I believe that the Scudder California tax free bond which your client sold is free from California state tax, but not federal. As dividends and/or interest are paid on the bond each year and reinvested, they are not taxed like stock dividends. The gain on bonds is taxed when the bond is sold. When she sold her bond in 2005 she should have received a 1099-B from Morgan Stanley showing the sale price of the bond, and this transaction should have been reported at that time on Schedule D.
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