What is the Pennsylvania tax treatment of zero-coupon municipal bonds?

by Paul S. Carpenter, CPA | Mar 06, 2018

I have a variety of zero coupon municipal bonds. Some are issued in Pennsylvania and are tax-free. I also hold some out of state, such as Harris County, Texas, which is also a zero-coupon municipal bond. What is the Pennsylvania tax treatment for this bond? I paid $982 for it back in 1989, and it matured November 2017 at $5,000. I was originally going to pay the 3.07 percent on the $4,000 in interest. Is this correct, as it was held to maturity? I have other out-of-state bonds that I was going to treat this way, but my brokerage statement is showing the tax-exempt interest as original issue discount. What is correct for Pennsylvania treatment?

Interest on obligations of other states, territories, and their political subdivisions and instrumentalities is taxable for Pennsylvania personal income tax purposes.
Zero-coupon bonds don't have coupons, so they don't make annual interest payments. Instead, they are originally sold at a steep discount to face value, also known as an original issue document (OID). For example, a bond with a face value of $1,000 may be sold for $500. So, while zero-coupon bonds don't make interest payments, they do offer an interest rate that is a function of the difference between the purchase price and face value, and the time remaining until maturity. For example, a 10-year zero-coupon bond sold at $500 for a $1,000 bond offers an interest rate, or yield, of 7.05 percent.

Whether the bond is taxable or tax exempt, you have to accrue interest on the bond. That means you have to calculate the portion of the difference between the purchase price and face value that accrued to you each tax year, even though you didn't receive any payment. The interest accrues at the interest rate you obtained when you bought the bond. Using the earlier example, if you paid $500 for a 10-year, $1,000 bond getting an interest rate of 7.05 percent, you would accrue $35.25 of interest in the first year:

$500 x 0.0705 = $35.25

Your adjusted issue price, or cost basis, in the bond would then become $535.25.

$500 + $35.25 = $535.25

The following year, you would accrue $37.74 of interest.

          $535.25 x 0.0705 = $37.74

And so on.

Check out Chapter 8 of the Pennsylvania Personal Income Tax Guide for more information on the taxability of interest.

For more resources, check out PICPA’s Money & Life Tips, Ask a CPA, or CPA Locator.

Answered by: Paul S. Carpenter, CPA, is president of Carpenter Capital Advisors in Johnstown, Pa.

The responses are based on the limited information provided by the questioner and apply the laws and regulations at the time of posting. Other options could arise as rules and regulations may change over time, including but not limited to the passage of the Tax Cuts and Jobs Act of 2017. They are intended to provide general information, not specific accounting or tax advice; they are not intended or written to be used and cannot be used for the purpose of avoiding or evading taxes or penalties under the IRS code or regulations. Views expressed do not imply an opinion of the PICPA, its officers, directors, employees, or members.
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