taxes on bondsThe taxation of bond interest is relatively straightforward. Assuming the bonds are held in a taxable account, the interest on corporate bonds is generally subject to all income taxes: federal, state (if applicable), and local (if applicable). Treasury issues pay interest that’s subject to federal income tax but not state or local tax. Most municipal bonds pay interest that’s exempt from federal income tax. If you buy a bond issued in your home state, you probably will avoid all tax on the interest income.

Plus or minus

You may have a more difficult time figuring capital gain or loss on a bond, however. Bonds are issued at so-called par value (for example, $1,000 per bond). Then prices fluctuate as interest rates move up or down. Therefore, when you buy a bond, you may be buying at a premium or discount to par.

Example 1: Corporation ABC issued bonds at a $1,000 par value. The interest rate was 5%, or $50 per year, per $1,000 bond. Since then, interest rates on similar issues have moved up to 6%. Therefore, investors are less interested in ABC’s bonds; they’ll pay less for a bond with a below-market yield. To attract investors, ABC’s bonds sell for $940 in this hypothetical example. Investors can buy the bond at a discount to par value.

Example 2: Municipality XYZ issued bonds at $1,000 par value. The interest rate was 4%, or $40 per year, per $1,000 bond. Since then, interest rates on similar issues have moved down to 3%. Therefore, investors are more interested in XYZ’s bonds. They’ll pay more for a bond with an above-market yield. To reflect the increased demand from investors, XYZ’s bonds sell for $1,060 in this hypothetical example. Investors must pay a premium over par value to buy these bonds.

Paying a premium

Today, most bonds have low effective interest rates, reflecting a low-yield environment. If you buy a bond issued years ago, chances are that you’re paying a premium.

Example 3: Sue Walker buys $10,000 worth of Municipality XYZ’s tax-exempt bonds for $10,600. The bonds mature in six years. Each year, Sue’s basis in the bonds drops. The actual calculation is complicated and will be done by Sue’s broker. To simplify this example, assume that Sue’s bonds are amortized (decline in basis) by $100 per year. She gets no tax benefit for the amortization of her municipal bonds.

After two years, Sue’s basis in the bonds will drop by $200, from $10,600 to $10,400. If Sue sells those bonds then for $10,500, she will have a $100 long-term capital gain; if Sue sells them for $10,100, she will have a $300 long-term capital loss.

The rules on buying a taxable bond at a premium are different.

Example 4: Sue Walker buys $10,000 worth of Corporation UVW’s taxable bonds for $10,600. These bonds mature in six years. With taxable bonds, you can choose to amortize the premium you’ve paid. If Sue chooses to amortize, she will recognize a partial loss each year, offsetting taxable interest Income.

If you do not amortize a premium you’ve paid, the premium will be included in your basis, so you’ll have a larger capital loss when you sell or redeem your bonds (or a smaller taxable gain if interest rates fall and you sell at a profit). You typically should make the election to amortize if you’ve bought taxable bonds at a premium because you’ll get more tax savings.

Dealing with discounts

If interest rates rise from today’s low levels, recently issued bonds will lose value, and you’ll be able to buy them at a discount. Bonds trading at a discount due to interest rate fluctuations are called market discount bonds. Regardless of whether you buy a taxable or tax-exempt bond at a discount, you’ll owe tax at maturity, unless you elect to annually report the accrued market discount in your income.

Example 5: Jim Miller buys $10,000 worth of bonds for $9,400. They mature in 2017, and Jim collects $10,000. He will have $600 of ordinary income taxed at the same rate as he would pay on investment interest. That’s true for tax-exempt or taxable bonds.

Suppose, though, that Jim sells his bonds before maturity. He may have a capital gain or a loss, depending on how much of Jim’s $600 discount has been accrued (reduced). Halfway to the maturity date, $300 of Jim’s $600 discount will have accrued, so his basis in the bonds will have increased from the $9,400 purchase price to $9,700. Then, Jim would have a $100 gain on a sale for $9,800 and a $100 loss on a sale for $9,600. That gain or loss would be in addition to the $300 of ordinary income Jim would recognize from the accrual of the discount.

Note that the rule illustrated in this example may not apply to a bond purchased before May 1, 1993. Tax-exempt bonds purchased before this date are not subject to the market discount rules; therefore, the accrued market discount on them will be treated as capital gain. The treatment of taxable bonds purchased before May I, 1993, varies according to the bond’s issue date. Bonds issued after July 18, 1984, are subject to the market discount rules. Taxable bonds purchased before that date are not.

As mentioned previously, investors who buy bonds at a discount have the option of recognizing the accrued income each year. The basis of the bonds is increased by the amount of market discount that you include in income each year, thus reducing the tax on sale or redemption of the bonds. Our office can help you determine if recognizing accrued income at the end of each year will be advantageous.

2011 Q2 | Taxes on Bonds Bought at a Premium or Discount
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