Cost basis is an important part of the taxation of a municipal bond. Investors who have purchased municipal bonds need to know what their cost basis is and how to calculate it, so they will understand how to report their bond transactions for the purposes of taxes.
Cost Basis Requirements
The interest received on municipal bonds is usually tax-free. However, income from selling the bond itself is subject to capital-gains taxation. The tax rate on capital gains depends on whether the bond was held for more or less than 12 months. The amount of income that is taxable depends on a figure called the cost basis, or tax basis, of the bond. This number is a combination of the amount of money paid for the bond and any investment gains.
The first step in calculating cost basis is to find the purchase price of the bond. This is not the par value of the bond -- it is the price actually paid for the bond in the market. If the bond had a par value of $1,000, and the investor paid $900 for it upon issue, the purchase price was $900.
The purchase price figure is then adjusted upward to account for the fact that the bond was not held to maturity. To adjust cost basis, the investor needs to know the lifetime of the bond and the difference between the purchase price and the par value. If the bond in our example was a five-year bond, and we already know that the discount was $100, we can divide the discount by the lifetime to get 100/5 = $20 per year. For every year the investor holds the bond, the cost basis increases by $20.
Calculating Tax Liability
If the investor in this example sells the bond for $1,100 after holding it for three years, his adjusted cost basis is $900 + ($20 *3) = $960. Subtracting $960 from 1,100 gives $140, the capital gains that would be subject to taxation. Because the bond was held for more than 12 months, the maximum tax rate on that gain is 15 percent, or $21.
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