Nobody likes taxes, but tax reporting is an inevitable and unavoidable part of investing. Determining your costs basis for stocks is a slightly frustrating but fairly straightforward exercise. Your cost basis is the price you paid per share, including sales commissions, adjusted for corporate actions such as stock splits, mergers, and dividend payments. If you’ve kept good records, the mathematics aren’t too difficult. If you buy bonds, the picture is substantially more complex.
The 12 Shades of Gray
Determining the tax liability on bond holdings requires the navigation of a series of questions. The first one is “what is the purchase date?" This matters because it will determine whether the gains will be treated as short-term or long-term gains. Short-term gains are taxed at a higher rate than long-term gains.
Purchase date is also important because, for long-term gains, there are different rules for determining tax liability based on purchase date. Bondholders making purchases after January 1, 2014 will have the easiest time determining their tax liability because legislation enacted in 2008 requires brokerage firms to track the cost basis on bonds sold after that date. When these investors sell their holdings, the brokerage firm will send them a copy of form 1099-B, which will include the cost basis of the purchase, the date of the purchase, the sale price and the date of the sale.
The next task is to determine whether the bond is “taxable or tax exempt?” This matters because, while interest generated by tax-exempt bonds is not subject to taxation, any capital gains are subject to federal income tax.
For bonds purchased between 1993 and 2013, the process is considerably more complex. After answering the first two questions, investors also need to determine whether the bond was bought at a discount, for a premium, or at par. The grids below provide insights into the resulting tax liability for the corresponding status.
|Taxable Bond||Cost Basis if Held Until Maturity||Cost Basis if Sold Prior to Maturity|
|Bought at par||The original purchase price listed on your trade confirmation.||The original purchase price listed on your trade confirmation. If sold prior to maturity at a price greater than the purchase price, the difference between the purchase price and the sale price is treated as a capital gain.|
|Bought at premium||The original purchase price listed on your trade confirmation, assuming you did not choose to amortize the premium over the lifetime of the bond.||The original purchase price listed on your trade confirmation, assuming you did not choose to amortize the premium over the lifetime of the bond.|
|Bought at discount||The original purchase price listed on your trade confirmation. The difference between purchase price and the par price (which will be paid at maturity) is treated as interest.||The original purchase price listed on your trade confirmation. If sold prior to maturity at a price greater than the purchase price, the difference between the purchase price and the sale price is treated as a capital gain.|
The name “tax-exempt” is a bit misleading. While the income generated from bonds of this type is exempt from certain taxes, there are still potential tax implications involved in the purchase and sale of tax-exempt bonds. The chart below provides a general overview of those implications. Before purchasing a tax-exempt bond, you will want to consider these implications, as well as determining if state, federal, or local tax will be imposed on any income the bonds generate.
|Tax-Exempt Bond||Cost Basis if Held Until Maturity||Cost Basis if Sold Prior to Maturity|
|Bought at par||The original purchase price listed on your trade confirmation.||The original purchase price listed on your trade confirmation.|
|Bought at premium|| The original purchase price listed on your trade confirmation. Taxation rules assume amortization of the premium over the lifetime of the bond, which can be a negative development with regard to your state income tax liability, as it means you will pay income tax on more interest than you earned. The higher the premium that you paid, the greater your tax liability.
As previously noted, when a bond is issued at a discount, a prorated portion of the discount must be reported as income each year until the bond reaches maturity. When bonds are purchased at a premium, a prorated portion of the premium is tax deductible each year. For example, if 100 bonds are purchased for a total expenditure of $118,000 and held for 18 years (until maturity), $1,000 can be deducted each year.
Note that it is not necessary to amortize any of the premium in the year the bond was purchased. Deductions can begin in any tax year. Note that there are several additional complications that must be considered. If you choose to deduct the premium for a single bond, amortization of the premium for all other similar bond must occur on the same schedule. Also, cost basis on the bonds must be reduced by an equivalent amount.
Alternatively, if no premiums are deducted, a capital loss can be claimed when the bonds are redeemed at maturity or sold for a loss.
| To determine the cost basis, you must first determine the yield to maturity of the bond. If you saved the trade confirmation from when you made your original purchase, it will have this information listed.
The next step is to determine the accrual periods, which start when the bond is purchased and end when it matures. Each period cannot exceed twelve months in length.
Following that, the amount of premium that must be amortized for a given period needs to be calculated. This is done by multiplying the adjusted acquisition price at the beginning of the accrual period by the yield to maturity and then subtracting the amount from the qualified stated interest for the period. Note that the adjusted acquisition price at the beginning of the first accrual period is the same as the cost basis.
After the initial amortization calculation, cost basis is decreased by the amount of bond premium previously amortized. To see an example of this calculation, refer to Premium Bonds: Problems And Opportunities.
|Bought at discount||The cost basis is the original purchase price listed on your trade confirmation. The difference between purchase price and the par price (which will be paid at maturity) is treated as interest.||The cost basis is the original purchase price listed on your trade confirmation. If sold prior to maturity at a price greater than the purchase price, the difference between the purchase price and the sale price is treated as a capital gain.|
An Added Twist
The examples above are all based on the assumption that you purchased your holdings in a single transaction and sold all holdings at later date in a single transaction. If you make multiple purchases, you will need to keep track of which lot you sell in order to accurately determine the purchase price and the resulting capital gain or loss. From a recordkeeping standpoint, the simplest choice is to make your purchase in a single transaction. From a pricing perspective, buying at par is the simplest choice.
Older is Even Harder
Bonds purchased before 1993 may be subject to different rules. The tax laws have changed multiple times over the years, so a bit of digging may be required in order to determine the proper methodology for determining cost basis and tax liability.
The Bottom Line
Clearly, determining tax liability on bonds can be a significant challenge. In the future, brokerage firms will provide all the information that you will need to make the appropriate calculations. Good recordkeeping is critical, so it is important to save your trade confirmations and keep them organized. If it all sounds like too much hassle, or the math is a bit too involved for your tastes, you always hire an accountant to help you out.
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