Tax Treatment of Taxable Debt Securities

Tax treatment of bonds varies depending on whether the bond was issued at a discount, purchased at a premium, or bought at a market discount in the secondary market.

Interest Income

The simplest tax rule for bonds:

• Coupon (interest) payments on corporate bonds are taxed as ordinary income
• Taxable at the federal, state, and local level
• Interest is taxable in the year received (cash basis) or accrued (accrual basis)

Original Issue Discount (OID)

OID applies when a bond is issued at a price below par. The most common example is a zero-coupon bond.

OID = Par Value - Original Issue Price

• The OID must be accreted (amortized upward) annually over the life of the bond
• Each year's accretion is taxed as ordinary income even though no cash is received; this is called phantom income
• The annual accretion increases the bondholder's cost basis (adjusted basis)
• At maturity, the adjusted basis equals par value, so there is no capital gain or loss

Think of it this way: The IRS treats the discount as interest you are earning over the life of the bond, even though you do not receive any cash until maturity. You owe tax each year on income you have not actually collected yet.

Example: Zero-coupon bond issued at $600, matures at $1,000 in 20 years:

• Total OID = $400
• Approximately $20/year accreted and taxed as ordinary income (actual accrual uses the constant yield method)
• Cost basis increases from $600 toward $1,000 over the 20 years
• At maturity: adjusted basis = $1,000 = par value, so no gain or loss

Exam Tip: Gotchas

• OID = phantom income = ordinary income (not capital gain). The investor owes tax each year on income not yet received in cash.
• Zero-coupon bonds are better suited for tax-deferred accounts (IRAs, 401(k)s) where annual phantom income is not immediately taxable.

Bonds Purchased at a Premium in the Secondary Market

When you buy a bond above par in the secondary market, you have paid a market premium.

• Corporate bond premium may be amortized over the remaining life to reduce annual interest income (optional for taxable bonds, but most investors elect to amortize)
• Amortization reduces the cost basis each year
• If not amortized, the investor realizes a capital loss at maturity (cost basis above par)

Example: Buy a bond at $1,050, par = $1,000, 10 years to maturity:

• Premium = $50
• If amortized: $5/year reduces taxable interest income; cost basis decreases from $1,050 toward $1,000
• If not amortized: at maturity, receive $1,000 with cost basis of $1,050 = $50 capital loss

Exam Tip: Gotchas

• Premium amortization on corporate bonds is optional (unlike municipal bonds, where it is required).
• Amortizing lowers your cost basis. If you amortize fully, basis = par at maturity and there is no gain or loss. If you skip amortization, you take a capital loss at maturity.

Bonds Purchased at a Discount in the Secondary Market (Market Discount)

When you buy a bond below par in the secondary market (for a bond originally issued at par), you have a market discount.

• Market discount = Par Value - Purchase Price
• At maturity or sale, the market discount is taxed as ordinary income (not capital gain)
• The investor may elect to accrue market discount annually (similar to OID treatment) or recognize it all at disposition

Exam Tip: Gotchas

• Market discount at maturity = ordinary income, not capital gain. This is a common exam trap. The gain up to the amount of the market discount is recharacterized as ordinary income.

Capital Gains and Losses

When a bond is sold before maturity:

Basis adjustments:

• OID accretion adjusts basis upward
• Premium amortization adjusts basis downward

Exam Tip: Gotchas

• OID accretion raises cost basis; premium amortization lowers it. The direction of the basis adjustment is a frequently tested distinction.