I have not be able to research this completely yet, and I am not an expert, but this MAY be what is happening.
1) if you buy the Treasury in the primary market, you have an OID (Original Issue Discount). This is reported as Interest on your 1099-INT
2) If you buy the Treasury on a secondary market, discount you get is not longer matched to the original OID of the treasury (for example, when interest rates move). Therefore, it is further away from representing interest. This all comes on your 1099-R as accrued market discount that gets pushed to your Schedule B as interest (instead of a gain) so it can be taxed like interest. I think the states may take away the state tax-exempt status of the Treasury in the secondary market because because the discount may have changed when interest rates changed and you really are not getting anything that resembles the original intent.
Again, this is just a theory, I need to look at this more. If it is true, I just learned a lesson the hard way.
