When calculating the tax liability of bond holdings, investors must primarily consider the purchase date on which they acquired these assets. This key informational nugget is vital to determining whether the profits generated will be treated as long-term-gains or short-term gains--the latter of which is taxed at a substantially higher rate.

The purchase date is also important due to the fact that 2008 legislation requires brokerage firms to track the cost basis on bonds sold after January 1, 2014. Consequently, bondholders who sell investments acquired after that date will have an easier experience calculating their tax liabilities, because their brokerage firm must furnish them with a copy of Form 1099-B. This document contains the cost basis of the purchase, the date of the purchase, the date of sale, and the price at sale.

Investors must also determine whether they bought their bonds at a discount, for a premium, or at par. The following two grids detail the tax liability for each status. The first grid considers taxable bonds, while the second considers tax-exempt bonds.


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.

 


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 aforementioned examples assume investors purchased their bond holdings in a single transaction, then likewise sold those holdings in a single transaction at a later date. When making multiple purchases, investors must itemize each transaction, in order to accurately determine the purchase price, as well as the resulting capital gains or losses.

The Bottom Line

Determining the tax liability on bonds can be challenging. Good recordkeeping is essential to this effort, so it is important to save trade confirmation slips and keep them well organized. Enlisting help from an accountant can go a long way toward ensuring complete and accurate tax calculation.

Tax-exempt bonds are exempt from certain taxes—but not all, as some may trigger federal or local taxes under certain circumstances.