Bonds - QuickFinder 5-22 and 5-26
OID is a form of interest. It is the excess of a debt instrument's stated redemption price at maturity over its issue price (acquisition price for a stripped bond or coupon). Zero coupon bonds and debt instruments that pay no stated interest until maturity are examples of debt instruments that have OID. Publication 1212 Page 2
Including OID in income. Generally, you include OID in income as it accrues each year, whether or not you receive any payments from the debt instrument issuer. Pub 1212 Page 6 (if it is a tax exempt bond you just show the income but do not pay tax on it).
The bond issuer will send you a Form 1099-OID. This form shows the amount of OID (Box 1) to include in your income. Sometimes you might need to recalculate the OID. Ex: You bought the bond after the date it was originally issued, and you paid a premium for it
Original issue discount (OID) is a form of interest. You generally include OID in your income as it accrues over the term of the debt instrument, whether or not you receive any payments from the issuer. A debt instrument generally has OID when the instrument is issued for a price that is less than its stated redemption price at maturity. OID is the difference between the stated redemption price at maturity and the issue price. Publication 17 Page 64
Information reporting requirement. If you must file a tax return, you are required to show any tax-exempt interest you received on your return. This is an information reporting requirement only. It does not change tax-exempt interest to taxable interest.
What is original issue discount (OID) and is it taxable?
Publication 1212
Box 5. For a taxable covered security acquired with market discount, enter the amount of market discount that accrued during the period the holder owned the debt instrument provided the holder notified you of an election made under section 1278(b) to include market discount in income as it accrued.
Box 6. For a taxable covered security acquired with acquisition premium, enter the amount of acquisition premium amortization for the period the holder owned the debt instrument. If a net amount of OID is reported in box 1 or box 8, as applicable, leave this box blank.
Your gain or loss is the difference between the amount you realized on the sale, exchange, or redemption and your basis in the debt instrument. Your basis, generally, is your cost increased by the OID you have included in income each year you held it. In general, to determine your gain or loss on a tax-exempt bond, figure your basis in the bond by adding to your cost the OID you would have included in income if the bond had been taxable. For a covered security, your broker will report the adjusted basis of the debt instrument to you on Form 1099-B.
Investment income and expenses
Is OID on tax-exempt bonds taxable?
Publication 1212 / Page 9
Tax exempt bond. If you own a tax-exempt bond, figure your basis in the bond by adding to your cost the OID you would have included in income if the bond had been taxable. You need to make this adjustment to determine if you have a gain or loss on a later disposition of the bond. In general, use the rules that follow to determine your OID.
Tax exempt bonds taxable if issued in Puerto rico?
All bonds issued by the Government of Puerto Rico, or by its authority, shall be exempt from taxation by the Government of the United States, or by the Government of Puerto Rico or of any political or municipal subdivision thereof, or by any State, Territory, or possession, or by any county, municipality, or other municipal subdivision of any State, Territory, or possession of the United States, or by the District of Columbia.
Will a taxpayer recognize gain or loss if he holds tax-exempt zero coupon bonds to maturity?
Publication 1212 / Page 4
Short Term Obligations Redeemed at Maturity - If you redeem a short-term discount obligation for the owner at maturity, you must report the discount as interest on Form 1099-INT. To figure the discount, use the purchase price shown on the owner's copy of the purchase confirmation receipt or similar record, or the price shown in your transaction records. If the owner's purchase price cannot be determined, figure the discount as if the owner had purchased the obligation at its original issue price. A special rule is used to determine the original issue price for information reporting on U.S. Treasury bills (T-bills) listed in Section III-A. Under this rule, you treat as the original issue price of the T-bill the noncompetitive (weighted average of accepted auction bids) discount price for the longest-maturity T-bill maturing on the same date as the T-bill being redeemed. This noncompetitive discount price is the issue price (expressed as a percent of principal) shown in Section III-A. A similar rule is used to figure the discount on short-term discount obligations issued by the organizations listed in Section III-B through Section III-F.
Will a taxpayer recognize any gain or loss if he sells tax-exempt zero coupon bonds prior to maturity?
Redemption before maturity. If, before the maturity date, you redeem a deferred interest account for less than its stated redemption price at maturity, you can deduct OID that you previously included in income but did not receive.
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How do I figure out the amount of OID that must be amortized?
Constant yield method - This discussion shows how to figure OID on debt instruments issued after July 1, 1982, and before 1985, using a constant yield method. OID is allocated over the life of the debt instrument through adjustments to the issue price for each accrual period.
Figure the OID allocable to any accrual period as follows. 1. Multiply the adjusted issue price at the beginning of the accrual period by the debt instrument's yield to maturity. 2. Subtract from the result in (1) any qualified stated interest allocable to the accrual period. Accrual period. An accrual period for any OID debt instrument issued after July 1, 1982, and before 1985 is each 1-year period beginning on the date of the issue of the obligation and each anniversary thereafter, or the shorter period to maturity for the last accrual period. Your tax year will usually include parts of two accrual periods.
Publication 1212 / Page 8
How is a contingent debt instrument taxed?
Treatment of gain or loss on sale or exchange. If you sell a contingent payment debt instrument at a gain, your gain is ordinary income (interest income), even if you hold the debt instrument as a capital asset. If you sell a contingent payment debt instrument at a loss, your loss is an ordinary loss to the extent of your prior OID accruals on the debt instrument. If the debt instrument is a capital asset, treat any loss that is more than your prior OID accruals as a capital loss.
Publication 1212 / page 11-12 and CFR 1.1275-4 AND http://www.sec.gov/answers/equitylinkedcds.htm
Tax-exempt bond and the basis?
If you own a tax-exempt bond, figure your basis in the bond by adding to your cost the OID you would have included in income if the bond had been taxable. You need to make this adjustment to determine if you have a gain or loss on a later disposition of the bond. In general, use the rules that follow to determine your OID.
Publication 1212 / Page 9
Market Discount Bonds
What is a market discount bond?
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 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, this is due to an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.
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Is the market discount on tax-exempt bonds taxable?
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. See Partial principal payments, later in this discussion. If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Limit on interest deduction for market discount bonds, later.
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Premium Bonds
What is the tax treatment of a premium paid on a taxable bond?
If you pay a premium to buy a bond, the premium is part of your basis in the bond. If the bond yields taxable interest, you can choose to amortize the premium. This generally means that each year, over the life of the bond, you use a part of the premium to reduce the amount of interest includible in your income. If you make this choice, you must reduce your basis in the bond by the amortization for the year. If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year. Bond premium. Bond premium is the amount by which your basis in the bond right after you get it is more than the total of all amounts payable on the bond after you get it (other than payments of qualified stated interest). For example, a bond with a maturity value of $1,000 generally would have a $50 premium if you buy it for $1,050.
Publication 550 / page 34
What is the tax treatment of a premium paid on a tax-exempt bond?
If a tax-exempt bond is purchased at a premium (i.e., at a price in excess of the face amount of the bond), whether at original issue or in the secondary market, the bond premium MUST BE amortized over the remaining term of the bond using the same constant yield to maturity method discussed above under “Original Issue Discount.” The amount of bond premium amortized each year is not deductible by the holder but instead reduces the holder's tax basis. Amortizable bond premium can also result if a holder purchases a bond that was originally issued at a discount and the purchase price exceeds the issue price of the bond plus any accrued OID on the bond.
Not citable.
Acquisition premium. You bought a debt instrument at an acquisition premium if both the following are true. You did not pay a premium. The instrument's adjusted basis immediately after purchase (including purchase at original issue) was greater than its adjusted issue price. This is the issue price plus the OID previously accrued, minus any payment previously made on the instrument other than qualified stated interest. Acquisition premium reduces the amount of OID includible in your income. For information about figuring the correct amount of OID to include in your income, see Figuring OID on Long Term Debt Instruments in Publication 1212.
Publication 550 / Page 14
Does the sale or redemption of a tax-exempt bond results in capital gain or loss?
Publication 550 / page 34
How do I figure the amount of amortization?
You choose to amortize the premium on taxable bonds by reporting the amortization for the year on your income tax return for the first tax year you want the choice to apply. You should attach a statement to your return that you are making this choice under section 171. See How To Report Amortization, next.
How To Figure Amortization
For bonds issued after September 27, 1985, you must amortize bond premium using a con-stant yield method on the basis of the bond's yield to maturity, determined by using the bond's basis and compounding at the close of each accrual period.Constant yield method. Figure the bond pre-mium amortization for each accrual period as follows.
Step 1: Determine your yield. Your yield is the discount rate that, when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be con-stant over the term of the bond and must be fig-ured to at least two decimal places when ex-pressed as a percentage.
If you do not know the yield, consult your broker or tax advisor. Databases available to them are likely to show the yield at the date of purchase.
Step 2: Determine the accrual periods. You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each ac-crual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.
Step 3: Determine the bond premium for the accrual period. To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result from the qualified stated interest for the period.
Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.
Publication 550 / Page 34
This choice is binding for the year you make it and for later tax years. It applies to all taxable bonds you own in the year you make the choice and also to those you acquire in later years.You can change your decision to amortize bond premium only with the written approval of the IRS. To request approval, use Form 3115. For more information on requesting approval, see section 5 of the Appendix to Revenue Procedure 2011-14 in Internal Revenue Bulletin 2011-4.
Tax free we have an option to amortize or not. Once you do then you always must.
Tax exempt you MUST amortize.
Publication 550 / Page 35
What is market discount and how is it taxed?
Market discount generally exists when a bond is purchased on the secondary market at a price below par. Market discount is the difference between the purchase price of a bond and its stated redemption price at maturity. In the case of a bond sold with original issue discount (OID), such as a zero-coupon bond, market discount is the difference between the purchase price and the issue price of the bond plus accreted OID. (See Q&A 7.) Accreted market discount is taxed as ordinary interest income in the year a bond is sold, redeemed or transferred.
How was the tax treatment of market discount on municipal bonds changed in the 1990s?
Before May 1993, market discount on municipal securities was treated as capital gain, not as ordinary income. Under current law, accreted market discount is taxed as ordinary income at the time a bond is sold or redeemed. (A taxpayer may elect to include accreted market discount in taxable income on a current basis during the period he or she holds the bond. In most cases, however, this would not be advantageous.) The new rules for the taxation of market discount on municipal bonds apply to instruments acquired after April 30, 1993. Market discount bonds acquired before May 1, 1993 are still subject to the old rules.
What is the "de minimis" rule?
The de minimis rule governs the treatment of small amounts of market discount. Under the de minimis rule, if a bond is purchased with a small amount of market discount—an amount less than 0.25 percent of the face value of a bond times the number of complete years between the bond’s acquisition date and its maturity date—the market discount is considered to be zero. If the market discount is less than the de minimis amount, the discount on the bond is generally treated as a capital gain upon disposition or redemption rather than as ordinary income.
Is market discount the same as original issue discount?
No. OID exists when a bond is issued at a price below its redemption value. OID represents interest paid by the issuer and, for municipals, is generally treated as taxexempt interest. Market discount exists when a bond falls in value after it has been issued. Market discount is not treated as tax-exempt interest because it does not represent an interest expense of the issuer. An OID bond may be subject to the market discount rules if purchased after original issue at a time when the price of the bond reflects a market discount, i.e., if the bond is purchased at a price below its revised, or adjusted, issue price. (See below.)
OID and market discount are taxed differently. For taxable OID bonds, accrued OID must be recognized annually as taxable interest income. For tax-exempt municipal OID bonds, this income is not subject to the ordinary income tax, although it is required to be reported for informational purposes in the same manner as other tax-exempt bond interest. Accrued OID on municipal bonds is also potentially subject to the alternative minimum tax in the same manner as other municipal bond interest. Unlike OID, market discount is not subject to taxation annually. Accreted market discount only becomes taxable in the year the bond is sold or redeemed. Also unlike OID, market discount is taxable income regardless of the tax-exempt nature of a bond’s interest income.
How does the market discount rule work?
For bonds acquired after April 1993, the amount of a bond’s market discount is accreted between the bond’s date of acquisition and its date of maturity. Accreted market discount must be included as ordinary, taxable income in the year a bond is sold, redeemed or otherwise disposed of. An investor may choose to accrete market discount on a daily basis using the ratable, or straight-line method, or using the constant interest rate method. The constant interest rate method corresponds to the economic accrual of interest based on the yield on a market discount bond at the time it is purchased.
For example, suppose an investor buys a tax-exempt bond—originally issued at par—in the secondary market at a price of 90 with ten years left until maturity. Five years later, he or she sells the bond at a price of 95. Assuming the discount is amortized on a straight-line basis, the investor must treat the five-point gain as ordinary income in the year the bond is sold. (Total market discount at the time the bond is purchased is ten points, accreted on a straight-line basis over the ten years until maturity. After five years, accreted market discount totals five points.) Suppose under the same circumstances, the investor sells the bond after five years at a price of 96. Five points (the total accreted market discount) are taxed as ordinary income and one point is taxed as a capital gain. Suppose, again under the same circumstances, that the investor holds the bond to maturity. Ten points (the entire amount of market discount) are taxed as ordinary income in the year the bond is redeemed. Finally, suppose the investor sells the bond after five years at a price of 88. In this case, the investor would recognize no market discount income and would recognize a capital loss of two points.
In another example, suppose the investor buys the bond at a price of 98 with ten years left until maturity. Because the amount of market discount, two points, is less than the de minimis amount (which in this case is 2.5 points, or 0.25 percent of the face value of a bond times the number of years between the bond’s acquisition and its maturity), the market discount is considered to be zero and the difference between purchase price and sales price or redemption is generally treated as a capital gain upon disposition or redemption.
How does the market discount rule apply to OID bonds?
For OID bonds, market discount arises when a bond is purchased on the secondary market at a price below the revised issue price of the bond (the bond’s issue price plus accrued OID). The revised issue price for tax-exempt OID bonds is calculated annually using the constant interest rate method and is equal to the original issue price plus accrued OID through the date of purchase. (The constant interest rate method corresponds to the economic accrual of interest based on the yield on an OID bond at the time it is issued.) For OID bonds, market discount is the excess, if any, of the revised issue price over the purchase price. As with other tax-exempt securities, market discount on OID bonds is accreted from the date the bond is purchased to the maturity date. Accreted market discount is taxed as ordinary income at the time a bond is sold or redeemed.
For example, suppose an investor purchases a 20-year, zero-coupon municipal bond at an original issue at a price of 50. Suppose further that after ten years, the revised issue price of the bond using the constant interest rate method is 70 (the original issue price of 50 plus 20 points of accrued OID) and the investor sells the bond to a second investor at a price of 60. When the bond matures, the second investor must include as ordinary, taxable income ten points of gain (the revised issue price at acquisition of 70, less the purchase price of 60). The remaining gain on the taxexempt bond attributable solely to OID (30 points) is not taxed.
What is Accrued Interest Paid?
When you buy a bond between interest payment dates, there is interest that has accrued since the last interest payment date. The price you pay for the bond will include this accrued interest. The accrued interest is taxable to the seller, whereas the interest that is earned from the date of purchase to the end of the year is taxable to the purchaser.
How to Report?
If you received a Form 1099-INT that reflects accrued interest paid on a bond you bought between interest payment dates, include the full amount shown as interest on the Form 1099-INT on Schedule B
Then, below a subtotal of all interest income listed, enter "Accrued Interest" and the amount of accrued interest you paid to the seller.
Subtract that amount from the interest income subtotal.
Pub 550