The taxation of fixed-income instruments is complex and often misunderstood.
The taxation of fixed-income instruments is complex and often misunderstood. For any generalization regarding the taxation of fixed income, there will be numerous caveats and exceptions. For the purpose of this article, only the tax treatment of individuals holding these instruments as capital assets will be discussed. Special situations such as people holding bonds as part of straddles or conversion transactions or as currency hedges, are not addressed. Derivative-type products such as Collateralized Mortgage Obligations, and other Real Estate Mortgage Investment Contracts, and bonds with coupons that step up over time, will also be excluded from this discussion. We will save the discussion of the taxation of the various forms of savings bonds, Series I bonds, and Treasury Inflation-Protected Securities for another article.
The types of fixed-income instruments covered here include certificates of deposit; Treasury bills, notes, and bonds; government agency bonds; corporate bonds; and municipal bonds.
The tax laws distinguish between two types of return for these instruments:
Note that for tax purposes, interest income and the bond's coupon payments are not equivalent. Similarly, capital gain or loss is not necessarily equal to the appreciation or decline in a bond's price. Both interest income and capital gains treatment are determined by the investor's tax basis in the bond or CD. This tax basis can remain constant over the life of the bond, as in the case of a bond purchased at par, or can change over the life of the bond as happens with bonds purchased at a discount or at a premium to face value.
Issued and Purchased at Par
When a fixed-income instrument is issued at par, it means that a bond with a $1,000 face amount sells at issue for $1,000 (plus any transaction costs or markups). The purchaser pays $1,000 and, assuming no defaults, will collect $1,000 at maturity, along with the stated interest from the bond's coupon.
In this example, the bond's yield is equal to its coupon interest rate and the investor's tax basis remains constant at $1,000. The $1,000 received at maturity is generally considered to be the proceeds from a sale or trade and is offset by the original investment (tax basis) in the bond, and thus is generally not taxable. The interest payments received during the life of the bond are considered to be interest income and will be taxable, unless exempt from taxation as is the case with most municipal bonds. For the purposes of this discussion we will ignore the potential AMT tax liability generated by a certain types of municipal bonds.
Original Issue Discount