How Corporate Bonds are Taxed

The following basic information addresses the general tax issues for individuals investing in corporate bonds. For advice about your specific situation, you should consult your tax adviser.

Interest.  The interest received from corporate bonds is subject to federal and state income tax.

Gains and losses.  Corporate bond holdings may generate capital gains if sold or redeemed at a profit before maturity.  If a bond is sold or redeemed after being held for one year or less, any gain is short-term capital gain and is taxed at the same rate as ordinary income.  If a bond is sold or redeemed after being held for more than one year, any gain is long-term capital gain and is currently taxed at a maximum rate of 15%.  Conversely, if a bond is sold or redeemed for less than its tax basis (which is generally its purchase price), the loss will normally be a capital loss.  Capital losses will offset dollar-for-dollar an unlimited amount of capital gains realized on other investment (bonds, stocks, mutual funds, real estate, etc.).  If capital losses exceed capital gains, an individual may currently deduct up to $3,000 of net capital losses annually from ordinary income.  Any net capital losses in excess of $3,000 can be carried forward and used in future years.

Original-issue discount.  When bonds are issued at substantially less than par value, the difference between the face amount and the initial offering price is known as original issue discount.  Zero-coupon bonds are the best-known variety of this category of bonds.  The tax treatment of original issue discount bonds is particularly complicated, so it is essential to consult a tax attorney or adviser when considering such an investment.  In general, the total amount of original issue discount will be included as income over the term of the bond based on a constant yield to maturity method, prior to the receipt of cash, even if the bondholder is an individual using the cash basis of accounting.  Thus, a holder will have to pay tax each year on a portion of the original issue discount even though no actual cash interest is received.  The amount of original issue discount that accrues during the time a holder owns the bond (i) constitutes interest includable in the holder’s gross income and (ii) is added to the holder’s tax basis for purposes of determining gain or loss on the maturity, redemption, sale, or other disposition of the bond.  If an original issue discount bond is purchased at issuance and held to maturity, the investor will not recognize any additional gain or loss (and will not owe any taxes) at maturity because the investor will have already included the discount in income over the life of the bond.

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