I thought my accountant handled it as, if memory served, a capital loss, since we got cash that was somewhat less than our cost basis for the bond, held onto our accrued interest, and booked the transaction as a loss against the best estimates we could present on market value at the time of the trade.

It's possible to have a gain or loss on the sale of a bond (just not at maturity). For example, say you find a 1,000 face value muni paying..oh, 8% interest (real high rate), that matures in 5 years. You pay 1,100 for it. Basically, every year you'd amortize that 100 premium by about $20/year. (it's really a constant rate calc instead of a straight line calc), and reduce the tax-exempt income you report by $20 each year.

After two years, you decide to sell the bond. Your basis would now be 1,060. Say rates have gone up and you're only able to get 1,010 for it. You'd have a capital loss of 50 bucks.

Of course, if you held to maturity, you'd amortize the entire hundred bucks, so your basis would be 1,000, and the amount you'd receive on disposition would also be 1,000.

This is similar to the OID rules, where you have to report a certain amount of OID as "income" each year. Otherwise you could purchase OID bonds and sell them after holding for at least a year, effectively converting ordinary income into (lower-taxed) long term capital gain.

The concepts are simple, but the calculations can get pretty complicated.

hope this is helpful,

-synchronicity