A:

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.

RELATED FAQS
  1. What risk factors should investors consider before purchasing a callable bond?

    Understand the difference between callable and non-callable bonds and consider all the various risk factors associated with ... Read Answer >>
  2. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
  3. How is a corporate bond taxed?

    Understand the three components of a corporate bond that are subject to taxes. Learn about the ways the federal and state ... Read Answer >>
  4. What are the accounting entries when a company issues a callable bond?

    Learn how callable bonds are treated on balance sheets, and understand why callable bonds often pay investors a premium for ... Read Answer >>
  5. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
  6. What happens to the price of a premium bond as it approaches maturity?

    Learn how bonds trade in regard to premiums and discounts, and how bond prices shift closer to par value as bonds approach ... Read Answer >>
Related Articles
  1. Investing

    Bond Call Features: Don't Get Caught Off Guard

    Learn why early redemption occurs and how to avoid potential losses.
  2. Investing

    Taxation Rules for Bond Investors

    Several factors affect the taxable interest that must be reported. Learn more here.
  3. Investing

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
  4. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  5. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  6. Investing

    The Basics Of Municipal Bonds

    Investing in these bonds may offer a tax-free income stream but they are not without risks.
  7. Investing

    Callable Bonds: Leading A Double Life

    Find out more about these dangerous and exciting cousins to regular bonds.
RELATED TERMS
  1. Original Issue Discount - OID

    The discount from par value at the time that a bond or other ...
  2. Accumulation Bond

    A bond issued at an original issue discount (OID). This means ...
  3. Market Discount

    The difference between a bond's stated redemption price and its ...
  4. Callable Bond

    A bond that can be redeemed by the issuer prior to its maturity. ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Bond

    A debt investment in which an investor loans money to an entity ...
Hot Definitions
  1. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  2. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient short-term assets to cover its immediate liabilities. ...
  3. Floating Exchange Rate

    A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that ...
  4. Taxes

    An involuntary fee levied on corporations or individuals that is enforced by a level of government in order to finance government ...
  5. Impaired Asset

    A company's asset that is worth less on the market than the value listed on the company's balance sheet. This will result ...
  6. Solvency Ratio

    One of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size ...
Trading Center