==UPDATE==
Having seen no response to my post below I am marking it (my own answer) as the best answer.
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I am again questioning whether the answers given to my question are correct.
From IRS Publication 550:
"Market Discount Bonds
A market discount bond is any bond having
market discount except:
• Short-term obligations (those with fixed
maturity dates of up to 1 year from the date
of issue),
• Tax-exempt obligations you bought before
May 1, 1993,
• U.S. savings bonds, and
• Certain installment obligations.
Market discount arises when the value of a
debt obligation decreases after its issue date.
Generally, this is due to an increase in interest
rates. If you buy a bond on the secondary market, it may have market discount."
THEN IT SAYS:
"When you buy a market discount bond, you
can choose to accrue the market discount over
the period you own the bond and include it in
your income currently as interest income. If you
do not make this choice, the following rules
generally apply.
• You must treat any gain when you dispose
of the bond as ordinary interest income, up
to the amount of the accrued market discount. See Discounted Debt Instruments
..."
https://www.irs.gov/pub/irs-pdf/p550.pdf
see pages 14 and 15
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So this is a "Market Discount Bond" and according to how I read the IRS rule relating to market discount bonds the gain is treated as ordinary interest income, NOT as a capital gain.
So it appears to me the answers that were given in this thread are incorrect. And also, since the gain is treated as ordinary interest income that the state tax income exemption is preserved.
I welcome any correction or validation of my understanding but it appears to me that the previous answers were wrong.
