My Stupid Bond Question #34833

[MercyMe]

On a non-callable bond that is intended to be held until maturity, wouldn't it be better to buy a low/no coupon bond (instead of a bond with an identical YTM and higher coupon) since the gain at maturity would be taxed as LTCG instead of ordinary income?

I feel like this is a really stupid question... one that I wouldn't dare to post on that other forum.

 

[COcheesehead]

It doesn’t matter the size of the coupon, it will always be taxed as interest if in a taxable account.
Buying below par is a different story.

 

[Texas Proud]

It doesn’t matter the size of the coupon, it will always be taxed as interest if in a taxable account.
Buying below par is a different story.

Yes, there is an interest component and a cap gain component...


If you bought a $1,000 par zero coupon at the issue price of say $200... then you have $800 of interest... and you pay each year on an imputed amount..




From FINRA...



One last thing you should know about zero coupon bonds is the way they are taxed. The difference between the discounted amount you pay for a zero coupon bond and the face amount you later receive is known as "imputed interest." This is interest that the IRS considers to have been paid, even if you haven't actually received it. Therefore, the IRS requires that you pay tax on this "phantom" income each year, just as you would pay tax on interest you received from a coupon bond.

 

[njhowie]

Yes, there is an interest component and a cap gain component...


If you bought a $1,000 par zero coupon at the issue price of say $200... then you have $800 of interest... and you pay each year on an imputed amount..




From FINRA...



One last thing you should know about zero coupon bonds is the way they are taxed. The difference between the discounted amount you pay for a zero coupon bond and the face amount you later receive is known as "imputed interest." This is interest that the IRS considers to have been paid, even if you haven't actually received it. Therefore, the IRS requires that you pay tax on this "phantom" income each year, just as you would pay tax on interest you received from a coupon bond.

This is correct. And your brokerage should/will provide this automatically in the 1099. If you use Turbotax and import from the brokerage, it's all nicely taken care of for you.

 

[njhowie]

On a non-callable bond that is intended to be held until maturity, wouldn't it be better to buy a low/no coupon bond (instead of a bond with an identical YTM and higher coupon) since the gain at maturity would be taxed as LTCG instead of ordinary income?

I feel like this is a really stupid question... one that I wouldn't dare to post on that other forum.

There are no stupid questions when you're learning. Better to ask what you perceive is a stupid question and know the answer for sure rather than not asking, making an assumption, and getting it wrong. It could be costly.

 

[Scusan]

It sounded to me like the OP is asking about market discount bonds, not OID or zeros. <<Edit the original post does mention "no coupon bonds", I read through that the first time see post below. My comments in this post are about the "the gain at maturity would be taxed as LTCG instead of ordinary income?" question. I think the gains are taxed as ordinary income and you have two ways to claim that. I haven't looked into OID or zeroes and any similarities/differences they may have to the taxation of market discount bonds.>

I'm still learning (always learning I hope..), but I found this in page 14 of IRS pub 550, which also clarifies what a market discount bonds is:

".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. See Discounted Debt Instruments, later......"

that makes it sound like the difference between the discounted purchase price and the par value of the bond will in all cases be taxed as interest, but you have a choice between accruing it over the life of the instrument or at the end. (Yeah, I "have a dog in this fight", can explain if interested)

So my answer to the question about whether the difference would be taxed as a LTCG is:

"No, but I really like the way you think!"

Will be really curious to hear from someone who's actually done this and how it worked out.

 

[njhowie]

It sounded to me like the OP is asking about market discount bonds, not OID or zeros.

...no coupon bond...

That sure sounds like a zero to me.

 

[Scusan]

>>That sure sounds like a zero to me.<<

Good point, missed the "no coupon" part. I'll try to edit my post for more clarity.

My comments were towards a bond procured at a market discount on the secondary market, which I think also fit in his description.

I'm trying to learn here not pick a fight, believe me. Sounds like you have some knowledge in this area. So do we agree:

1..the difference between the discounted purchase price and the face value of the bond is considered interest and not capital gain? ( It looked like this was clarified many years ago so I'm talking about purchases made today).

2…. you can choose whether to be taxed on this interest either all at once when you dispose of the bond (maturity or sale), or incrementally through the "accrual" method.

If not, let me know where I am coloring outside the lines! I'd much rather read it on an internet BB than in an IRS audit notice, believe me.

 

[Rianne]

Good thread. Here's a follow-up question. Obviously, if the bond were purchased inside a tIRA and you withdrew the coupon amount for cash flow bi-yearly, it is taxed as ordinary income and you have to pre-pay the previous year (correct?)
Example: Discounted bond price $97 Face Value $1000
5 years
Coupon: 5%
YTM 5.5%
What would be the coupon amount distributed into the settlement account?
What would be the YTM amount? Would you get at maturity .5% after the coupon rate was paid bi-yearly?
I hope that makes sense.

 

[COcheesehead]

Good thread. Here's a follow-up question. Obviously, if the bond were purchased inside a tIRA and you withdrew the coupon amount for cash flow bi-yearly, it is taxed as ordinary income and you have to pre-pay the previous year (correct?)
Example: Discounted bond price $97 Face Value $1000
5 years
Coupon: 5%
YTM 5.5%
What would be the coupon amount distributed into the settlement account?
What would be the YTM amount? Would you get at maturity .5% after the coupon rate was paid bi-yearly?
I hope that makes sense.

The payment into your settlement account is $25 twice a year, $50 total until it matures or is called. The other .5% is the difference between what you paid and the par value of $1000. That difference comes mostly as you get near maturity or call when you are paid $1000.
If buying on the secondary market, you will prepay any accrued interest - equal to the interest since the last coupon, but get that back at the next coupon payment. If you buy a new issue, there is no prepaid interest.

 

[jazz4cash]

Yes, there is an interest component and a cap gain component...
.

But to clarify, the ‘capital gain’ component is taxed as ordinary income. None of the gain is not eligible for the capital gains tax rate.

 

[Freedom56]

I routinely buy securities bellow par and they either get called, mature at par, or I sell above par before maturity or in response to a tender offer.

I verified the tax treatment with the consolidated 1099 received from my brokers. This is the case for brokered CDs, preferred stocks, corporate bond/notes (exchange traded or over the counter). It does not include zero coupon bonds.

The coupon payments are reported in your 1099-INT
Dividend payments (from preferred stocks) in your 1099-DIV

The disposition from a sale/call/maturity of a preferred stock, CD, or corporate note is reported a 1099-B transaction and the capital gain (if any) to the IRS as either a short or long term gain depending on the duration it was held.

 

[Scusan]

Freedom,

Thanks for your input and real world experience. You've helped a lot of people on here, myself included.

I don't understand the disparity between your actual experience and what I read in the IRS pub.

From your post (above) and your real world experiences:

>>The disposition from a sale/call/maturity of a preferred stock, CD, or corporate note is reported a 1099-B transaction and the capital gain (if any) to the IRS as either a short or long term gain depending on the duration it was held.<<

From the IRS pub:

>>You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount.<<

So are you saying that you pay tax on the "gain" portion of a bond sale as a LTCG or STCG vs ordinary interest income?

This topic is of some interest to me as this year's effective fedtax bracket is 35.8, next year 24 and LTCG would be 15 if I'm doing it right. If I get to vote on this, I vote for your way of doing it!

TIA

 

[COcheesehead]

Freedom,

Thanks for your input and real world experience. You've helped a lot of people on here, myself included.

I don't understand the disparity between your actual experience and what I read in the IRS pub.

From your post (above) and your real world experiences:

>>The disposition from a sale/call/maturity of a preferred stock, CD, or corporate note is reported a 1099-B transaction and the capital gain (if any) to the IRS as either a short or long term gain depending on the duration it was held.<<

From the IRS pub:

>>You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount.<<

So are you saying that you pay tax on the "gain" portion of a bond sale as a LTCG or STCG vs ordinary interest income?

This topic is of some interest to me as this year's effective fedtax bracket is 35.8, next year 24 and LTCG would be 15 if I'm doing it right. If I get to vote on this, I vote for your way of doing it!

TIA

This article might help for secondary market purchased bonds.

https://www.investopedia.com/articles/tax/08/bond-tax.asp

 

[Freedom56]

Freedom,

Thanks for your input and real world experience. You've helped a lot of people on here, myself included.

I don't understand the disparity between your actual experience and what I read in the IRS pub.

From your post (above) and your real world experiences:

>>The disposition from a sale/call/maturity of a preferred stock, CD, or corporate note is reported a 1099-B transaction and the capital gain (if any) to the IRS as either a short or long term gain depending on the duration it was held.<<

From the IRS pub:

>>You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount.<<

So are you saying that you pay tax on the "gain" portion of a bond sale as a LTCG or STCG vs ordinary interest income?

This topic is of some interest to me as this year's effective fedtax bracket is 35.8, next year 24 and LTCG would be 15 if I'm doing it right. If I get to vote on this, I vote for your way of doing it!

TIA

Here is an example from my 1099. I also do my own taxes with the help of tax software.

The transaction was for the disposition of Seagate technology corporate notes in 2019 that I acquired in 2018 below par on the secondary market. The coupon payments up to and including the day of the disposition was reported in the 1099-INT details. The disposition was reported in the 1099-B and was reported to the IRS as a long term capital gain. The tax software carried the transaction to Schedule D as a long term capital gain. This was tax year 2019. The same rules applied in 2020, and 2021.

I hope this helps.