If an investor holds a 5% municipal bond bought at 102 1/2 to maturity, what will be the tax effect of this investment?

When an investor purchases a municipal bond at a premium, such as buying a 5% bond at 102 1/2, the bond's price is higher than its face value (100). At maturity, the bond will redeem at its par value, which is typically 100. The difference between the purchase price and the par value results in a premium that the investor has paid.

For tax purposes, the Internal Revenue Service allows for the amortization of this premium over the life of the bond. This means that the investor can gradually deduct a portion of the premium as an adjustment to the interest income received from the bond. Consequently, at maturity, though the investor will redeem the bond at its face value, they would have already accounted for the premium in their tax reporting. The result is that there are no capital gains or losses associated with this transaction for tax purposes if the bond is held to maturity.

Thus, the tax effect of holding the bond to maturity is that the investor realizes no taxable gain or loss, aligning perfectly with the choice indicating that there is a loss of 0 for tax purposes. This understanding is critical for investors as it highlights the benefit of municipal bonds and the favorable tax treatment they receive, further incentivizing their inclusion in