- A client purchases a newly issued 10-year zero-coupon corporate bond at original issue for $400 (par value $1,000) at the beginning of the 2026 tax year and holds it throughout the year. The bond's accreted value rises from $400 to $438.38 during the year. The client asks the IAR how the bond will affect 2026 taxes. Which response is correct?
Answer: The client will owe tax on $38.38 of ordinary interest income for 2026, equal to the bond's annual accretion in value.
Under IRC § 1272, original issue discount on a zero-coupon bond is accrued under the constant-yield method and is included in ordinary income each year even though no cash is received. Here the first-year accretion is $38.38 ($438.38 - $400), so that amount is taxable and is added to the investor's basis. Deferring all tax until maturity as long-term capital gain misstates the OID rules, which require annual ordinary income inclusion. The $60 figure comes from straight-line allocation of the $600 discount over ten years, not the constant-yield accrual. The basis does not remain $400; each year's OID inclusion increases the basis.
- Which of the following statements regarding a corporate convertible bond is true?
Answer: The holder may exchange the bond for a fixed number of the issuer's common shares, and the conversion ratio is adjusted for stock splits.
Under a convertible bond's indenture, the holder has the right to exchange the bond for a fixed number of common shares, and anti-dilution provisions generally adjust the conversion ratio for stock splits and stock dividends. The statement that the issuer may require conversion when the stock falls below the conversion price is wrong: the conversion privilege belongs to the holder, and converting when the stock is below the conversion price would be economically irrational; the issuer's comparable right is to call the bond for cash. The statement that the conversion price equals the stock's market price at issuance is wrong: the conversion price is typically set above the market price, which creates a conversion premium. The statement that a convertible bond pays a higher coupon is wrong: because the conversion feature has value, convertible bonds generally pay lower coupons than comparable non-convertible bonds of the same issuer.
- Under the federal income tax rules in effect for tax year 2026, which of the following statements regarding a newly issued corporate zero-coupon bond held to maturity in a taxable account is true?
Answer: The original issue discount is includible in ordinary income each year and added to the bond's basis, so no gain is recognized at maturity.
IRC § 1272 requires the holder of a taxable bond issued at a discount to include a portion of the original issue discount in gross income as ordinary interest each year, even though no cash is received; the adjusted basis is increased by the amount included, so a holder who keeps a newly issued zero-coupon bond to maturity receives the redemption price with a basis equal to that price and recognizes no gain. The statement that the discount is recognized at maturity as a long-term capital gain is wrong: the annual inclusion is mandatory, and the income is ordinary interest, not a capital gain. The statement that the investor may elect to defer the discount until maturity is wrong: no deferral election exists for original issue discount; the market discount rules contain an election that works in the opposite direction by accelerating income. The statement that the discount is included annually but the basis remains at original cost is half right: the annual inclusion is correct, but the basis is increased by each year's accrual, which is what prevents the same income from being taxed again at maturity.
- For tax year 2026, an investor in the 32% federal and 4% state marginal income tax brackets is comparing a tax-exempt in-state municipal bond yielding 4.0% with a fully taxable corporate bond. The investor itemizes deductions on Schedule A and is below the state and local tax (SALT) deduction cap, so state income taxes paid would be fully deductible from federal taxable income. For purposes of this question, assume the investor is not subject to the 3.8% net investment income tax. What yield on the corporate bond would produce the same after-tax return as the municipal bond?
Answer: 6.13%
Tax-equivalent yield concept. Under the stated assumptions and ignoring the NIIT, because state income taxes are deductible against federal income, the effective state rate is 4% × (1 − 0.32) = 2.72%, giving a combined effective rate of 32% + 2.72% = 34.72%. The tax-equivalent yield is 4.0% ÷ (1 − 0.3472) ≈ 6.13%. The 5.56% answer treats the combined rate as 32% − 4% = 28%; the 5.88% answer ignores the state tax entirely and uses only the 32% federal bracket; and the 6.25% answer simply adds the two statutory rates (36%) without adjusting for the federal deduction of state tax.
- A client owns a corporate bond that is convertible into shares of the issuer's common stock. The client converts the bond into stock when the stock's market value exceeds the bond's adjusted basis. Which statement about the tax consequences is correct?
Answer: The conversion is not a taxable event; the stock's basis equals the bond's basis, and the bond's holding period carries over to the stock.
Under long-standing tax principles (Rev. Rul. 72-265), the conversion of a convertible bond into the issuer's common stock pursuant to the bond's terms is a nontaxable exchange. No gain or loss is recognized at conversion. The client's basis in the stock is the same as the adjusted basis of the converted bond, and the holding period of the stock includes the holding period of the bond. The options that treat the conversion as a taxable event, recognize ordinary income for the conversion privilege, or step up the stock's basis to fair market value on the conversion date each misstate the carryover-basis treatment.
- Which of the following statements regarding a bond callable at the issuer's option is true?
Answer: The issuer may redeem the bond before maturity at a call price at or above par, with the call premium generally declining near maturity.
Under a bond indenture, a call feature gives the issuer the right to redeem the bond before maturity at a stated call price, typically at or above par, and the call premium generally declines on a schedule as the bond nears maturity. The statement that the bondholder may require redemption at par when rates rise describes a put feature, not a call, so it is not true of a bond callable at the issuer's option. The statement that coupon payments continue until the original maturity date after a call is wrong: the call terminates the bond, and interest stops on the call date. The statement that a callable bond must offer a lower coupon is wrong: investors demand a higher coupon on callable bonds because the issuer is likely to call the bond when interest rates fall, forcing the investor to reinvest at lower yields.
- Under the federal income tax rules in effect for tax year 2026, which of the following statements regarding the tax treatment of a municipal bond held by an individual investor in a taxable account is true?
Answer: The interest is generally exempt from federal income tax, and a gain realized on a sale of the bond is taxable as a capital gain.
IRC § 103(a) excludes interest on state and local government obligations from federal gross income, and the exclusion covers the interest only, not gains. A gain on the sale of a municipal bond is a capital gain, and the exemption never depends on the length of time the bond is held. The statement that the federal exemption applies only to bonds issued in the investor's state of residence is wrong: all qualifying municipal bond interest is exempt from federal tax; the state-of-issue limit is a state income tax matter, not a federal one. The statement that revenue bond interest is not exempt is wrong: revenue bonds of a state or local issuer are generally tax-exempt to the same extent as general obligation bonds; the distinction between the two concerns the source of repayment and credit quality, not federal tax status. The statement that municipal bond interest is always an alternative minimum tax preference is wrong: only interest on private activity bonds is an AMT preference item, and most municipal bond interest is not.
- An investor is evaluating a corporate bond with a 6% coupon quoted at 108. The bond matures in 12 years but is callable at 104 in three years. The investor's objective is to maximize income over the next five years while minimizing the risk of an early redemption. Which yield measure should the IAR emphasize?
Answer: Yield to call, because a premium-priced callable bond may be called when rates fall; return is measured to the earliest call date.
Bond yield concept — yield to call. For a bond trading above par with a call feature, the issuer has an economic incentive to call the bond if market rates fall, so the first call date and call price cap the investor's likely return. Yield to call measures total return to that call date and is the more conservative, decision-relevant measure here. Yield to maturity assumes the bond remains outstanding for the full 12 years and therefore overstates expected return for a premium-priced callable bond; current yield ignores the call feature and the premium amortization; and taxable-equivalent yield addresses tax comparisons, not call risk.
- An investor owns XYZ Corp 5% coupon bonds maturing in 2030 that have declined in value. The investor sells the bonds on December 15, 2026, to recognize a capital loss in the 2026 tax year but wants to remain exposed to XYZ's debt. Which purchase made within 30 days after the sale would disallow the capital loss?
Answer: Purchasing 100 of the same XYZ Corp 5% coupon bonds that mature in 2030.
Under IRC § 1091, a loss on the sale of stock or securities is disallowed if the taxpayer acquires substantially identical securities within 30 days before or after the sale. For bonds, substantially identical generally means the same issuer, the same coupon rate, and the same maturity. Purchasing 100 of the same XYZ Corp 5% coupon bonds maturing in 2030 is a wash sale, and the disallowed loss is added to the basis of the replacement bonds. Bonds of the same issuer with a different maturity date, bonds of the same issuer with a different coupon rate, and bonds of a different issuer are not substantially identical, so those purchases would not disallow the loss.
- An investor pays $102,000 for a $100,000 par tax-exempt municipal bond carrying a 5% coupon and maturing in ten years. For federal income tax purposes (tax year 2026), which statement correctly describes the treatment of the $2,000 premium?
Answer: The investor must amortize the premium over the bond's life; each year's amortized amount reduces the basis toward par but is not deductible.
Under IRC § 171(a)(2), the premium on a tax-exempt municipal bond must be amortized over the bond's remaining life. Each year's amortization reduces the investor's basis toward par by maturity, but because the bond's interest is exempt from federal income tax, the amortized premium is not deductible. The option of forgoing amortization and taking the premium as a capital loss at maturity applies only to taxable bonds. The premium cannot be claimed on Schedule A, and it cannot be deducted in full in the purchase year.
- An investor purchased a newly issued 10-year zero-coupon general obligation municipal bond for $600 (par value $1,000). Five years later, during tax year 2026, the bond's accreted value is $800, and the investor sells it in the secondary market for $850. Which statement correctly describes the federal income tax treatment?
Answer: The annual OID accretion is exempt from federal tax, but the $50 gain over the accreted value is a taxable long-term capital gain.
IRC §103 excludes interest on state and local governmental bonds from federal gross income, and IRC §1288 treats OID on a tax-exempt obligation as tax-exempt interest. The $200 of OID accretion is therefore not taxable as it accrues; it increases the bond's adjusted basis from $600 to $800. Because the bond was held more than one year, the $50 excess of the $850 sale price over the $800 adjusted basis is a taxable long-term capital gain. The $250-spread option would tax the exempt OID accretion as gain, the all-proceeds-exempt option ignores the taxable gain, and the ordinary-income option misapplies the OID rules to a tax-exempt bond.
- An investor holds $100,000 par value of Treasury Inflation-Protected Securities (TIPS) in a taxable account. In the current year, the inflation adjustment increases the principal by $3,000, and the investor receives $1,250 in coupon interest on the adjusted principal. Which tax treatment is correct?
Answer: The $3,000 inflation adjustment is taxed as ordinary federal income in the current year, and both the adjustment and the $1,250 coupon are exempt from state income tax.
Under IRC § 1272 and the Treasury rules for TIPS, the annual inflation adjustment to principal is treated as interest income in the year it accrues, and the coupon is interest income when received. Both amounts are taxed at the federal level. Because TIPS are issued by the U.S. Treasury, the interest — including the inflation adjustment — is exempt from state and local income taxes. The answer claiming the coupon is deferred until maturity is wrong, as is the claim that TIPS are exempt from federal tax; and calling the inflation adjustment a capital gain mischaracterizes it as a disposition gain rather than annual interest.
- An investor purchased a corporate bond in the secondary market for $900. The bond had a $1,000 par value and had originally been issued at par. At the time of purchase, it had five years remaining to maturity. After holding the bond for two years, the investor sold it at $980 in 2026. Assuming no special election has been made, what portion of the gain is taxed as ordinary income?
Answer: $40 is ordinary income and $40 is long-term capital gain, representing the market discount accrued during the holding period.
Under IRC § 1276, gain on the sale of a market discount bond is ordinary income to the extent of the accrued market discount. The market discount at purchase was $100 ($1,000 − $900). With five years remaining to maturity, the ratable accrual over the two-year holding period is 2/5 × $100 = $40, so $40 of the $80 gain is ordinary income. The remaining $40 is long-term capital gain because the bond was held for more than one year. Treating the entire gain as long-term capital gain ignores the § 1276 recapture; treating all of it as ordinary income overstates the recapture; and the $32/$48 split results from applying the 2/5 time ratio to the $80 gain rather than to the $100 market discount.
- Under the federal income tax rules in effect for tax year 2026, which of the following statements regarding accrued interest when a corporate bond is sold between coupon payment dates is true?
Answer: The seller reports the accrued interest received as ordinary interest income, and the buyer adds the accrued interest paid to the bond's cost basis.
When a bond is sold between coupon dates, the sale proceeds include accrued interest. The seller reports the accrued interest as ordinary interest income, and the buyer adds the accrued interest paid to the bond's cost basis. When the buyer receives the first coupon, the portion that represents the pre-purchase accrual is a nontaxable recovery of that basis, and only the balance is taxable interest. The statement that the buyer may deduct the accrued interest as an itemized deduction is wrong: prepaid accrued interest is added to basis, not deducted. The statement that the seller treats the accrued interest as a nontaxable return of principal is wrong: it is ordinary interest income to the seller because it represents interest earned through the sale date. The statement that the buyer must report the entire first coupon and may not reduce it is wrong: the buyer recovers the accrued interest paid from the first coupon without including that portion in income.
- Under the federal income tax rules in effect for tax year 2026, which of the following statements regarding the tax treatment of U.S. Treasury securities held in a taxable account is true?
Answer: Interest on Treasury notes is subject to federal income tax but exempt from state and local income tax, while a gain on their sale is generally subject to state income tax.
Interest on Treasury notes, bills, and bonds is fully taxable for federal income tax purposes but is exempt from state and local income taxes; gains realized on the sale of Treasury securities are not interest, so they are generally taxable by the states. The statement that Treasury interest is exempt from both federal and state income taxes is wrong: the federal exemption belongs to municipal bond interest rather than Treasury interest. The statement that a Treasury bill's discount is a long-term capital gain at maturity is wrong: the discount on a bill issued at a discount is interest income, and a bill's term never exceeds one year, so the gain cannot be long-term. The statement that a TIPS inflation adjustment is deferred until maturity is wrong: each year's increase in inflation-adjusted principal is included in income as interest in the year it accrues, even though the holder receives no cash until the security matures.
