When a bond is sold for a capital gain, the seller will face taxation on the profit. The profit from the sale will either be treated a capital gain or ordinary income depending on the nature of the sale. The Internal Revenue Service (IRS) states that if a bond is sold with "intention to call a debt instrument before maturity", then it will be taxed as ordinary income.

Intention is triggered when the issuer of a callable bond exercises the call option, declaring an intent to purchase the instruments, which forces the bondholder to sell. A bond having a call provision does not constitute intent, until the option is triggered. The profit amount subject to be taxed as ordinary income is limited to earned "original issue discount (OID)". Any gain over the earned OID, will be subject to capital gains tax.

For example, an investor purchases a 10-year bond callable after five years for $800. The face value of the bond is $1,000. Seven years later, the investor sells the debt, when there is an intention to call, for $950, earning a profit of $150 ($950 - $800). The original issue discount was $200 ($1,000 - $800). The total maturity of the bond in months is 120 (12 x 10 years), and the investor held the bond for 84 months (12 x 7 years). The earned OID equals the proportion of time the investor held the bond, multiplied by the OID, which equals $140 (84/120 x 200). Any profit from the sale (up to $140) will be taxed as ordinary income, but the remaining $60 (200-140) will be treated as capital gains.

To learn more about bonds, see our Bond Basics Tutorial.