Seach this financial encyclopedia by using the search engine below.
 | Custom Search |
Home | Archives | Blog | Bonds | Credit & Debt | Forex | Futures | Insurance | Mutual Funds | Options | Real Estate | Stocks | Taxes | Other Investment Topics | New Money Articles
The interest earned from bonds is taxed as ordinary income. However, if the bond is sold before maturity, or if the bond was bought in the secondary market for other than par value, then there will also be a capital gain or loss, depending on whether the sale or redemption price was greater or less than the purchase price. The capital gain is not recognized until the sale or the redemption of the bond.
However, taxes on interest must be paid in the year earned, whether it is received or not. For bonds that make regular coupon payments, taxable interest for the year is the interest received or payable for that year.
However, for original issue discount (OID) bonds, the bondholder must pay interest that was earned, but not received, which is based 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, which is issued at a deep discount, but pays no interest, the imputed interest rate, which is simply 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.
Some OID bonds do pay regular interest periodically, but the coupon rate was below prevailing interest rates when issued, and so was sold at a discount to its par value. Thus, these bonds pay a stipulated amount of interest, but also have an imputed interest that must be added yearly to determine taxable income. The coupon rate and the imputed interest rate will equal the yield to maturity for the bond. The imputed interest will be proportional to the original issue discount.
Original Issue Discount = Redemption Value - Purchase Price
When a bond with imputed interest is sold, the capital gains or loss is determined by adding the imputed interest to the purchase price of the bond, and subtracting this value from the sale or redemption price.
The major exceptions to reporting OID as interest includes:
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 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.
If the imputed interest is greater than $10 for the year, then you should receive Form 1099-OID either from the issuer or your broker, if you kept the securities in a brokerage account, which will show the interest that must be reported. However, if the issue was purchased in the secondary market for a premium, or if the issue is stripped bond or coupon, then the OID interest must be refigured.
A market discount bond is any bond having market discount except:
Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),
Tax-exempt obligations that you bought before May 1, 1993,
U.S. savings bonds, and
Certain installment obligations.
Market discount arises when the value of a debt obligation decreases after its issue date, generally because of an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.
When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.
You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount.
You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount.
If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited.
Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than 1/4 of 1% (.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond). If a market discount bond also has OID, the market discount is the sum of the bond's issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.
Generally, a bond that you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you are also considered to have acquired it at original issue.
A bond you acquired at original issue can be a market discount bond if either of the following is true.
Your cost basis in the bond is less than the bond's issue price.
The bond is issued in exchange for a market discount bond under a plan of reorganization. (This does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same.)
The accrued market discount is figured in one of 2 ways:
Treat the market discount as accruing in equal daily installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.
Ratable Accrual = [(Market Discount) / (Maturity Date - Purchase Date) Days] x Number of Days Actually Held
Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond. For information about using the constant yield method, see Figuring OID using the constant yield method under Debt Instruments Issued After 1984 in Publication 1212. To use this method to figure market discount (instead of OID), treat the bond as having been issued on the date you acquired it. Treat the amount of your basis (immediately after you acquired the bond) as the issue price. Then apply the formula shown in Publication 1212.
If you sell a bond between interest payment dates, part of the sales price represents interest accrued to the date of sale. You must report that part of the sales price as interest income for the year of sale.
If you buy a bond between interest payment dates, part of the purchase price represents interest accrued before the date of purchase. When that interest is paid to you, treat it as a return of your capital investment, rather than interest income, by reducing your basis in the bond.
For much more information on the taxation of original issue discount instruments, see Guide to Original Issue Discount (OID) Instruments, Publication 1212.
Seach this financial encyclopedia by using the search engine below.
| Custom Search |