Quick Answer
Converting a convertible bond or convertible preferred stock into common stock is not a taxable event. The common shares' total cost basis equals the converted security's cost basis, and the original holding period tacks on. The conversion price sets the share count; the purchase price sets the basis per share.
When a convertible bond or convertible preferred stock is converted into common stock, the conversion itself is not a taxable event. The cost basis transfers directly to the new shares, and the exam frequently tests whether a candidate confuses the conversion price with the actual purchase price.
Conversion of Convertible Bonds
The core rule: When a convertible bond is converted to common stock, the cost basis of the common shares equals the cost basis of the bond.
- The conversion is not a taxable event; no gain or loss is recognized
- Cost basis per share = bond cost basis / number of shares received
- The holding period of the bond tacks on to the common stock
Exam Tip: Gotchas
- Conversion is never a taxable event. Tax consequences only arise when the common shares are eventually sold.
- The holding period carries over. If you held the bond for 14 months before converting, the common shares are already long-term from day one.
Calculation examples:
| Bond Purchase Price | Conversion Ratio | Shares Received | Cost Basis Per Share |
|---|---|---|---|
| $1,000 (at par) | 50:1 ($20 conversion price) | 50 shares | $1,000 / 50 = $20.00 |
| $900 (at discount) | 50:1 ($20 conversion price) | 50 shares | $900 / 50 = $18.00 |
| $1,100 (at premium) | 50:1 ($20 conversion price) | 50 shares | $1,100 / 50 = $22.00 |
The Key Distinction: Conversion Price vs. Cost Basis
This distinction matters:
- The conversion price ($20 in the example above) determines how many shares you receive. It is based on the bond's par value ($1,000 / $20 = 50 shares)
- The cost basis per share depends on what the investor actually paid for the bond, not par value
If you paid $900 for a bond that converts at $20 per share (50 shares), your cost basis per share is $18 - not $20.
Exam Tip: Gotchas
- Conversion price sets the share count (based on par value). Purchase price sets the cost basis per share. If a bond bought at $900 converts at $20 (50 shares), the cost basis per share is $18, not $20.
Convertible Preferred Stock
The same rules apply:
- Cost basis of the preferred stock transfers to the common shares received
- No taxable event upon conversion
- Holding period of the preferred tacks on to the common stock
Think of it this way: Whether you start with a convertible bond or convertible preferred, the tax logic is identical. The IRS treats conversion as a change in form, not a sale. You bought an investment, and now it looks different, but you have not cashed out. Tax only matters when you eventually sell the common shares.
What Should You Check on Exam Day?
- Conversion of a convertible bond or convertible preferred stock is never a taxable event
- Cost basis per share equals the converted security's cost basis divided by the number of shares received, not the conversion price
- The holding period of the original bond or preferred stock tacks on to the common shares received