Bond Tax Question

Yes, Long Term. And anytime you sell anything for more than you bought it, the difference is a capital gain. The 12-month holding period simply qualifies it as a long-term gain, which is taxed at a lower rate.

Bill

Is the bond zero coupon? Is it a muni? Did you elect to amortize all your taxable bonds?

The simple answer is no, the $8 is regarded as interest (at least for bonds bought after 1993). The more complex answer is concerned with how that interest is taxed (in the case of a muni bond, it may or may not be taxable; it is always taxable for taxable bonds), and when the income is recognized (imputed as you go along, or at maturity).

Here's an entry point into Pub 550 that should get you started on tax treatment of market discount bonds:

It wouldn't matter if it is zero bond, because the original question was about the repayment of the *principal*.

Assume it is a corporate bond, not a muni.

What are the options to amortize the bonds? Why would someone do that?

I think in the distant past this was true, but for the past decade or more the IRS wants to tax this difference between market discount and face value as regular interest income, payable generally in the year of sale/maturity, the mechanics for this being described in detail in several recent threads here.

It's pretty confusing because other places in their publications the IRS states very clearly that bonds are "capital gain property".

Steve

For practical purposes, isn't the principal $92 since that's what you paid for the bond? The repayment of the real face value or principal of $100 constitutes $8 profit.

If the bond is a muni, you have to amortize it. If the bond is a corporate, the default is to not amortize, although you can elect to amortize it as stated in

One more question. Was it an original issue at $92? If yes, then: Assuming the corporate pays no interest and you're not amortizing (the default), then all of the $8 is a capital gain. If you were amortizing, then part of the $8 would be deductible in each year on Schedule A Misc deductions not subject to 2% floor or AMT, and there is no capital gain/loss at the end. If the bond pays interest, and you're not amortizing, then you just report the interest on Schedule B. If you are amortizing, then you reduce your interest on Schedule B by the amortization, and only if this is less than zero do you deduct the remainder on Schedule A Misc deductions not subject to 2% floor.

If you bought the bond on the secondary market, then you have to calculate the true price of the bond at the time you bought it for $92. I imagine this calculation depends on the price of the bond when it was originally issued and the number of years to maturity when it was originally issued. Say it was originally issued at $70 and matured in 10 years. So the true price increases $3 a year. Say you bought it 1.5 years before maturity, so the true price is $100-$3*1.5$95.50. But if you use the constant yield method, the formula is more complicated (I haven't figured it out yet) and you get a different number. You bought it for $92. So $3.50 is ordinary income reportable on Schedule B, and the rest is capital gain. The $3.50 is by default reportable all at once in the year of sale, but you can elect to pay it each year you hold the bond per

If you amortize bonds, you get a deduction every year, which lowers your income, and you don't have to deal with capital gains at the end.

Disclaimer: I'm new to all this bond stuff, so some things I said may not be correct.

Last sentence above does not look correct to me. The amortization on discount bonds is not deductible on Schedule A, but is rather added as interest on Schedule B. And yes, there is no capital gain/loss at the end. I said you get a deduction and no capital gain/loss at the end, which obviously makes no sense!

Again, last sentence above is not correct. You would have to add amortization to the coupon interest.

Amortizing all your taxable bonds does not make sense because you have to report the discount as ordinary income, which is taxed at a higher rate.

Again, I cannot understand why anyone would want to amortize a bond. These days you don't have any certainty of getting your principal back, so why accelerate the repayment of principal reported on your tax return by amortizing? If muni bonds are required to be amortized, I guess that gives me a reason to never buy one. Our cities can thank the Federal Government for that. Who needs that kind of hassle and time killing complexity to make 4% interest rates?

If you buy the corporate bond at $92, and get repayment of the original bond face value of $100 in >12 months, I hear half the people responding to this thread saying it is capital gains and the other half saying that it is not. I gather the recent IRS rules are that this is "interest".

It seems like this should be a capital gains event since it does involve a capital purchase, and *the capital is at risk of total loss*, and the capital does appreciate in greater than 12 months. It's a shame if the government has created one more complex twist to make things intolerably complicated when they don't need to be.

How does the government view someone who pays $80 for a Ford Bond and ends up selling it for $20? This is considered a short term capital loss even when it is long term?

I think in almost all real cases the TP does not want to elect to report taxable bond market discount amortization as it occurs each tax year. But it was pointed out here in a recent thread that this would have the effect of spreading the income into more tax years, thus possibly hitting a lower tax bracket.

Steve

If you paid over par for it, you'll pay less taxes prior to maturity.

The law says it isn't that the capital appreciates, but rather that you're earning interest.

If you buy a bond at par, that's a capital purchase, and all the capital is at risk, but the income is still interest.

Why would it be?

Seth

So the law in this case is making up both theory and practice that are just false. If I buy a bond for $20 and am lucky enough to be paid $100 par value in three years, then there is no basis for calling this $80 profit "interest". There is no contract between the lendor and the borrower to pay any interest at all on the $20. The contract is only for payment of interest against the par value, and for a return of capital at par value at the end of the bond holding period, or at some call interval. So at intervals after I buy the $20 bond, I receive interest and should pay tax on interest. At the end of the bond holding period, I am (if I am lucky) paid $100 par value and the final interest payment. I understand the final interest payment is interest. I do not understand by what theory the $80 increase in bond value is called interest. That's just a bizarre reading of facts. Maybe it is the law. But the law is just based on bad assumptions in that case.

Of course that's clear. But that's not the case I was ever discussing. The interest on a bond is always interest. The question is what happens when I buy the bond years after issue at either premium or discount from par. To construe changes of par value as "interest" of any kind is a complete distortion of reality. It may be the law. But it is a bad law, based on a bad theory. How would it be any different than buying a house in 1990 and selling it for a gain in 1996 and calling the difference "interest"?

If I pay $80 for a Ford Bond and sell it three years later for $20, is this any kind of capital loss? If not, how does tax law classify it? It's an ordinary income loss?

Since you knew in advance you could get $100 at maturity on a bond you paid $20 for, it's not unreasonable for the IRS to call the difference ordinary income. A capital asset is something that may go up or down in value, and you take that risk.

Stu

There is absolutely no question bonds are a capital asset (it says so in Pub 550). It is just that, through a series of tax code changes over the years, they have jiggered it so that almost any form of gain on any bond is ordinary income. If you hold the bond to maturity, it is all ordinary income. If you sell before maturity, you can see gain or loss. (And of course, if it defaults.)

I am still trying to interpret the rules in Pub 1212 regarding OID on zero-coupon bonds bought in the secondary market. I think these rules actually say to ignore the "original" OID and just treat any purchase discount as OID instead. This also has the effect of eliminating capital gain or loss if you hold to maturity. I'm not quite certain of this yet however.

Steve

There's no guarantee at purchase the bond will be paid at maturity. He could just as easily lose the $20 (in fact, at the time of purchase, that could well be the more probably outcome elst the price wouldn't have been discounted so deeply).

If I correctly recall the motivation for this tax law change, it was the introduction of special derivatives, namely the appearance of zero- coupon bonds and also stripped treasuries. I don't recall whether this happened before or after the 1986 tax reform or not.

But the basic idea behind the zero-coupon bond was that instead of paying interest normally, the bond would be issued at a discount instead. Under the prevailing rules, which roughly followed W's line or reasoning is that the change in value from the issue discount to the final redemption would become capital gains. So, here we had what was a "bond" that didn't pay any interest, but instead had a pre-set capital appreciation. This was guaranteed (OK, as much as any bond principal repayment is guaranteed), and thus had none of the normal risk attributes of capital gains.

So what happened is that one magically had managed to turn ordinary interest income into capital gains. And with a favorable tax rate for capital gains, this looked like a great tax avoidance strategy. So given this set of facts and motivations, Congress stepped in and using a function over form argument decreed that the increase in value of the bond was, in effect, interest, since it was a fixed, predictable and guaranteed return. Just like any normal bond paying interest.

So, at a macro-level this all makes sense.

The one part I don't quite understand is what happens in a stripped bond transaction. I know that this involves taking a normal bond and splitting it into a zero-coupon part and an income stream part. But that makes it look like you are managing to increase the amount of ordinary income, since the zero-coupon part appreciation ends up being OID "interest" and the income stream is presumably also considered ordinary interest. And what is the tax treatment of the payment made by the person buying the income stream? Do they at least get to consider part of the income stream a return of capital (i.e., non- taxed?)

Just to clarify this: if one sells a bond before maturity, these are ordinary gains or ordinary losses?

The irony of these tax code changes is that the government may be giving large ordinary income tax write-offs to bondholders who sell before maturity at a loss. So instead of cutting off a tax savings on a capital gain transaction, they are creating ways to write off lots of ordinary income. That probably ends up helping rich people a lot more than the retired people who so often depend on income from bonds.

Here is my understanding: suppose one buys a non-deep-discount bond at a market discount in the secondary market, and then sells it for 100 sometime before maturity. Upon sale, the accrued market discount is reported as if it were interest income, and is added to the basis. Since the new basis is still less than 100, the difference is capital gain. The gain results from the accrued market discount being less than the total market discount.

Only if you buy the bond at a premium, AND elect to amortize it, can this be an ordinary loss. Otherwise it is a capital loss. And only the premium amount can be an ordinary loss; if you sell the bond below 100, that part of the difference is always a capital loss.

Steve

If a bond is selling for $20 now, and will be worth $100 at maturity in three years if the company survives, then the market is saying that there's an excellent chance that the company will not survive, hence that bond is very risky.

Seth

No, it isn't. If you buy one coupon, the amount of the coupon payment in excess of the price you paid is interest, the rest is return of principal.

Yes.

The result is that the total amount of interest doesn't change much.

Seth