A tax free zero coupon bond is issued with a yield to maturity of 3.5%. After some time, an investor buys the bond at 50. ( 50 cents on the dollar ). When he buys the bond, the bond has a yield to maturity of 3.4%. After some time, he sells the bond for 80 cents on the dollar. In computing his cost basis in the bond, for tax purposes, should he use the 3.4% interest rate or the 3.5% interest rate? I believe he should use the 3.5% interest rate which will save him tax money.
i would say 3.4% because if you used 3.5% and held to maturity you would end with a basis higher than PAR (maturity value) resulting in a "capital loss". "capital losses" are not allowed for this type of bond held to maturity.
but see this article which says take the original issue discount and divided by years to maturity. then every year add that amount to the basis. That means the basis increases by the same amount for each full year.
This is now what I think but I am not confident that I have it right. You have to calculate the rate based upon the original issue of the bond and the price you paid for the bond. That gives you two rates. You then select the lower rate (which maximizes your tax). You then compute the interest you got from the bond.
The way I see it, the amount of interest you get every year increases because of compounding. The link you referenced said implied that you can assume that the bond accrued the same amount of interest every year. That does not seem right to me. However, it does simply the calculations a lot and it would make sense before the days of computers. So I can believe it.
In my example, if the investor help the bond to maturity using a 3.5% tax rate than his cost basis would be 100. I now think 3.4% is the right interest rate. This means that if the investor holds the bond to maturity his cost basis would be less than 100. The difference is not a capital gain but Market Discount Interest which is fully taxable.
However, I admit I am not sure of my facts.