I'll address each of your questions separately:
1. The cost basis reported on the 1099-B was less than the face value of the CD and therefore a gain was reported, so I am not sure I follow your example.
Yes, your situation would actually be the opposite of my example. In your case, your cost basis is lower than the face value of the CD because the market rate of interest was higher on the date of death than the fixed rate of the CD.
2. According to your reply, does this mean the market (interest) rate was less than the rate when the CD was first purchased?
No, if the cost basis reported to you was less than the face value of the CD, that indicates that the market interest rate on the date of death was more than the CD's fixed rate.
3. According to your statement, as the CD gets closer to maturity, and the value moves closer to face value, shouldn't the gain get closer and closer to zero, therefore the gain would no longer be applicable?
Yes, that is correct. But things are different in your situation because your basis is different than the face value of the CD. Your cost basis represents what would have been received if the CD was sold on the date of death.
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