Tax reporting might seem overwhelming, but understanding the basics makes it a lot easier. In the case of municipal bonds -- debt obligations issued by state and local government entities to raise capital -- cost basis is used to determine your capital gains or losses. To put it simply, cost basis allows you use the original price you paid for a security, plus any fees or commissions paid to your financial advisor, to calculate the amount of taxes you owe.

Organize your financial statements detailing your initial bond purchases. Confirm your purchase method. Bonds can be purchased in three ways: at a discount, meaning when the purchase price is lower than the maturity value or principal amount; at par, sometimes called at face value, meaning when the purchase price is equal to the maturity value; and, at a premium, meaning when the purchase price is higher than the maturity value.

Calculate your adjusted cost basis. This is the original cost of the municipal bond, plus any adjustments, such as capital returns or interest. For example, if you purchased a 10-year municipal bond at $1,000 with a discount of $800 and a 5-percent coupon, your adjusted cost basis will be $800 based on $800, plus any interest accrued. Use the discounted price and interest rate to calculate the interest for the first year, which amounts to $40. In this example, the adjusted cost basis for the first year is $840.

Calculate any capital gains and losses using the Internal Revenue Service Form 1099-INT provided to you by your financial institution when you earn interest on investments. Gains and losses are the difference between the sale price of bonds and your adjusted cost basis. For example, if you purchased a municipal bond at par at $1,000 with a 5-percent coupon and sold the bond at maturity, which is 10 years in this example, your adjusted cost basis would be $1,500. To calculate the interest earned, multiply the face value by the coupon percent, and then by the number of years that you held the bond. If you sold the bond for $2,000 you would gain $500.

### Items you will need

- Financial statements
- IRS Form 1099-INT
- Calculator

#### Tip

- Present your cost-basis calculations to a professional tax consultant to ensure accuracy.

#### References

- Charles Schwab: A Guide to Cost Basis Tax Reporting Changes and How They Affect You
- Morgan Stanley Smith Barney: Municipal Bonds, A Foundation of Quality
- PIMPCO: Investment Basics -- Everything You Need to Know About Bonds
- Wells Fargo: Guide to Investing in Municipal Securities
- Fidelity.com: Municipal Bonds
- United States Securities and Exchange Commission: Investor Bulletin: Municipal Bonds

#### Photo Credits

- Jupiterimages/BananaStock/Getty Images