When you buy a bond between interest payment dates, there is interest that has accrued since the last interest payment date. The price you pay for the bond will include this accrued interest. The accrued interest is taxable to the seller, whereas the interest that is earned from the date of purchase to the end of the year is taxable to the purchaser. However, at year end the purchaser will receive a Form 1099 showing the total interest received during the tax year. This total interest amount will include the accrued interest that is taxable to the seller and the interest that is taxable to the purchaser. Therefore, the purchaser must note the portion of this interest income that is accrued interest, which is then deducted from their total interest to show the amount attributable to the purchaser.
If the interest is tax exempt, then the total interest is not taxable. However, if some of the tax exempt interest falls under the definition of accrued interest as mentioned above, it must be taken into account. The amount of tax exempt accrued interest must be subtracted from the total tax exempt interest in order to find the amount of tax exempt interest that is attributable to the purchaser.