Chartered Retirement Planning Counselor (CRPC) Practice Exam

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How are market discount bonds taxed?

  1. The market discount is ignored

  2. The market discount is taxed as capital gain

  3. The market discount is taxed as ordinary income upon sale or redemption

  4. The market discount can be deferred

The correct answer is: The market discount is taxed as ordinary income upon sale or redemption

Market discount bonds are taxed in a specific manner where the discount that occurs because the bond was purchased for less than its face value is treated as ordinary income when the bond is sold or redeemed. When an investor acquires a bond at a market discount, the gain recognized upon its sale or redemption is not considered a capital gain. Instead, this gain is treated as ordinary income in the tax year when the bond is disposed of. This treatment is meant to align the taxation of the market discount with how interest income is taxed, as the discount effectively represents interest over the life of the bond that has accrued but has not yet been received by the investor. Therefore, the correct understanding of market discount taxation is that the gain is taxed similarly to interest income, thus leading to the conclusion that the market discount is taxed as ordinary income upon sale or redemption.