Bond capital gains and losses
When bonds bought at a premium are sold or called at a loss, and when bonds bouight at a discount are sold or called at a gain, how is the situation reported to the IRS. I’m getting vastly different stories from my CPA, financial advisor(s) and broker. Love your column. Many thanks.
Terry Says
Aha, there’s a reason you’re getting a lot of answers; this is a complicated questions.
First let me explain to others how the issue arises. Suppose a bond is initially issued with a value or $1,000 and a fixed interest rate coupon. But as rates rise in the marketplace, the price of the bond drops. No one wants to pay you $1,000 for your old 3% bond if similar new bonds are yielding 4%. So the price of the bond will be discounted, depending on the maturity of the bond — ie how long you might be “stuck” holding that older, low-rate bonds. The trading market sets the discount, but for purposes of this example, let’s say the “secondary” market price of the bond is now $925 instead of the “face value” of $1,000. (No, you don’t have to sell the bond at a loss — but you’ll be stuck earning less for years, which is reflected in the market price discount. And eventually you’ll get your $1,000 back from the issuer at maturity, but that cash won’t buy as much because of inflation!)
OK, now you have the idea: When interest rates rise, bond prices FALL.
If you sell and take a loss, that is a capital loss, depending on how long you’ve owned the bond. And it can be offset against capital gains, or to a limited amount against ordinary income.
If you bought a bond at a premium — paying more than the $1,000 face value — then at maturity you’ll still get back the $1,000. But what about the premium you paid — the purchase price amount that was over $1,000? That money “disappeared” — but along the way you did earn higher interest income.
The tax treatment of that premium on redemption depends on whether that was a municipal bond or a taxable bond. Generally, you can declare a capital loss if it is was taxable bond — but NOT if it was a municipal bond!
Note, we are talking about gains or losses on sale of a bond, or on redemption by the issuer at maturity. Those are “capital” gains or losses and treated as such on your tax return, depending on how long you held the bond, and what type of bond it was. BUT, the INTEREST you earn on the bond is treated as ordinary income (on taxable bonds) and as “tax-free income” to the extent that it is allowed on your federal return and potentially on your state tax return, depending on what municipal bonds you purchased.
One more thing! The above comments deal with bonds purchased at a premium and redeemed at “par value”. But if you are trading bonds and take a loss on a sale other than redemption, then the loss is considered a capital loss — either long term or short term, and a gain is similarly considered a capital gain — either short or long term – much as any securities gains or losses.
And if you’re still confused about my description — and I admit is IS confusing — consult a sophisticated tax adviser or CPA regarding your specific situation.
