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, and the year that the bond was issued.
All bonds earn interest, which is taxed as ordinary income in the year that is earned, whether or not it was actually received.
If the bond is sold before maturity or bought in the secondary market, there may be a capital gain or loss equal to the redemption price minus the purchase price that is recognized in the year that the bond was sold or redeemed.
Capital Gain or Loss = Redemption or Sale Price - Purchase Price
For original issue discount (OID) bonds, the bondholder must pay tax on the imputed interest—the interest that the OID bond earns based on a constant yield method, or straight-line amortization. For a zero-coupon bond, the imputed interest rate, equal to the yield to maturity, is determined by the purchase price, the par value, and the term of the bond, so the IRS requires the use of this rate regardless of changes in the bond’s price in the secondary market.
No OID interest is reported for:
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.
Yield to Maturity = Coupon Rate + Imputed Interest Rate
Original Issue Discount = Redemption Value - Purchase Price
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.
Capital Gain or Loss of Bond with Imputed Interest = Sale Price - Purchase Price - Imputed Interest
The interest can be treated as zero if the discount is less than the de minimus OID:
De Minimus OID = 0.0025 x Redemption Value x Number of Years from Issue to Maturity
The de minimus OID will, however, have to be reported as a capital gain if held to maturity.
The de minimus OID for a 10-year bond with a face value of $1,000 = 0.0025 x 1,000 x 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.
Imputed interest of more than $10 earned from securities held in a brokerage account should be reported by the broker or issuer on Form 1099-OID. However, the OID interest must be calculated for a stripped bond or coupon or if the bond was purchased for a premium.
A market discount bond is any bond bought for less than par value in the secondary market except:
Market Discount = Par Value - Bondholder's Original Basis
Market Discount = 0, if Market Discount < Par Value x Number of Full Years Until Maturity x 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. If reported as a lump sum, then any partial payment 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, the market discount is the sum of the bond's issue price plus total OID includible in the gross income of all holders the bond was acquired minus the bondholders original basis.
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 for a market discount bond because of a reorganization.
There are 2 methods for determining the accrued market discount:
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.
| Ratable Accrual = | Market Discount ─────────────────────────────── (Maturity Date - Purchase Date) in Days | x | Number of Days Actually Held |
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 OID discount can also be calculated with this method by treating the bondholder's date of purchase as the issue date and the price paid as the issue price. See Publication 1212, Guide to Original Issue Discount Instruments for more info.
When a 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 tax 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.
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.