Taxation Rules for Bond Investors

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Taxation Rules for Bond Investors

What Are the Taxation Rules for Bond Investors?

Bondholders fill out IRS tax form 1099-INT every year to record their yearly taxable interest income. While this paper seems to give simple instructions for filing tax on income earned by stated interest rates, there are typically complicated aspects fixed income investors must consider. This page delves into the specifics of bond taxes for government, business, and municipal bonds.

Key Takeaways

  • The interest paid on fixed income instruments such as bonds and notes is often taxed.
  • Government, corporate, and municipal bonds are all taxed differently.
  • While the IRS tax form 1099-INT provides bondholders with simple rules for reporting tax on income earned by the stated rate of interest, there are typically complicated issues to consider for fixed income investors.

Taxation Rules for Bond Investors

Government Bonds

The interest on Treasury bills, notes, and bonds is federally taxable, but not at the state or municipal levels. Certain US government agency securities are taxable at the federal level but not at the state or municipal levels. Bonds issued by the Federal Home Loan Bank, Financing Corporation, and Tennessee Valley Authority, among others, are included.

Taxation of Zero-Coupon Bonds

Despite the fact that there is no declared coupon rate, zero-coupon investors must report a pro-rated amount of interest as income each year, even if interest has not been paid out. Governments issue zero-coupon bonds at a discount and they mature at par value, with the spread distributed evenly over the number of years until maturity. As a result, they are taxed as interest just like any other original issue discount bond.

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Savings Bonds

Governments provide savings bonds to the public, which are regarded as secure investment instruments with several advantages. Series E and EE savings bonds are likewise tax-free on a state and municipal level, although their interest income may be delayed until maturity. Series H and HH bonds pay semi-annually till maturity, but Series I bonds pay taxable interest that may also be delayed. Interest on Series E and I bonds may also be deducted from income if the funds are used to pay for higher education.

Municipal Bonds

Municipal bonds are often preferred by high-income investors seeking to decrease taxable investment income. If investors live in the same state or municipality as the issuers, the interest on these bonds is tax-free at the federal, state, and local levels. Those who acquire municipal bonds in the secondary market and subsequently sell them may be taxed on any incurred profits at conventional long- or short-term capital gains rates. Municipal bonds pay a lower interest rate than other bonds since they are tax-free.

Corporate Bonds

Corporate bonds are the most basic sort of bond in terms of taxation, since they are completely taxed at all levels. Because these bonds have the biggest default risk, they also have the highest interest rates of any major bond category. As a result, investors who purchase 100 corporate bonds having a par value of $1,000 and each paying 7% annually might expect to collect $7,000 in taxable interest each year.

Capital Gains

Any debt issuance exchanged in the secondary market, regardless of the kind of bonds issued, will generate either a capital gain or loss, based on the price at which the bonds were acquired and sold. This involves difficulties with the government and municipalities, as well as business debt. Gains and losses on bond transactions are reported in the same manner as gains and losses on other assets, such as stocks or mutual funds, for capital gains purposes.

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Amortization of Bond Premium

As previously stated, when a bond is issued at a discount, the taxpayer reports a pro-rated amount of the discount as income each year until maturity. When bonds are acquired at a premium (more than $1,000 per bond), a pro-rated part of the excess may be deducted on the purchaser’s tax return each year.

For example, if an investor purchases 100 bonds for $118,000 and keeps them for 18 years, they may deduct $1,000 every year until maturity. That investor would also benefit from the ability to deduct nothing each year and merely declare a capital loss upon redeeming the bonds at maturity or selling them for a loss.

However, investors are not required to amortize premiums in the year they purchase the bond since they may begin doing so in any tax year. However, investors who choose to amortize the premium for one bond must likewise amortize the premium for all other comparable bonds, both for that year and for future years. Furthermore, investors who amortize a bond’s premium must lower the cost basis of their holdings by the same amount.

The Bottom Line

If taxable bond income is a significant component of your yearly taxes, you may consider employing a certified public accountant to help you with tax preparation methods.

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