. Capital losses come into play when you trade bonds on the secondary market and lose money in the process.
OIDs and Premiums
Figuring capital losses and gains on municipal bonds can get complicated when you buy a bond at a premium -- which is paying more than its face value -- or when you buy a bond that has an original issue discount. An OID occurs when a bond is sold at less than face value and ends up maturing to its full face value. When you buy a bond with an OID, any gain that you receive up to the face value is tax-exempt. On the other hand, when you buy a bond at a premium, you have to spread the premium out over the life of the bond. If you pay a $10 premium on a 10-year bond, you'll reduce your cost by $1 every year for 10 years until you've gotten rid of the entire premium. As the cost goes down, any capital loss that you realize on its sale also goes down.
The Wash Sale Rule
When you sell a municipal bond at a loss, you can't repurchase it or another very similar bond. If you do, the IRS will consider it to be a "wash sale" and will disallow your loss. To sell a bond at a loss and reinvest the funds without breaking the wash sale rule, you have two options. You can wait 30 days to reinvest the money, or you can buy a bond where at least two of the following three aspects are different from the one you sold: the bond's issuer, its coupon rate or the date on which it matures.
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