Understanding Bond Taxes: A Comprehensive Guide

Investing in bonds is common, but the tax implications can be complex, particularly if you don’t hold a bond until maturity. This guide simplifies the tax rules for bonds that pay regular interest and have maturities exceeding a year. However, it does not cover more specialized debt instruments like zero-coupon bonds or STRIPS.

Determining Bond Taxation

1. Who Issued the Bond?

Tax treatments vary based on the type of bond:

• Corporate Bonds: Issued by private companies and subject to federal and state taxes.
• Treasury Bonds/Notes: Issued by the U.S. government, taxable federally but exempt from state taxes.
• Municipal Bonds (Munis): Issued by state or local governments, usually exempt from federal taxes and possibly state taxes if purchased within your state.

2. What Type of Income Was Generated?

Bonds provide income in three main ways:

• Interest Income: Typically paid semiannually, tax treatment depends on the issuer.
• Capital Gains/Losses: If a bond is sold before maturity, gains may be taxed at short-term or long-term capital gains rates, depending on the holding period.
• Discount Accretion: If a bond is purchased at a discount, the price difference can be recognized as income over time or at maturity, impacting your tax liability.

3. Purchase Price vs. Face Value

• Par Purchase: If bought at face value, the tax treatment is straightforward.
• Premium Purchase: If purchased at a higher price, investors may amortize the premium, reducing taxable interest income.
• Discount Purchase: If acquired below face value, tax rules depend on whether the bond has an original issue discount (OID), market discount, or qualifies for the de minimis exemption.

Tax Implications Based on Purchase Price

Bonds Bought at Par

• Interest is taxed based on the bond type.
• No capital gain or loss if held to maturity.
• If sold before maturity, gains or losses are based on the difference between the sale price and cost basis.

Bonds Bought at a Premium

• Investors may choose to amortize the premium, gradually reducing the bond’s cost basis and taxable interest income.
• If held to maturity with amortization, no capital gain or loss occurs.
• If sold before maturity, gains or losses depend on the sale price and adjusted cost basis.

Bonds Bought at a Discount

• Original Issue Discount (OID): Discount is recognized as additional interest income annually.
• Market Discount: Can be recognized either annually or at the time of sale/maturity, potentially leading to higher taxes.
• De Minimis Discount: If the discount is small (less than 0.25% of face value per year to maturity), it is treated as a capital gain instead of interest income.

If you buy a bond between interest payments, a portion of the next payment belongs to the seller. The buyer reduces their cost basis accordingly, while the seller reports the accrued interest as taxable income.

Navigating bond taxes can be tricky, especially when dealing with discounts, premiums, or sales before maturity. Consulting a tax professional or investment advisor is recommended to ensure compliance with tax laws and optimize your tax strategy.