Taxation of Bond Income
There are 2 ways to earn money from a bond: interest and capital gains. Interest and short-term capital gains are taxed as ordinary income, while long-term capital gains are generally taxed at a lower rate. While this is simple enough, bond taxation is complex because there are several considerations that require different tax treatments, especially if the bonds were purchased in the secondary market:
- accrued interest
- whether the bond is an original discount or coupon bond
- whether the bond was acquired at a market discount or premium
- the issue date of the bond.
This article discusses the general principles of the taxation of bonds. There are many specific rules in the tax code regarding bonds, especially for bonds that were issued or bought before 1994, but most of these rules result in only minor changes from the rules that apply today.
The interest from most municipal bonds is tax-free, if they are in registered form. However, if the bonds are federally guaranteed, then they are generally taxable. Private activity bonds — where at least 10% of the bond proceeds goes to a private business whose property secures the issue or where the lesser of 5% of the proceeds or $5 billion benefit nongovernmental parties — is also usually taxable, except for qualified bonds, such as qualified student loan bonds, exempt the facility bonds, enterprise zone facility bonds, qualified small issue bonds, qualified redevelopment bonds, qualified mortgage bonds, and qualified bonds issued by charitable organizations and hospitals. However, the tax-exempt interest on qualified private activity bonds may be treated as a tax preference item when calculating the alternative minimum tax; only some qualified bonds are exempt from the AMT. The tax status of the private activity bond can be obtained from the issuer and will also be reported on Form 1099-INT, Interest Income, which is sent to taxpayers earning interest annually.
All bonds earn interest. Taxable interest is taxed as ordinary income in the year when it is earned, whether or not it was actually received. Imputed interest is interest that is recognized as income but that was not received by the bondholder, and is the result of the bond either being issued at a discount or bought at a discount in the secondary marketplace. If the bond is sold before maturity or bought in the secondary market, there may be a capital gain or loss that is recognized in the year when the bond was sold or redeemed. However, imputed interest will invariably lower any capital gains or increase capital losses. Note that even tax-exempt bonds must be reported on Form 1040, even though they are not taxable.
Tax Update: Brokers Are Required to Report Cost Basis of Bonds
Beginning January 1, 2014, brokers will be required to report the cost basis of bonds and options. Brokers are already required to report the cost basis for stocks and mutual funds. However, the new rules will only apply for bonds purchased in 2014 and thereafter. Hence, the taxpayer must maintain records of bonds that were purchased before then.
The simplest case of bond taxation is that of coupon bonds purchased for par value. Because all of the interest is paid periodically, there are no imputed interest complications. The taxpayer simply pays ordinary income tax rates on the interest received. However, there will be imputed interest if a coupon bond was bought at a discount in the secondary marketplace.
Imputed Interest for Original Issue Discount Bonds
Original issue discount (OID) bonds are bonds that were issued at a discount to the face value of the bond. The reason why this occurs is because it takes a certain amount of time after the coupon rate has been determined to get regulatory approval for the bond issue. In that duration, interest rates may have changed, forcing the issuer to sell the bonds at a discount if interest rates rose in the interim. On the other hand, the issuer may have intended to issue OID bonds, such as with zero-coupon bonds.
Stripped bonds or stripped coupons are also treated similarly, since they pay no interest and are issued at a discount. Note that this differs from market discount bonds, which are bonds that were bought in the secondary marketplace at a discount. The difference between the face value of the OID bond and the discounted offering price is treated as interest, which is prorated over the term of the bond and taxed annually, even though the bondholder does not actually receive this interest annually, but receives it as the difference between the face value and the issue price when the bond matures. Because OID interest is not paid as interest by the issuer, tax law refers to this type of interest as imputed interest. Note, if the OID bond is tax-exempt, then there is no imputed interest on the bond. Tax law also makes a distinction between the imputed interest attributable to the original issue discount and the imputed interest attributable to a market discount, so hereafter the 2 will be distinguished as OID interest and market discount interest. In most cases, the taxpayer does not have to calculate OID, since the broker or the issuer must send the bondholder a Form 1099-OID that will have the amount of OID earned for the year in Box 1. In some cases, however, the taxpayer may have to modify that amount.
Original Issue Discount = Redemption Value – Issue Price
OID also accrues daily, so that the bondholder's adjusted basis is increased by the amount of the accrued OID, which can be approximated with the following formula:
|Accrued OID||≈||(Current Date – Issue Date) in Days|
(Maturity Date - Issue Date) in Days
Accrued interest is determined according to accrual periods, which are generally 6 months long, with one of those periods ending on the maturity date. If the bond is a coupon bond, then accrual periods begin or end on the coupon payment dates. The OID interest is calculated by the constant yield method:
|=||Price at Beginning|
of Accrual Period
|×||Yield to Maturity|
Number of Accrual Periods in 1 Year
|–||Stated Interest Allocable|
to the Accrual Period
Note that the yield to maturity (YTM ) is for the accrual period, so if the yield to maturity is 12% compounded semiannually, but the accrual period is 6 months long, then the YTM is half of that, or 6%. Note also that the price at the beginning of each accrual period is increased by the amount of the OID allocated to the previous accrual period. The stated interest is the interest that is actually paid by the issuer, which in most cases, is simply the coupon payment.
In most cases, the sale or purchase of a bond will not be at the beginning or end of an accrual period, so it will be necessary to calculate the daily OID, which is then multiplied by the number of days in the short accrual period:
|Daily OID =||Price at Beginning|
of Accrual Period
|×||Yield to Maturity / Number of Accrual Periods in 1 Year|
Number of Days in Accrual Period
However, no OID interest is reported for:
- short-term debt securities, with terms ≤ 1 year from date of issuance;
- United States savings bonds;
- most tax-exempt securities.
OID is also reported as interest for certificates of deposits, time deposits, or other savings accounts with a term greater than 1 year if interest is only paid at maturity. For inflation-indexed debt instruments, such as Treasury inflation-protected securities, increases in the principal amount because of inflation are also treated as OID. if the principal decreases because of deflation, then this can be used offset the interest earned during the tax year. For stripped tax-exempt obligations, OID must also be accrued and added to basis to figure taxable gain on disposition.
Imputed interest of more than $10 earned from securities should be reported by the broker or issuer on Form 1099-OID, Original Issue Discount. However, the OID interest must be calculated for a stripped bond or coupon or if the bond was purchased for a premium.
Market Discount Bonds
If a coupon bond is sold for less than par value in the primary market — usually because market interest rates were higher than the coupon rate — then there will be some imputed interest proportional to the discount that must be added to the coupon interest for the year that it is earned.
A market discount bond is any bond bought for less than par value in the secondary market except:
- short-term debt securities, with original maturities ≤ 1 year;
- U.S. savings bonds;
- tax-exempt obligations purchased before May 1, 1993;
- certain installment obligations.
Market Discount = Par Value – Purchase Price
De Minimus Market Discount = 0, if Market Discount < Par Value × Number of Full Years Until Maturity × 0.0025
The market discount is treated as interest, which can be reported annually as accrued interest over the term of the bond or it can be reported as a lump sum when the bond is sold or redeemed. The taxpayer must elect to report the market discount interest annually and the election will apply to all bond purchases made by the taxpayer thereafter. The taxpayer can only change the election with the consent of the IRS. If the market discount is reported as a lump sum, then that portion of the repayment of principal is treated as ordinary interest. The market discount interest that must be reported either as a lump sum or when the issuer pays some of the principal is limited by the market discount.
If a market discount bond also has OID, then the market discount is calculated thus:
Market Discount = Purchase Price – Issue Price – Accrued OID
An OID bond can also be considered a market discount bond if the bondholder's basis is less than the issue price or the bond was issued as a market discount bond because of a reorganization. If the bondholder sells the bond before maturity, then the sale must be reported on Form 8949, Sales and Other Dispositions of Capital Assets.
Examples: Calculating the Original Issue Discount and the Market Discount of a Bond
A corporation issues an OID bond for $800 that pays $1000 upon maturity. However, because demand for the bond was less than anticipated, you pay only $700 to the issuer for the bond. Therefore, $200 of the discount is treated as OID and the remaining $100 of the discount is treated as a market discount. Both discounts are treated as interest, so if you hold the bond until maturity, you have no capital gain.
Case 1: Instead of buying from the issuer, you bought it in the secondary marketplace for $700. The original term of the bond is 10 years, and you bought it 2 years after the issue date; 4 years later you sell it for $900. Therefore:
- Accrued OID at time of Sale = 6/10 × $200 = $120
- Note that the tax on OID is paid annually, but the value is needed to determine your basis and the amount of market discount. The amount of OID tax paid includes that of all previous holders of the bond.
- Market Discount = 4/10 × ($900 – $700 – $120) = 4/10 × $80 = $32
- Your Adjusted Basis = $700 + $120 + $32 = $852
- Your Long-Term Capital Gain = $900 – $852 = $48
Accrued Market Discount
There are 2 methods for determining the accrued market discount:
- ratable accrual method
- constant yield method
Ratable Accrual Method
The ratable accrual method simply divides the market discount by the number of days between the maturity date and the purchase date multiplied by the number of days that the bond was actually held.
|Accrued Market Discount||=||Market Discount|
(Maturity Date – Purchase Date) in Days
|×||Number of Days Actually Held|
Constant Yield Method
The constant yield method must be chosen by attaching a statement to a timely filed return identifying the bond to which the constant yield method will be applied and cannot be changed for that bond. A constant interest rate can be used to calculate the accrued market discount. The constant yield method, presented in the OID section, is the same method applied to OID bonds. See Publication 1212, Guide to Original Issue Discount Instruments for more info.
De Minimis Imputed Interest is Not Treated as Interest
The interest can be treated as zero if the discount is less than the de minimus value:
De Minimus OID = 0.0025 × Redemption Value × Number of Years from Issue to Maturity
De Minimus Market Discount Interest = 0.0025 × Redemption Value × Number of Years from Purchase Date to Maturity
The de minimus value will, however, have to be reported as a capital gain if held to maturity.
Example — Calculating the De Minimis OID
The de minimus OID for a 10-year bond with a face value of $1,000 = 0.0025 × 1,000 × 10 = $25. If the OID interest is less than $25, then it does not have to be reported as interest, but it must be reported as a capital gain at maturity.
Amortization of Bond Premiums
A bond with a higher coupon rate than prevailing rates will sell for a higher price than par value, so a bond buyer will pay a premium for the bond for its higher interest rate. The paid premium can be amortized over the remaining life of the bond, allowing the bondholder to deduct the amortized amount from the annual taxable interest earned. The annual amortized premium is calculated using the constant yield method for all bonds issued after September 27, 1985. If the premium is not amortized, then a capital loss could be claimed on the maturity date or if the bond is sold before then for less than its purchase price.
Example — Amortizing a Bond Premium
You pay $1100 for a bond with a face value of $1000 maturing in 10 years that pays a coupon rate of 6%. The bond premium = $1100 – $1000 = $100. Therefore, each year, you can deduct $100/10 = $10 from the $60 received as interest, so you are taxed on $50 of income.
Generally, it will almost always be more advantageous to deduct the amortized premium from the interest income reported annually. Any excess premium that cannot be deducted can be claimed as a miscellaneous deduction not subject to the 2% floor on Schedule A, Itemized Deductions, but the deduction is not available if the standard deduction is claimed. However, the deduction cannot be greater than the total interest on the bonds minus the total premium deductions taken in prior years. If the taxpayer elects to amortize the premium for one bond, then that same choice must apply to all similar bonds acquired thereafter. This election can only be revoked with IRS permission. The election to amortize bond premiums can be made at any time, but the amortized amount of previous years will be added to the cost basis of the bonds. Amortized premiums are deducted from the total interest on Schedule B, Interest and Ordinary Dividends. The amortized premium should be labeled "ABP Adjustment".
If the bond is a tax-free bond, the premium must be amortized, but no deduction is allowed since the interest is not taxable. The amortization is still necessary to reduce the bondholder's tax basis in the tax-free bond to determine if there is a capital gain upon disposition. The amortized premium also reduces the amount of interest that must be reported, although this does not save on taxes.
Tax Treatment of Accrued Interest
When a coupon bond is purchased in the secondary market between interest payment dates, then the sale price includes accrued interest, which is the interest earned by the bond that has not been paid. The accrued interest of the purchased bond is treated as a return of capital, so the buyer of the bond can subtract the accrued interest from the interest reported on Form 1099-INT. The buyer's adjusted basis in the bond is reduced by the same amount, so when the bond is disposed of, the subtracted accrued interest becomes part of the capital gain. When a bond with accrued interest is sold, then the seller must report that part of the sales proceeds attributable to the accrued interest as ordinary interest income.
Example of Tax Treatment of Accrued Interest to Both Buyer and Seller
Joe purchases a bond with a par value of $1,000 that pays $50 semiannually (10% annually), then sells it to Sally before receiving the first interest payment.
- Joe's Purchase Price = $1,000
- Sale Price = $1,040
- Accrued Interest at Sale = $30
- Joe reports interest of $30 even though he receives the interest payment as part of the sale price. Therefore, the sale amount is reduced by the amount of the accrued interest.
- Sale Amount = Sale Price - Accrued Interest = $1,010
- Capital Gains = Sale Amount - Purchase Price = $1,010 - $1,000 = $10
- After buying Joe's bond, Sally receives 2 $50 interests payments for the tax year.
- Sally receives Form 1099-INT, reporting the $100 of interest that she received on the bond.
- Sally lists the $100 interest payment on Schedule B of Form 1040.
- Below that line, Sally writes "Accrued Interest" and subtracts the $30 of accrued interest to yield $70 in total interest.
- Sally paid $1,040 for the bond, but her tax basis is reduced by the $30 of accrued interest, so she must subtract $1,010 from the sale or redemption price to determine her capital gain or loss when the bond is disposed of. So if Sally holds the bond until maturity, then she would report a capital loss of $10 ($1,000 – $1,010).
Bond Issuer Default
If the issuer becomes bankrupt, interest may still accrue if a guarantor continues to pay the interest when due, in which case, it is still taxable. However, a loss may be claimed if the bonds are not redeemed at maturity or if they are sold below the tax basis of the bondholder. If the bonds are exchanged in a tax-free reorganization for stock, or other securities or property, then a portion of the value of the exchanged property is treated as the payment of accrued interest.
When bonds are purchased with defaulted interest, then any later payment of that defaulted interest is treated as a tax-free return of capital that reduces the basis of the bond; any interest earned after the purchase is taxed as ordinary income.
Capital Gains or Losses
The capital gain or loss of a bond with imputed interest is determined by subtracting both the purchase price and the imputed interest from the sale price. The imputed interest must be subtracted because it is implicit in the bond's price and accrues over time; the interest from a coupon bond does not have to be subtracted because the interest is paid separately. If a bond, such as a callable bond, is redeemed before maturity, and if the issuer pays more than the combined total of bond price plus accrued interest, then the excess is treated as a capital gain.
Example: Capital Gain on a Callable Bond Redeemed by the Issuer before Maturity
You buy a callable bond that pays interest on January 1 and July 1. The bond issuer sets the call date for the bond on July 1. You present the bond for redemption on June 10, but the issuer pays you the call price and the semiannual interest that would have been due on July 1, so you receive the call price for the bond plus the interest payment. However, only the interest that has accrued as of June 10 is reportable as interest; the remaining part of the interest payment is treated as capital gain.
Because a market discount is treated as interest, it accrues over time even if the taxpayer elects to pay the tax on the interest when the bond is redeemed or sold, in which case, the accrued imputed market discount interest must be subtracted, along with any accrued OID interest, from the sale or redemption price to calculate capital gain or loss.
Note that if the bondholder holds a discounted bond until maturity, then the redemption price minus the purchase price is treated as interest, and there is no capital gain even though the bond was bought at a discount. Hence, the capital gain or loss of a bond can be summarized by the following equation:
Capital Gain or Loss = Sale or Redemption Price – Purchase Price – Accrued OID Interest – Accrued Market Discount Interest
Example — Calculating the Capital Gain or Loss of a Bond
You buy a bond with a par value of $1000 for $800 that matures in 10 years.
Case 1: you hold the bond until maturity. Therefore, the $200 of discount is treated as interest, for which you must pay ordinary income tax. It does not matter if the discount is OID or a market discount or a combination of the 2. There is no capital gain.
Case 2: you sell the bond after holding it for 5 years for $950. Therefore, since you held the bond for 50% of its remaining term, 50%, or $100, of the discount is treated as interest, and the remaining $50 is a long-term capital gain.
Case 3: same as Case 2, except that you sell the bond for $850. Because your adjusted basis in the bond is the $800 purchase price + $100 of accrued market discount interest, you have a long-term loss of $50.
United States Savings Bonds
US savings bonds have a maturity of 30 years, but they can be redeemed earlier. Interest earned by US savings bonds are taxable as ordinary interest, but the bondholder has the choice of paying the tax annually or deferring the payment of tax until the earlier of when the bond is redeemed or at maturity. If the bonds are used to pay for qualified educational expenses, then the accumulated interest can be excluded from income when the bonds are redeemed.
Series I bonds are indexed to inflation and are bought at face value, but the inflation-adjusted increments, like the interest earned on Series EE bonds, are treated as ordinary interest, for which the tax can be paid either annually or at redemption.
If bonds are registered in the name of the child, and the child's investment income is less than $2100, then the interest will not be subject to the kiddie tax if reported annually. Annual reporting may be advantageous, especially if the child has no other income, since no tax will be due on the reported interest; otherwise, the reporting of interest should be deferred until the bond is redeemed, since the child will be old enough to avoid the kiddie tax that would otherwise subject the interest to the parent's highest marginal rate.
The option to report interest annually on bonds or to defer the interest until redemption can be changed at any time, from reporting the interest annually to deferring the interest, or vice versa. However, all EE and I bonds, and any bonds acquired later, must be reported using the same option. If interest was reported annually, then that amount must be subtracted on Schedule B, since the Form 1099-INT shows all the interest that was paid on the bond when the bonds mature or are redeemed.
Use the deferral method if you plan to use the proceeds of the savings bond to pay for qualified educational expenses, since, then, the interest will be tax-free, unless you project that your income will be too high to benefit from the exclusion.
To switch from deferral to annual report requires that all unreported accrued interest up until the reporting year must be reported for that year. Thereafter, the accrued interest for the year is reported annually.
To switch from annual reporting to deferral, the IRS must be notified by attaching a statement to the federal income tax return with the following information: the number 131 typed or printed at the top; name and Social Security number; year of change, including both the beginning and ending dates; identification of the savings bonds to which the change will apply; the taxpayer's agreement to report all unreported interest on bonds acquired before, during, or after the year of change when they are redeemed or when they mature.
If a bond is co-owned, then reporting requirements and tax liability on the interest of the bonds depends on who pays for the bond. If 1 of the owners pays for the entire bond, then that person is taxed on the interest, even if the other co-owner redeems the bond. Likewise, if each owner pays part of the purchase price, then each pays tax on that portion of interest, regardless of who redeems the bond. If one owner buys a bond, but then re-issues the bond in someone else's name, then the original owner must report and pay tax on interest that has accrued up until the reissue date; thereafter, the interest accrues to the new owner. However, there is no tax requirement if a new owner is merely added as a joint owner.
If the bonds are transferred to a spouse or to a charity, then the bondholder must pay tax on all the accrued interest up until the transfer. Likewise, if the transfer was to a trust, unless the trust as a grantor trust owned by the bondholder, in which case, interest can continue to be deferred.
If a bondholder who deferred interest dies, then the accumulated interest can be reported on the decedent's final return; otherwise, the new owner must either report the interest annually or defer it until the earlier of redemption or maturity. Any estate tax that was paid on the interest can be claimed as a miscellaneous itemized deduction, not subject to the 2% of AGI floor, when taxes are paid on the accumulated interest.
US Treasuries are generally taxed like other bonds and notes. However, Treasury inflation-protected securities (TIPS) not only pays interest, but the principal is adjusted for inflation, which must be reported as OID, which lowers the tax basis by the same amount.
Treasury bills (T-bills) are short-term Treasuries with maturities of 4, 13, 26, or 52 weeks. The gain at maturity is taxed as interest, which is recognized in the year of maturity, even if purchased in the prior year. If the T-bill was held for less than the full term, then OID must be calculated to determine capital gain or loss:
Total Gain = Sale Price – Purchase Price
|T-Bill OID||=||Total Gain||×||Days T-Bill Was Held|
Days from Acquisition Date to Maturity
T-Bill Capital Gain = Total Gain – T-Bill OID
Example: Calculating Capital Gain and OID for a T-Bill
- Buy $10,000 26-week Treasury: $9920
- Discount = Face Value of Treasury – Purchase Price = $10,000 – $9920 = $80
- Term: 182 days
- Sale price: $9970
- Days held: 90
- Total Gain = Sale Price – Purchase Price = $9970 – $9920 = $50
- OID = Days Held ÷ Term Length in Days × Discount = 90/182 × $80 = $40
- Capital Gain = Total Gain – OID = $50 – $40 = $10
The constant yield method can also be used to calculate OID and capital gain.