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Part VI: Bonds.

Short-Term Taxable Obligations (Maturities One Year or Less)

7713. What is a Treasury bill?

Treasury bills (T-bills) are obligations of the United States government, generally issued with 4-week, 13-week, 26-week, and 52-week maturity periods. Treasury bills are issued in minimum denominations of$100 with $100 increments thereafter. Treasury bills are issued without interest and on a discount basis (that is, they are issued at a price that is less than the amount for which they will be redeemed at maturity). The price is determined at auction (generally on Monday of each week for 13- and 26-week bills; 4-week bills are generally auctioned on Tuesday of each week; 52-week bills are generally auctioned every four weeks on Tuesday).

7714. Is an investor who holds a T-bill required to include interest in income prior to sale or maturity of the bill?

No. The amount of interest, represented by the discount (at issue or on the market) from face value, is not required to be included in income by a cash basis investor until the date on which the obligation is paid at maturity, sold or otherwise disposed of as discussed in Q 7715. (1)

However, a cash basis investor may elect to include in income as it accrues prior to sale or redemption the difference between the stated redemption price at maturity and his basis in the obligation (this difference is called "acquisition discount"). Such an election may not be limited to a particular bill, but applies to all short-term taxable obligations acquired on or after the first day of the first taxable year for which the election is made, and it continues to apply until the Service consents to revocation of the election. (2) (Short-term obligations are those having a fixed maturity date of one year or less after issue. (3)) The election affects short-term taxable corporate obligations, as well; however, in the case of corporate obligations, original issue discount is included unless the investor chooses to include "acquisition discount" with respect to all of them. (4) With respect to interest-paying, short-term corporate obligations, elections to include discount as it accrues will also have the effect of requiring the taxpayer to include stated interest payments (not otherwise includable in income until paid) in income as they accrue. (5) See also Q 7716.

Under the election, acquisition discount is considered to accrue daily on a ratable basis. That is, the amount of discount is divided by the number of days after the day the taxpayer acquired the obligation up to and including the day of its maturity. (6) He must include an amount equal to the sum of the daily portions for each day in the tax year he held the obligation. (7) However, a taxpayer electing to include acquisition discount as it accrues may elect, under regulations, with respect to particular obligations, a constant interest rate (using yield to maturity based on the cost of the bill and daily compounding) and use ratable accrual on other short-term obligations. Once made, this election is irrevocable with respect to the obligations to which it applies. (1a)

This election may, under some circumstances, be advantageous where leveraging is used by a cash basis investor to purchase or carry Treasury bills, since deduction of the interest expense up to the amount of discount accruing during the year must be deferred unless discount is currently included (see Q 7928).

While a cash basis investor is not usually required to include discount in income prior to sale or other disposition, certain taxpayers must include acquisition discount in income. The mandatory accrual rules apply to bills (1) held by accrual basis taxpayers, (2) held by a bank, (3) held by a regulated investment company or common trust fund, (4) held as inventory, (5) identified (2a) as part of a hedging transaction, or (6) held by a pass-through entity (e.g., a trust, partnership or S corporation) formed or availed of to avoid the mandatory inclusion rule, or a pass-through entity in any year in which 20% or more of the value of the interests in the entity are owned for 90 days or more in a year by taxpayers who would be subject to the rule. (3a) A taxpayer subject to these mandatory accrual rules may, under regulations, elect irrevocably to accrue discount with respect to any obligation on a constant rate (compounded daily) instead of ratably. (4a)

The basis of a T-bill is increased by amounts of accrued discount and interest included in income prior to disposition or redemption. (5a)

7715. How is an investor taxed on the gain or loss on the sale or maturity of a Treasury bill?

T-bills are capital assets. (6a) On sale or maturity of the bill, the seller recovers his tax basis (generally his cost plus broker's fees on acquisition) tax free. Any gain realized over his tax basis must be treated as ordinary income to the extent it represents recovery of discount. Any excess over that is capital gain. (7a) (Generally, the gain is short-term because the holding period for short-term gain is one year or less. (8a) See Q 7524 for the treatment of capital gains and losses.)

The amount of discount treated as ordinary income is determined in the following manner. Any individual holding the bill at maturity includes as ordinary income the difference between his tax basis and the bill's face value. (The difference between an individual's basis and the bill's face value is called "acquisition discount.") Any individual who sells the bill prior to maturity includes as ordinary income only a portion of his acquisition discount based on the total time he held the bill; the amount included is his acquisition discount multiplied by a fraction having as numerator the number of days he held the obligation and as denominator the number of days after he acquired the bill up to and including the maturity date. (9a) This formula enables each holder to determine the portion of any gain to be treated as interest income without reference to the original discount or the treatment applicable to any other holder.

An owner may elect irrevocably on a bill-by-bill basis to compute the amount of discount on a daily compounding basis instead of in equal daily portions. (1b)

If the investor has elected to include discount in income as it accrues prior to sale, his basis is increased by the amount included, and the entire gain is capital gain (see Q 7714). (2b)

If instead of a gain, loss is realized on sale or maturity, it is capital loss.

The installment method for recognizing and taxing gain is not available for securities traded on an established securities market. As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year. (3b)

The interest is exempt from all state and local income taxes. (4b)

If a Treasury bill was held as part of a tax straddle, the additional rules and qualifications explained in Q 7698 to Q 7705 apply; if a Treasury bill was held as part of a conversion transaction, the additional rules explained in Q 7706 and Q 7707 apply.

If the transfer is between spouses, or between former spouses incident to divorce, see Q 7555. (5b)

7716. Is an investor who holds a short-term taxable corporate obligation required to include discount in income prior to sale or maturity? Is he required to include interest as it accrues?

Original issue discount (the difference between the issue price and the stated redemption price) on a taxable corporate debt instrument having a maturity date of one year or less is generally not included in income by a cash basis investor prior to sale or redemption. (6b) Interest payable on such bonds is generally not included in income by a cash basis taxpayer until it is received. However, a cash basis investor may elect to include original issue discount as it accrues. Such an election may not be limited to a particular obligation but applies to all short-term taxable corporate obligations (and to Treasury bills with respect to acquisition discount) acquired on or after the first day of the first taxable year for which the election is made, and it continues to apply until the Service consents to revocation of the election. (7b) If a taxpayer elects to include discount as it accrues, he must also include stated interest (not otherwise included in income until it is paid) as it accrues. (8b)

The taxpayer making the election must include as income an amount equal to the sum of the daily portions of original issue discount (in the case of T-bills, daily portions of acquisition discount) for each day that he held the obligation in the tax year.

An irrevocable election may be made, on an obligation-by-obligation basis, to determine the amount of original issue discount by using daily compounding at a constant interest rate. (1c)

Rather than electing to include original issue discount as it accrues, a taxpayer may elect to include "acquisition discount" (the difference between the stated redemption price at maturity and his basis in the obligation) as it accrues. (2c) The manner in which acquisition discount accrues is discussed in Q 7714. The election to accrue acquisition discount applies to all such obligations (and Treasury bills) acquired by the taxpayer on or after the first day of the first taxable year to which the election applies and thereafter until the Service consents to a revocation.

Certain investors must include original issue discount (or, by election, acquisition discount) in income prior to sale or other disposition of corporate short-term taxable obligations. They must also include interest payable on the obligation as it accrues. (3c) The mandatory inclusion rules apply to obligations: (1) held by accrual basis taxpayers; (2) held by a bank; (3) held by a regulated investment company or common trust fund; (4) held as inventory; (5) identified (4c) as part of a hedging transaction; or (6) held by a pass-through entity (e.g., a trust, partnership or S corporation) formed or availed of to avoid the mandatory inclusion rule, or a pass-through entity in any year in which 20% or more of the value of the interests in the entity are owned for 90 days or more in a year by taxpayers who would be subject to the rule. (5c) Discount must also be included in income as it accrues on a stripped bond or stripped coupon held by the person who stripped the bond or coupon or by a person whose basis is determined by reference to the basis in the hands of the person who stripped the bond or coupon (e.g., a person who receives it as a gift) (see Q 7757). (6c)

The basis of a short-term taxable corporate obligation is increased by amounts of accrued discount included in income prior to disposition or redemption. (7c) As to how gain or loss is treated upon disposition of corporate short-term taxable obligations with original issue discount when the taxpayer has not made an election to include discount as it accrues, see Q 7717.

7717. How is an investor taxed on gain or loss on the sale or maturity of a short-term taxable corporate obligation?

As a general rule, gain or loss is a capital gain or loss. However, gain on the sale or redemption of short-term corporate obligations is ordinary income up to the portion of the original issue discount allocable to the time the obligation was held by the taxpayer (and not included in income as it accrued). (8c) Original issue discount is the difference between the stated redemption price and the issue price. (9c)

The share of original issue discount allocable to the taxpayer is the amount that bears the same ratio to the total discount as the number of days he held the obligation bears to the number of days after the issue date up to and including the date of maturity of the obligation. An irrevocable election may be made, on an obligation-by-obligation basis, to determine the amount using daily compounding at a constant interest rate. (1d)

Short-term corporate obligations are not subject to the market discount rules that require market discount to be treated as ordinary income on disposition. (2d) Therefore, any excess amount realized on sale after recovery of basis and original issue discount not previously included in income (see Q 7716) is treated as capital gain. (3d) See Q 7521 regarding holding periods and Q 7524 for the treatment of capital gains and losses.

If the taxpayer has a loss resulting from a sale to a related person (see Q 7523), the loss may not be deducted or used to offset other capital gains. (4d)

If "substantially identical" securities are acquired within 30 days before or 30 days after a sale that results in a loss, the loss deduction will be disallowed under the wash sale rule (see Q 7651), but the amount of loss disallowed is added to the basis of the new property. (5d)

The installment method for reporting gain is not available for securities traded on an established securities market. As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year. (6d)

Generally, neither gain nor loss is recognized on a transfer between spouses, or between former spouses if incident to divorce (see Q 7555). (7d)

Interest expense and short sale expense that were not deductible in the previous year because of the deferred taxability of the discount or interest (see Q 7928) are deductible in the year the obligation is sold or redeemed, whether at a gain or loss. (8d)

If a corporate obligation was held as part of a tax straddle, the additional rules and qualifications explained in Q 7698 to Q 7705 apply; if a corporate obligation was held as part of a conversion transaction, the additional rules discussed in Q 7706 and Q 7707 apply.

7718. Are interest expenses deductible if Treasury bills or short-term taxable corporate obligations are purchased or carried with borrowed funds?

Deduction of interest paid on amounts borrowed by the taxpayer to purchase or carry Treasury bills or short-term taxable corporate obligations may be subject to limitation and deferral. See Q 7928 for details. (9d) Certain short sale expenses (see Q 7645, Q 7646) may be treated as interest within this rule. (10d) Any deductible interest expense will also be subject to the general limit on otherwise allowable investment interest expense deductions-see Q 7925.

Treasury Bonds and Notes

7719. What are Treasury bonds and Treasury notes?

Treasury bonds and notes are obligations of the federal government. They are essentially similar, except that bonds mature in more than 10 years while Treasury notes have maturity dates ranging from one to 10 years. (Thirty-year bonds are auctioned quarterly in February, May, August, and November with re-openings in the other eight months.) These obligations are issued in denominations ranging from $100 to $5,000,000. Bonds issued after September 3, 1982 and notes issued after 1982 must be in registered form (see Q 7772); however, bearer bonds and notes issued before the registration requirement date may continue to be bought and sold in bearer form. Bearer notes and bonds have coupons attached that are cut off and redeemed, generally through a commercial bank or the Federal Reserve Bank (or a branch). In the case of registered obligations, interest payments are paid to the registered owner by the Treasury Department. Interest is generally payable on these obligations every six months. They are redeemable at maturity for face value.

7720. What does the holder of a Treasury note or bond include in annual income?

(1) Unless the note or bond was issued before March 1, 1941 (in which case it may be only partly taxable), stated interest that accrues after the date of purchase is included as ordinary income in the year in which it is received or made available (i.e., as a general rule, the date the coupon becomes due or the interest check is received). (1e) If an individual purchased the bond between interest dates and paid the seller interest accrued but not yet due at the date of purchase, he does not deduct the amount or include it in his basis; instead, he recovers that amount tax free out of the first interest payment he receives and includes in income only the balance. (2e)

(2) If the bond or note was originally issued at a discount (that is, at a price below the stated maturity, or face amount) after July 1, 1982, any holder who did not pay more than the face value of the obligation must include in income each year a daily share of the "original issue discount" as discussed in Q 7737. (A discount of less than % of 1% (.0025) times the number of years from issue to maturity may be disregarded. This is normally the case with Treasury notes and bonds.) (3e) The holder's basis is increased by the amount of original issue discount he actually includes in income each year. (4e)

However, if the obligation was originally issued before July 2, 1982, the amount of discount is not includable in income until it is received on sale or maturity of the obligation (see Q 7721). (5e)

(3) Market discount accrued during the year on notes and bonds (acquired in tax years ending after July 18, 1984) must be included in income if an election to include market discount is in effect (see Q 7731).

(4) If the holder purchased the bond at a premium, he may elect to amortize the premium and reduce his basis accordingly (see Q 7741).

For tax on the sale or exchange of a Treasury bond or note, see Q 7721.

7721. How are the proceeds taxed on sale or redemption of Treasury notes and bonds?

On sale or on redemption at maturity, the proceeds must be separated into identifiable components for tax purposes.

(1) If the sale occurs between interest dates, as it generally does, the seller usually receives from the buyer an amount stated separately from the purchase price representing stated interest accrued to the date of sale, but not yet due. This is reported by the seller as interest income, not gain. (1f)

(2) Out of the proceeds (other than interest, discussed above) an amount equal to the taxpayer's adjusted basis in the note or bond and expenses of sale are recovered tax free. (2f) His basis is generally his cost of acquisition adjusted by (i) adding any original issue discount and market discount included in income as it accrued, (3f) or (ii) subtracting the amount of premium deductible or applied to reduce interest payments over the period he held the bond if he elected to amortize the premium (see Q 7731, Q 7737, Q 7741). (4f)

(3) As a general rule amounts in excess of (1) and (2) are treated as capital gain-long-term or short-term-depending on the holding period and the date of acquisition (see Q 7521 and Q 7524). However, in special circumstances part or all of the gain must be treated as ordinary income:

(a) If the note or bond was issued after July 18, 1984, or if the note or bond was issued on or before July 18, 1984 and was purchased on the market after April 30, 1993, gain equal to market discount accrued up to the date of disposition and not previously included in income is treated as interest income, not capital gain (see Q 7732, Q 7734). (5f) If a bond was issued on or before July 18, 1984, but acquired after that date at a market discount using borrowed funds, a part or all of the gain must be treated as ordinary income to the extent that a deferred interest expense deduction is taken (see Q 7929).

(b) If a note or bond originally issued on or before July 1, 1982 and after December 31, 1954 was originally issued at a discount of 1/4 of 1% (.0025) or more of the stated redemption price multiplied by the number of full years from issue to maturity and the holder did not pay a premium for it, any gain realized must be treated as ordinary income up to a prorated portion of the original issue discount. (6f) (The prorated portion is explained in Q 7738.)

If the seller purchased the note or bond at a premium (i.e., at a price in excess of the face amount of the obligation), none of the gain is original issue discount. (1g) The holder is considered to have purchased at a premium if his basis is the same, in whole or in part, for purposes of determining gain or loss from a sale or exchange as the basis in the hands of another person who purchased at a premium. Thus, for example, the donee is considered to have purchased at a premium if the donor did. (2g)

(c)With respect to bonds issued before January 1, 1955, the IRC did not deal with the problem of original issue discount; nonetheless, the Supreme Court ruled that under the pre-1954 Code original issue discount "serves the same function as stated interest" and "earned original issue discount, like stated interest, should be taxed ... as ordinary income" when realized. (3g) However, gain or loss from retirement of a bond is capital gain or loss only if the bond was issued with coupons attached or in registered form or was in such form on March 1, 1954. (4g)

(4) If there was no gain, the loss is treated as a capital loss-long-term or short-term-depending on the length of the holding period (see Q 7521). If "substantially identical" obligations were acquired (or a contract to acquire them was made) within 30 days before or 30 days after the sale, the loss will be subject to the "wash sale" rule discussed in Q 7651. If the sale is made to a related person, the loss deduction may be disallowed (see Q 7523).

If a Treasury bond or note was held as part of a tax straddle, the additional rules and qualifications explained in Q 7698 to Q 7705 apply; if the bond or note was held as part of a conversion transaction, the additional rules discussed in Q 7706 and Q 7707 will apply.

For the rules governing the substitution of newly issued bonds for outstanding bonds, see Rev. Proc. 2001-21. (5g)

7722. When does the holding period begin if Treasury notes and bonds were bought at auction or on a subscription basis?

The holding period of United States Treasury notes and bonds sold at auction on the basis of yield generally starts the day after the Secretary of the Treasury, through news releases, gives notification of his acceptance of successful competitive and noncompetitive bids. The holding period of Treasury bonds and notes sold through an offering on a subscription basis at an established yield generally starts the day after the subscription is submitted. (6g) (Under some circumstances, a holding period may be tolled or be deemed to have begun at a later date. See, for example, the rules for tax straddles (Q 7698 to Q 7705).)

The donee of a bond can include in his holding period the time the bond was held by the donor. (7g)

Corporate Bonds

7723. What amounts are included in income currently by an investor who holds a taxable corporate bond?

(1) Interest that accrues after the date of purchase is included as ordinary income in the year in which it is received or made available. (1h) As a general rule, interest is considered received on the date the interest check is received, if the bond is registered, or on the date the coupon matures, in the case of a bearer coupon bond. (2h) (See Q 7509 for an explanation of the doctrine of constructive receipt.) If the investor purchased the bond between interest dates and he paid the seller interest accrued but not yet due at that time, he receives that amount as a tax-free return of capital out of the first interest payment he receives. He includes in income only the balance of the interest. (3h) If principal or interest was in default at the time of purchase and the bond traded without allocation of price between principal and accrued interest, see Q 7754.

(2) If the holder purchased the bond at a premium, he may elect to amortize a part of the premium each year and reduce his basis by the amount deductible (or applied to reduce interest payments) (see Q 7741).

(3) Unless the bondholder purchased the bond at a premium (i.e., at an amount in excess of the face value of the bond), the holder of a bond originally issued at a discount after May 27, 1969 must include in income a portion of the original issue discount. However, if the discount at issue was less than % of 1% (.0025) of the stated redemption price multiplied by the number of full years from the date of original issue to maturity, the bond is treated as if it were not issued at a discount and no part of the discount is included in income as it accrues. (4h) Original issue discount on bonds issued after May 27, 1969 and on or before July 1, 1982 accrues as discussed in Q 7739. Original issue discount on bonds issued after July 1, 1982 accrues as discussed in Q 7737.

(4) If the bond was issued after July 18, 1984, or if the bond was issued on or before July 18, 1984 and was purchased after April 30, 1993, and the purchase occurred on the market at a discount of % of 1% (.0025) or more of the stated redemption price at maturity times the number of years until maturity, a cash basis investor must include the market discount in income as it accrues if he has made an election to include accrued market discount with respect to that bond or other market discount obligations, as discussed in Q 7731. (5h)

(5) Any partial payment of principal on a market discount bond acquired after October 22, 1986, is treated as a payment of market discount and included in income to the extent that market discount has accrued up to that time. (6h) Where principal is to be paid in two or more payments, the amount of accrued market discount will be determined under regulations. (7h)

7724. How are proceeds on the sale or retirement of a corporate bond taxed?

(1) If the sale occurs between interest due dates, as it generally does, stated interest accrued to the date of sale but not yet due is customarily added to the purchase price. This must be included in the seller's income as interest. (1i)

(2) Proceeds in excess of item (1), above, are recovered tax free to the extent of the investor's adjusted basis in the bond. (2i) As a general rule, his adjusted basis is his cost of acquisition adjusted by (a) adding any original issue discount included in income as it accrued (see Q 7737, Q 7739) and market discount included in income prior to the sale (see Q 7731, Q 7733, Q 7734), or (b) subtracting amounts of premium deductible or applied to reduce interest payments if an election was made to amortize bond premium (see Q 7741).

(3) Ordinarily, amounts in excess of interest and basis are treated as capital gain--long-term or short-term--depending on the investor's holding period (see Q 7521 regarding holding periods and Q 7524 for the treatment of capital gains and losses). However, if the bond was originally issued at a discount or was purchased on the market at a discount, part or all of the gain must be treated as interest instead of capital gain, if the discount was not included in income as it accrued. (Discount that is less than 1/4 of 1% (.0025) of face value multiplied by the number of complete years to maturity is considered no discount.)

(a) If the bond was issued after July 18, 1984, or if the bond was issued on or before July 18, 1984 and purchased on the market after April 30, 1993, gain to the extent it does not exceed market discount must be treated as interest income, not capital gain (see Q 7730, Q 7732, Q 7734). If a bond issued on or before July 18, 1984 was acquired after July 18, 1984 but before May 1, 1993 at a market discount using borrowed funds, a part of the gain must be treated as ordinary income if a deferred interest expense deduction is taken (see Q 7929).

(b) If the bond was originally issued at a discount of 1/4 of 1% (.0025) or more of the face amount multiplied by the number of full years from issue to maturity and the seller had not purchased the bond at a premium, a part of any gain realized is treated as ordinary income in the following cases:

If the bond was issued after May 27, 1969, original issue discount is includable in income annually (see Q 7737, Q 7739) and basis is adjusted for amounts included; (3i) however, if at the time of original issue there was an intention to call the bond in for redemption before maturity, gain on sale or redemption is ordinary income up to the entire amount of the original issue discount reduced by the portions of original issue discount previously includable in income by any holder. (4i) An intention to call is discussed in Q 7740. The amount of original issue discount allocable to each day, in the case of bonds issued after July 1, 1982, is discussed in Q 7737; the amount allocable to each month in the case of bonds issued on or before July 1, 1982 and after May 27, 1969, is discussed in Q 7739.

If the bond was issued on or before May 27, 1969 and after December 31, 1954, any gain realized on sale or redemption is taxed as ordinary income to the extent of an amount that bears the same ratio to the total original issue discount as the number of full months the bond was held by the taxpayer bears to the number of full months from issue date to maturity date. Days amounting to less than a full month are not counted. The period the taxpayer held the bond must include any period it was held by another person if the bond has the same basis, in whole or in part, in the taxpayer's hands as it would have in the hands of the other person. (1j) However, if there was an intention at the time of issue to call the bond before maturity, gain up to the entire original issue discount is included as ordinary income. (2j)

If the obligation was issued before 1955, the Supreme Court has ruled that original issue discount serves the same purpose as interest and should be taxed as ordinary income rather than capital gain. (3j)

(4) If there was a loss on the sale or redemption, no original issue discount or market discount is recovered. Loss will be treated as a capital loss. However, if "substantially identical" obligations were acquired (or a contract for their acquisition was made) within 30 days before or 30 days after the sale, the loss will be subject to the "wash sale" rule discussed in Q 7651. If the sale is made to a related party, the loss deduction may be disallowed (see Q 7523).

(5) Amounts received on retirement are treated as amounts received on sale (but for obligations issued before 1955, only if the obligation was in coupon or registered form on March 1, 1954). (4j)

The installment method for reporting gain is not available for securities traded on an established securities market. As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year. (5j)

If a corporate bond was held as part of a tax straddle, the additional rules and qualifications explained in Q 7698 to Q 7705 apply; if a bond was held as part of a conversion transaction, the additional rules discussed in Q 7706 and Q 7707 will apply.

If principal or interest was in default and the bond was bought or sold "flat", see Q 7754.

Generally, neither gain nor loss is recognized on a transfer between spouses, or between former spouses if incident to divorce (see Q 7555). (6j)

7725. How is the donor of a corporate bond taxed on interest that has accrued prior to the date of the gift?

Interest accrued, but not yet due, on corporate bonds (and Treasury bonds and notes) before the date of a gift is includable as ordinary income in the donor's income for the taxable year during which the bond interest is actually or constructively received by the donee. Therefore, the donor will not necessarily be taxed on such income in the year in which the gift is made. Amounts received from interest accruing after the transfer date are includable in the gross income of the donee. (1k)

For treatment of accrued market discount in a disposition by gift,

see Q 7733. See Q 7760 regarding gifts of Series E and EE bonds.

7726. How is a convertible bond taxed on conversion?

Ordinarily, a convertible bond is one exchangeable, at the holder's option, into a specified number of the company's common shares at a fixed price within a certain time period-usually up to the maturity of the bond. A bond may also be issued in such a form as to grant to the holder a right to convert the bond into another debt instrument of the issuing company.

Gain or loss is not recognized when, under the terms of a bond convertible into stock of the issuing corporation, the bond is exchanged for (converted into) that stock. This is true whether or not the fair market value of the stock exceeds the holder's adjusted basis in the bond and any additional amount paid on exercise of the conversion right. The holder's basis in the stock is his adjusted basis in the bond plus any amount he paid on conversion. (2k) It is unclear whether the same tax treatment would apply upon the conversion of a bond convertible into another bond of the issuer.

The conversion of a bond (in accordance with its terms) into stock of a different corporation is a taxable event (see Q 7724). (3k)

For the treatment of original issue discount in the case of a convertible bond, see Q 7727.

For the treatment of the sale of stock acquired on conversion of a market discount bond, see Q 7735.

For the treatment of a convertible bond that is part of a conversion transaction (as defined in IRC Section 1258), see Q 7706 and Q 7707.

7727. How is original issue discount determined in the case of a convertible bond?

No adjustment is made for the value of the conversion feature of a bond convertible into stock or another debt instrument of the issuer or a related party in calculating the bond's issue price for purposes of determining whether the bond was issued at an original issue discount. (4k) Under regulations, the issue price of a bond convertible into stock or another debt instrument of the issuer includes any amount paid for the conversion privilege, even if the privilege may be satisfied for the cash value of the stock or other debt instrument. (5k) Although the regulations are effective for bonds issued after April 3, 1994, taxpayers may rely on the regulations for bonds issued after December 21, 1992. (However, under amendments (issued February 28, 1991) to the 1986 proposed regulations, a portion of the bond's issue price was allocable to the conversion feature if the conversion feature principal amount at issuance over the security's inflation-adjusted principal amount for the maturity date. (1m) This type of payment is referred to in regulations (see Q 7729) as a minimum guarantee payment.

Treasury Inflation-Protection Securities were first issued in January 1997 and are currently available in the form of 5-year, 10-year, and 30-year inflation-indexed notes. The Treasury Department is authorized to offer notes with maturities as short as one year. (2m) Treasury Inflation Protection Securities (TIPS) are auctioned as follows: 5-year TIPS in April, with reopenings in October; 10-year TIPS in January and July, with reopenings in April and October; and 30-year TIPS in February, with reopenings in August.

Treasury Inflation-Protection Securities are taxed under the general rules applicable to inflation-indexed bonds (see Q 7729).

For the treatment of inflation-indexed savings bonds, see Q 7765.

7729. How are inflation-indexed bonds treated for tax purposes?

A bond is considered inflation-indexed for federal income tax purposes if: (1) it was issued for U.S. dollars and all payments on the instrument are denominated in U.S. dollars; (2) each payment on the debt instrument is indexed for inflation and deflation except for a minimum guarantee payment (defined below); and (3) no payment on the debt instrument is subject to a contingency other than the inflation contingency, a minimum guarantee payment, or certain inflation-indexed payments under one or more alternative schedules. (3m) A minimum guarantee payment is an additional payment that is made at maturity if the total amount of the inflation-adjusted principal paid on the bond is less than the bond's stated principal amount. (4m)

Holders and issuers of inflation-indexed debt instruments, including Treasury Inflation-Protection Securities (see Q 7728), are required to account for interest and original issue discount (inflation adjustments) with constant yield principles using either the coupon or discount bond methods described below.

Coupon Bond Method

The coupon bond method is a simplified version of the discount method (see below) that will apply if two conditions are satisfied: (1) the bond must be issued at par; and (2) all stated interest must be qualified stated interest. (5m) A bond is issued at par if there is less than a de minimis difference between the bond's issue price and its principal amount at issuance. (6m) An amount is de minimis if it is equal to .0025 multiplied by the product of the stated redemption price at maturity and the number of complete years to maturity from the issue date. (7m) Qualified stated interest is stated interest that is unconditionally payable in cash, or is constructively received at least annually at a fixed rate. (8m) Any qualified stated interest is taken into account under the taxpayer's regular method of accounting. (1n) Because Treasury Inflation-Protection Securities that are not stripped satisfy both of the above conditions, the coupon bond method applies to such securities. (2n)

Under the coupon bond method, an inflation adjustment is taken into account for each taxable year in which the bond is outstanding in an amount equal to the sum of the inflation-adjusted principal amount at the end of the period and the principal payments made during the period minus the inflation-adjusted principal amount at the beginning of the period. A positive inflation adjustment will result in original issue discount while a negative inflation adjustment will be accounted for under the deflation adjustment rules (see below). (3n)

Discount Bond Method

An inflation-indexed bond that does not qualify for the coupon bond method (e.g., it is issued at a discount) is subject to the more complex discount bond method. In general, the discount bond method requires holders and issuers to make current adjustments to their original issue discount accruals for inflation and deflation. A taxpayer determines the amount of original issue discount allocable to an accrual period using steps similar to those for original issue discount bonds that are not inflation-indexed (see Q 7737). (4n) First, the taxpayer determines the yield to maturity of the debt instrument as if there were no inflation or deflation over the term of the instrument. Second, the taxpayer determines the length of the accrual period, provided that accrual period is no longer than one month. Third, the percentage change in the reference index during the accrual period is determined by comparing the value at the beginning of the period to the value at the end of the period. (5n) Fourth, the taxpayer determines the original issue discount allocable to the accrual period and, fifth, allocates a ratable portion of the original issue discount for the accrual period to each day in the period. (6n)

Holders of stripped Treasury Inflation-Protection Securities must use the discount bond method to account for the original issue discount on the principal and coupon components of the bond. (7n)

Deflation Adjustments

Under the coupon and discount bond methods, a deflation adjustment reduces the amount of interest otherwise includable in a bondholder's income with respect to the bond for the taxable year. "Interest," for this purpose, includes original issue discount, qualified stated interest, and market discount. (8n) If the amount of the deflation adjustment exceeds the amount of interest otherwise includable in income by the holder for the taxable year with respect to the bond, the excess is treated as an ordinary loss for the taxable year. However, the amount treated as an ordinary loss is limited to the amount by which the holder's total interest inclusions on the bond in prior taxable years exceed the total amount treated by the holder as an ordinary loss on the bond in prior taxable years. If the deflation adjustment exceeds the interest otherwise includable in income by the holder with respect to the bond for the taxable year and the amount treated as an ordinary loss for the taxable year, this excess is carried forward to reduce the amount of interest otherwise includable in income with respect to the bond for subsequent taxable years. (1o)

Miscellaneous rules

If a bond features a minimum guarantee payment, the payment is treated as interest on the date it is paid. However, under both the coupon and discount bond methods, the minimum guarantee payment is ignored until such a payment is made. (2o)

A subsequent holder determines the amount of acquisition premium or market discount by reference to the adjusted issue price of the instrument on the date the holder acquires the instrument. The amount of bond premium is determined by assuming the amount payable at maturity on the instrument is equal to the instrument's inflation-adjusted principal amount for the day the holder acquires the instrument. Furthermore, any premium or market discount is taken into account over the remaining term of the bond as if there were no further inflation or deflation. (3o) For the treatment of market discount bonds, see Q 7730 to Q 7736. The treatment of bond premium is explained in Q 7741 to Q 7743.

A bondholder's adjusted basis is determined under the rules for original issue discount bonds that are not inflation-indexed (see Q 7737). (4o) However, the adjusted basis is decreased by the amount of any deflation adjustment the bondholder takes into account to reduce the amount of interest otherwise includable in income or treats as an ordinary loss with respect to the bond during the taxable year. (5o)

In the event of the temporary unavailability of a qualified inflation index, special rules apply. (6o)

Special rules apply in determining bond premium on inflation-indexed bonds. (7o) Bond premium is explained in Q 7741 to Q 7742.

For the treatment of qualified tuition programs, see Q 7517. For the treatment of inflation-indexed savings bonds, see Q 7765.

Market Discount

7730. What is market discount? What is a "market discount bond"?

Bond prices on the market fluctuate as interest rates change and as the borrower's credit rating changes. Therefore, bonds may be bought at a discount because of a decline in value of the obligation after issue. A bond acquired at a discount on the market is called a "market discount bond." For tax purposes the term "market discount bond" does not include tax-exempt municipal obligations purchased before May 1, 1993, short-term obligations, or U.S. Savings Bonds. (8o) With certain exceptions (e.g., bonds acquired at issue for less than issue price-usually by large institutional investors), bonds acquired at the time of original issue are not "market discount" bonds. (1p)

Market discount is the amount by which the stated redemption price exceeds the taxpayer's basis in the bond immediately after its acquisition, if the bond was originally issued at par. (2p) If the bond was originally issued at a discount and purchased on the market for less than the original issue price increased by the amount of original issue discount accruing since issue up to the date of purchase, the difference is market discount. (3p) If the total market discount is less than 1/4 of 1% (.0025) of the stated redemption price at maturity (or, if the bond was issued at a discount of the issue price increased by original issue discount accruing since issue to the date of purchase) multiplied by the number of complete years until maturity, it is treated as if there were no market discount. (4p)

7731. Is market discount on a taxable bond included annually in gross income as it accrues?

As a rule, market discount is not includable in income by a cash basis investor before sale or disposition of the bond or note. However, an election may be made to include market discount as it accrues on bonds and notes other than tax-exempt obligations purchased before May 1, 1993, short-term obligations, U.S. Savings Bonds, or certain obligations arising from installment sales of property. (5p) (Such an election may be necessary to permit current deduction of interest paid on amounts borrowed to acquire bonds issued after July 18, 1984, or issued on or before July 18, 1984, and purchased on the market after April 30, 1993. See Q 7929.) Once the election is made, it applies to all obligations having market discount (other than tax-exempt obligations purchased before May 1, 1993, short-term obligations, certain obligations arising from installment sales of property, or U.S. Savings Bonds) acquired by the taxpayer in the tax year of the election and any future years (whether or not using borrowed funds) unless he receives permission from the IRS to revoke the election. (6p) Amounts includable under the election are treated as interest (except for purposes of the tax on non-business income of nonresident aliens and foreign corporations and, apparently, for withholding generally). Thus, for example, includable market discount is counted as investment income for purposes of determining the limit on deductible interest expense (see Q 7925).

Any partial payment of principal on a market discount bond acquired after October 22, 1986, is includable as ordinary income to the extent it does not exceed the market discount on the bond that has accrued up to that time. The amount of accrued market discount is reduced accordingly (see Q 7732). (7p) If the principal of a bond acquired after October 22, 1986, is to be paid in two or more payments, the amount of accrued market discount is to be determined under regulations. (8p)

Under the election to include market discount in income as it accrues, market discount is accrued on a ratable basis, but the taxpayer may elect to use instead a constant interest rate with respect to particular bonds and notes. Under the ratable accrual method, the amount of market discount is determined by dividing the total market discount on the bond by the number of days after the date of acquisition up to and including the date of maturity. This method will accrue market discount in equal daily installments during the period between acquisition and maturity. Alternatively, the taxpayer may elect to accrue market discount on a constant interest rate method (the method used in determining daily portions of original issue discount on bonds issued after July 1, 1982-see Q 7737.)The constant interest rate election is irrevocable as to the bond for which the election is made, but the ratable method will apply to other obligations for which the constant interest rate election was not made. (1q)

The Service has established procedures for taxpayers to use in making the elections described above. Specific procedures are required to be followed under the following circumstances: (1) the taxpayer wishes to make an election under IRC Section 1278(b) for a taxable year ending after July 18, 1984, and his income tax return is filed (on time) on or after September 23, 1992, (2) the taxpayer wishes to make an election under IRC Section 1276(b) to have apply a constant interest rate to a market discount bond acquired in a taxable year ending after July 18, 1984, and his income tax return is filed (on time) on or after September 23, 1992, or (3) the taxpayer wishes to request consent to revoke an election under IRC Section 1278(b). If the procedures detailed by the Service are followed with respect to elections made under IRC Sections 1278(b) and 1276(b), the Service's consent to such elections will be automatic. (2q)

The taxpayer who elects to include market discount as it accrues increases his basis by the amounts included in gross income each year. (3q)

The rules applicable to market discount on tax-exempt municipal bonds are discussed in Q 7746.

7732. How is gain or loss treated when a market discount bond is sold?

When a cash basis taxpayer sells a market discount bond (as defined in Q 7730) issued after July 18, 1984, or issued on or before July 18, 1984 and purchased after April 30, 1993, or if the taxpayer sells a tax-exempt bond purchased on the market after April 30, 1993 at a discount, his gain is generally treated as interest income to the extent of market discount accrued up to the date of disposition. (4q) Only gain in excess of the amount of accrued market discount may be treated as capital gain. (See Q 7524 for the treatment of capital gains and losses.) However, if the taxpayer elected to include market discount in his income annually as it accrued, and to increase his basis, his gain would not include previously included market discount. (5q) The rule reflects recognition that market discount is a substitute for stated interest.

In determining how much market discount has accrued up to the time of sale, the discount is treated as accruing in equal amounts each day after the date of acquisition up to and including the date of maturity. But the taxpayer may elect (irrevocably) on a bond by bond basis to accrue using a constant rate of interest compounded at least annually as used in determining daily portions of original issue discount accruing on bonds issued after December 31, 1984 (see Q 7737). (6q) Under the constant rate method, the daily portions will accrue more slowly than under the ratable method in early years and more rapidly in later years, but the total amount accrued will always be less until maturity.

An adjustment must be made in determining the amount of accrued market discount on obligations issued after October 22, 1986, if a partial payment of principal was previously made, or if principal is paid in two or more payments (see Q 7731).

Gain treated as interest income will generally be treated as interest for all purposes of federal taxation. Thus, for example, it is investment income for purposes of the limitation on the deduction of interest expense-see Q 7925. However, accrued market discount will presumably not be treated as interest for withholding. (1r)

For taxable bonds issued on or before July 18, 1984 and acquired on the market after that date but before May 1, 1993, and for tax-exempt bonds purchased on the market before May 1, 1993, recovery of market discount on sale or disposition is generally treated as capital gain, rather than as interest income. However, gain on such taxable bonds acquired with borrowing (or the proceeds of a short sale) must be recognized as ordinary income to the extent of any deferred disallowed interest (or short sale) expense (discussed in Q 7929) that is deductible in the year of disposition. (2r)

Loss on sale or disposition of a market discount bond is capital loss (see Q 7524). (3r) For the revised rules governing the treatment of market discount when there is a substitution of newly issued bonds for outstanding bonds, see Rev. Proc. 2001-21. (4r)

The installment method for reporting gain is not available for securities traded on an established securities market (see Q 7512). As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year. (5r)

If the disposition is by gift, see Q 7733; by conversion of a convertible bond into stock, see Q 7726 and Q 7735; if the bond sold was acquired by gift, see Q 7734.

If a market discount bond was held as part of a tax straddle, the additional rules and qualifications explained in Q 7698 to Q 7705 apply; if a market discount bond was held as part of a conversion transaction, the additional rules discussed in Q 7706 and Q 7707 will apply.

Generally, neither gain nor loss is recognized on a transfer between spouses, or between former spouses if incident to divorce (see Q 7555). (6r)

7733. Does a donor include accrued market discount in income when he makes a gift of a market discount bond?

When a taxpayer makes a gift of a taxable bond issued after July 18, 1984, or a taxable bond issued on or before July 18, 1984 and purchased after April 30, 1993, or a tax-exempt bond purchased after April 30, 1993, any of which he acquired at a market discount and that has appreciated in value at the time of the gift, he must include in his gross income an amount equal to the market discount accrued to the date of the gift, but limited to the amount of gain he would have realized had he received fair market value on making the gift. (1s) The amount is treated as interest income (but not for withholding at the source). (2s) Discount is considered to have accrued on a ratable basis, or, if the taxpayer elects (irrevocably), at a constant interest rate, just as if he had sold the bond-see Q 7732. Had he previously elected to include market discount in his gross income as it accrued (see Q 7731), no accrued discount would be includable as a result of the gift. (3s)

If a bond was issued on or before July 18, 1984 and purchased before May 1, 1993, or if the bond is a tax-exempt issue purchased before May 1, 1993, no accrued market discount is included in income. (4s)

7734. How is market discount treated on sale of a market discount bond received as a gift?

If gain is realized by a donee on disposition of a taxable bond issued after July 18, 1984, or a taxable bond issued on or before July 18, 1984 and purchased after April 30, 1993, or a tax-exempt bond purchased after April 30, 1993, any of which were previously received as a gift but acquired at a market discount by the donor, the gain is reported as interest up to the amount of market discount accrued prior to the time of sale and not previously included in income by the donor or donee (see Q 7732). (5d) An adjustment to basis is made for any amount of accrued market discount recognized by the donor at the time of the gift and for any market discount included in the gross income of the donor and donee as it accrued. (6s)

If the donor used borrowed funds (or the proceeds of a short sale) to acquire or carry a taxable bond described above, and as a result there was disallowed interest expense (or short sale expense) with respect to the bond at the time of the gift that was not entirely deductible by the donor at the time the donor made the gift, the donee may take the excess disallowed expense deduction as his own when he sells the bond (see Q 7929). (7s)

Even if the taxable bond was issued on or before July 18, 1984 but acquired by the donor before May 1, 1993, the donee may deduct the disallowed expense. (8s) However, if there is a gain on the sale of such a bond, he must treat an amount equal to the interest (or short sale) expense deduction as ordinary income instead of capital gain (see Q 7929). (9s)

7735. How is market discount treated on the sale of stock received on conversion of a market discount bond?

If, on conversion of a market discount bond issued after July 18, 1984, or issued on or before July 18, 1984 and purchased after April 30, 1993, a taxpayer receives stock in the issuer of the bond, the amount of market discount accrued to the date of exchange must be treated as ordinary interest income upon sale or disposition of the stock, unless the taxpayer had elected to include in income market discount on the bond as it accrued. (1t)

7736. Are interest expenses deductible if market discount bonds are purchased or carried with borrowed funds?

If interest is paid on borrowing incurred or continued by the taxpayer in order to purchase or carry taxable market discount bonds, deduction of the interest expense may be subject to limitation and deferral. (2t) Certain short sale expenses (see Q 7645, Q 7646) may be treated as interest within this rule. (3t) See Q 7929 for details. Any amount deductible under these rules will also be subject to the general limit on the otherwise allowable deduction of investment interest (see Q 7925).

Original Issue Discount

7737. How is original issue discount on corporate and Treasury obligations issued after July 1, 1982, included in income?

If a bond is originally issued at a price that is less than its stated redemption price at maturity, the difference is original issue discount (OID). However, if the discount at which a bond was issued is less than 1/4 of 1% (.0025) of the stated redemption price multiplied by the number of complete years to maturity, the bond is treated (for tax purposes) as if it were issued without a discount. (4t)

If a bond is issued for property (stock or securities, or to the extent provided for in regulations, for other property in tax years ending after July 18, 1984) and either the bond or the property is traded on an established market, the issue price of the bond is considered to be the fair market value of the property. (5t)

The amount of original issue discount is included in income as it accrues over the life of the bond. For bonds issued after April 4, 1994, OID must generally be accrued using the constant yield method. The holder of a bond may use accrual periods of different lengths provided that no accrual period is longer than one year. Payments may occur either on the first day or final day of an accrual period. (6t)

The amount of original issue discount accruing each period is ratably allocated to each day in the period. These "daily portions" must be included in gross income by each owner for each day he holds the bond during his tax year. (7t) (More often than not, the individual's tax year will overlap two periods. If so, the owner simply totals the appropriate daily portions for the parts of each period that fall in his tax year.) Taxpayers who use the cash receipts and disbursement method of accounting and maintain a brokerage account that includes original issue discount debt instruments and stripped bonds must include in gross income for the taxable year the amount of accrued discount allocable to the portion of the taxable year in which they held the debt instrument. The taxpayers cannot defer the inclusion of original issue discount until it is actually received. (1u)

Gain on the sale, exchange, or retirement of a bond is treated as ordinary income to the extent of unaccrued original issue discount if at the time of original issue there existed an intention to call the bond prior to maturity. According to final regulations, an intention to call exists only if there is an agreement not provided for in the debt instrument that the issuer will redeem the instrument prior to maturity. (2u) This rule is not applicable to publicly offered bonds. (3u) The rules of this paragraph are effective for bonds issued on or after April 4, 1994, and may be relied upon by taxpayers with bonds issued after December 21, 1992.

If the holder purchased the debt instrument at a premium or an acquisition premium or made an election to treat all interest as original interest discount, the amount of original issue discount must be adjusted. (4u) Furthermore, for bonds held on or after March 2, 1998, a holder making an election to treat all interest on a bond as original issue discount is deemed to have elected to amortize any existing bond premium (see Q 7741). (5u)

The owner's basis is increased by the amount of discount included in income and decreased by the amount of any payment from the issuer to the holder under the debt instrument other than a payment of qualified stated interest. (6u)

The application of these rules to bonds acquired in a debt-for-debt exchange in a corporate reorganization is covered in Treasury Regulation Section 1.1272-2.

The Service ruled that a taxpayer who acquired two debt instruments that were structured so that it was expected that the value of one would increase significantly at the same time that the value of the other debt instrument would decrease significantly was not allowed to claim a current loss on the sale of the debt instrument that decreased in value while not recognizing the gain on the other debt instrument. The loss deductions for each set of debt instruments were denied under IRC Section 165(a) and Treas. Regs. [section][section]1.1275-6(c)(2) (the integration rule) and 1.1275-2(g) (the anti-abuse rule), respectively. (7u)

Special rules apply to determine the inclusion in income of original issue discount on debt instruments issued after 1986 that have a maturity that is initially fixed, but that is accelerated based on prepayments on other debt obligations securing the debt instrument. (8u) For rules applying to variable rate debt instruments and debt instruments that provide for contingent payments, see Treas. Reg. [section]1.1272-1(b)(2). The sale of additional Treasury or corporate debt instruments that are issued after the original issue but that are treated as part of the original issue is referred to as a "qualified reopening." For rules governing the treatment of original issue discount with respect to such sales, see Treas. Regs. [section][section]1.163-7(e), 1.1275 1(f), 1.1275-2(d); 1.1275-2(k), 1.1275-7(g). See also Rev. Proc. 2001-21, (1v) (providing an election that will facilitate the substitution of newly issued bonds for outstanding bonds).

These rules do not apply to tax-exempt bonds, to short-term government (federal or state) obligations (such asT-bills), to savings bonds (e.g., EE bonds), or to short-term corporate obligations. (2v)

The treatment of Treasury bills is discussed in Q 7714 and Q 7715, and short-term corporate obligations in Q 7716 and Q 7717.

7738. How is original issue discount treated in the case of Treasury notes and bonds issued before July 2, 1982 and after December 31, 1954?

Any original issue discount on Treasury notes and bonds issued between January 1, 1955 and July 1, 1982 (inclusive) is not included in income until the bond is sold or redeemed. (3v) (If the discount at issue was less than % of 1% (.0025) of the stated redemption price, multiplied by the number of full years from the date of original issue to maturity, the bond is not considered issued at a discount. (4v))

If the owner purchased the bond at a premium (i.e., at a price above the stated redemption price) no original issue discount is included in income on the sale or maturity of the obligation. (5v)

If the obligation is sold or redeemed by a seller who did not buy at a premium and gain is realized, a part of the proceeds must be treated by the seller as ordinary income attributable to the original issue discount. The amount of discount treated as ordinary income is based on the proportionate part of the time from issue to the date of maturity that the seller held the obligation; it is computed by multiplying the original issue discount by a fraction having as numerator the number of full months the obligation was held by the seller and as denominator the number of full months from the date of original issue to the stated date of maturity. (6v) Any days amounting to less than a full month are not counted. (7v)

In determining how many months the seller held the obligation, he must include any period it was held by another person if his tax basis for determining gain or loss is the same, in whole or in part, as it would be in the hands of the other person. (8v)
   Example: Mr. Wolfram purchases a 10-year bond for $900 at original
   issue on February 1. He sells it to Mr. Mueller on February 20 five
   years later for $940. The redemption price is $1,000. Mr. Wolfram
   has held the bond 60 complete months. The number of complete months
   from issue to maturity is 120. The proportionate part of the
   original issue discount attributable to Mr. Wolfram's period of
   ownership is $50 ($100 X 60/120). Thus, Mr. Wolfram's $40 gain is
   all ordinary income. If Mr. Wolfram had sold the bond for $800
   instead of $940, he would have a long-term capital loss of $100. If
   Mr. Mueller had bought it on February 1 for $800 and held it until
   maturity he would have $50 ($100 x 60/120) ordinary income and $150
   in long-term capital gain.


U.S. Savings Bonds are discussed at Q 7760 to Q 7764. Treasury Bills are discussed in Q

7714 and Q 7715.

7739. How is original issue discount on corporate bonds issued before July 2, 1982 and after May 27, 1969 treated?

A prorated part of the original issue discount is included in income as interest each year, even though it is not actually received, unless the owner paid a premium (i.e., more than the stated redemption price) when he purchased the bond, or the obligation matured in one year or less. The amount is determined as follows:

By the original owner. The original issue discount is divided by the number of complete months plus any fractional part of a month (as explained below) from the date of original issue through the day before the stated maturity date. (This is called the "ratable monthly portion.") (1w) The ratable monthly portion is multiplied by the number of complete months plus any fractional part of a month the taxpayer held the bond during the year. (2w)

By a subsequent owner. Like the original owner, a subsequent owner includes in income each year a "ratable monthly portion" of original issue discount multiplied by the number of months plus fractional parts of a month he held the bond. However, he may determine the ratable monthly portion in a different way if it results in a lower amount. Instead of dividing the original issue discount by the term of the bond, he may divide the amount by which the bond's stated redemption price at maturity exceeds the bond's cost to him by the number of complete months plus any fractional part of a month beginning on the day he purchased the obligation and ending on the day before the stated maturity date of the obligation. (3w) An individual is not considered to have "purchased" the bond if his basis is determined, in whole or in part, by reference to the basis of the obligation in the hands of the person from whom it was acquired, or by reference to the estate tax valuation. (4w)

Thus, if the amount paid by the subsequent owner is not more than the original issue price plus all amounts of original issue discount previously includable (whether or not included) in income by previous holders, his ratable monthly portion of the original issue discount is calculated like the original holder's. But, if he paid more than the original issue price plus the amount of original issue discount includable in the income of any previous holder, he may reduce the original issue discount remaining by the excess amount before determining his monthly portion. This excess amount is called an "acquisition premium." (In computing the amount of original issue discount includable by previous holders, one does not take into consideration any acquisition premium paid by previous holders or that a holder may, in fact, have purchased at a premium. (5w))

For either an original or subsequent holder, a complete or fractional month begins with the date of original issue and the corresponding day of each following calendar month (or the last day of a calendar month in which there is no corresponding day). If a holder sells the bond on any other day in the month, a part of the ratable monthly portion for that month is allocated between the seller and buyer based on the number of days in the month each held the bond. (Seller and buyer may allocate on the basis of a 30-day month.) The transferee is deemed to hold the obligations the entire day of acquisition, but not on the day of redemption. (1x)

The original or any subsequent holder increases his basis by amounts of includable original issue discount he actually included in his income. (2x)

7740. How is original issue discount on corporate bonds issued before May 28, 1969 and after December 31, 1954 taxed?

Original issue discount is included in income in the same manner as Treasury securities issued before July 2, 1982 (see Q 7738). (3x)

However, if at the time of original issue there was an intention to call the obligation before maturity, the gain up to the entire original issue discount is treated as ordinary income. (4x)

There is an intention to call before maturity if there is an understanding between the issuing corporation and the original purchaser that the issuer will redeem the obligation before maturity. The understanding need not be communicated directly to the purchaser by the issuer and the understanding may be conditional (e.g., it may be dependent on the issuer's financial condition on the proposed call date). Whether there is an understanding depends on all the facts and circumstances. That the obligation on its face gives the issuer the privilege of redeeming the obligation before maturity is not determinative of an intention, and if the obligation was part of an issue registered with the SEC and sold to the public without representation that the obligor intends to call, it is presumed that there was no intention at issue to call. (5x)

Bond Premium

7741. Must premium paid on taxable bonds be amortized annually? Must basis be reduced by the amount of amortizable premium?

An individual who purchased a taxable bond at a premium (that is, at an amount in excess of its face value), whether or not on original issue, may elect to amortize the premium over the remaining life of the bond (or in some cases, until an earlier call date). (6x) If the election to amortize bond premium is not made, the premium is recovered as part of the owner's basis in the bond, if the bond is sold for as much as or more than it cost, or is deducted as a capital loss if the bond is redeemed at face value or sold for less than the basis. See Q 7742 for an explanation of how the amount of amortizable bond premium is determined.

The election to amortize applies to all taxable bonds that are owned at the beginning of the first year to which the election applies and all bonds acquired thereafter, and may be revoked only with the consent of the Service. (1y) Under regulations generally in effect for bonds acquired on or after March 2, 1998, a revocation of the election applies to all taxable bonds held during or after the taxable year for which the revocation is effective, and the holder may not amortize any remaining bond premium on bonds held at the beginning of the taxable year for which the revocation is effective. (2y) See below for the effective date of the regulations.

The term "bond" to which the election applies includes any taxable bond, debenture, certificate or other evidence of indebtedness issued by any corporation, government or political subdivision. (3y) The taxpayer is not required to amortize premium on taxable bonds just because he has tax-exempt bonds that he is amortizing.

For bonds acquired after December 31, 1987, an electing taxpayer applies the part of the premium attributable to the year as an offset to interest payments (that is, in direct reduction of interest income) received on the bond to which the premium is attributable. (4y)

Taxpayers who elected to amortize premium on bonds acquired after October 22, 1986 and before January 1, 1988 could elect to use either the deduction or the offset method. (5y) These taxpayers treat the deduction as investment interest expense subject to the investment interest deduction limitations. (6y)

With respect to bonds acquired before October 23, 1986, a taxpayer who elected to amortize takes an annual itemized interest expense deduction. (7y) The deduction is not subject to the 2% floor on miscellaneous deductions. (8y) Such an election to amortize in effect on October 22, 1986, does not apply to bonds acquired after October 22, 1986 unless the taxpayer so elected. (9y)

Under regulations generally in effect for bonds acquired on or after March 2, 1998, a holder makes the election to amortize by offsetting interest income with bond premium in the holder's timely filed federal income tax return for the first taxable year to which the holder desires the election to apply. A holder should also attach a statement to the return that he is making the election. See below for the effective date of the regulations. Regulations reflecting the law in effect prior to October 23, 1986 provided that the election was made by deducting the premium attributable to the year as an interest expense for the first year to which the election was to apply. The election to amortize could not be made in a refund claim. (10y)

A bondholder making an election to treat all interest on a bond as original issue discount is deemed to have elected to amortize any existing bond premium (see Q 7737). (11y)

If a bondholder elects to amortize bond premium and holds a taxable bond acquired before the taxable year for which the election is made, the holder may not amortize amounts that would have been amortized in prior taxable years had an election been in effect for those prior years. (1z)

A taxpayer electing to amortize must also reduce his basis in the bond by the amount of premium that is an allowable deduction or that was applied in reduction of interest payments each year. (2z)

A bond with interest that is partially excludable from gross income is treated as two instruments, a tax-exempt obligation and a taxable bond. The holder's basis in the bond and each payment on the bond are allocated between the two instruments based on a reasonable method. (3z) See Q 7747 and Q 7748 regarding the amortization of premium on tax-exempt bonds.

Regulations provide special rules that apply to certain variable rate debt instruments, bonds subject to certain contingencies, and inflation-indexed debt instruments. (4z)

The regulations under IRC Section 171 do not apply to (1) a bond described in IRC Section 1272(a)(6)(C) (relating to regular interests in a REMIC, qualified mortgages held by a REMIC, and certain other debt instruments, or pools of debt instruments, with payments subject to acceleration); (2) a bond to which Treasury Regulation Section 1.1275-4 applies (relating to certain contingent pay debt instruments); (3) a bond held by a holder that elected to treat all interest on a debt instrument as original issue discount; (4) a bond that is stock in trade of the holder, a bond of a kind that would properly be included in the inventory of the holder if on hand at the close of the taxable year, or a bond held primarily for sale to customers in the ordinary course of the holder's trade or business; or (5) a bond issued before September 28, 1985, unless the bond bears interest and was issued by a corporation or by a government or political subdivision thereof. (5z)

Regulations generally in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998 in which an election to amortize is made) provided that, if in any year an individual who amortizes bond premium by deducting it as an interest expense does not itemize his deductions, but takes a standard deduction, the deduction is deemed to have been allowed and reduces his basis. (6b) Regulations also provided that an individual may, but need not, amortize premium in a year in which no interest is received. (7z) The final regulations, as amended December 30, 1997, do not include the above rules.

Amortization of premium on tax-exempt bonds is discussed in Q 7747.

Effective date of regulations. The regulations under IRC Section 171 (as amended December 30, 1997) apply to bonds acquired on or after March 2, 1998. However, if a bondholder elected to amortize bond premium for the taxable year containing March 2, 1998, or any subsequent taxable year, the regulations under IRC Section 171 apply to bonds held on or after the first day of the taxable year in which the election is made. (8z)

Furthermore, a holder is deemed to have made the election under regulations for the taxable year containing March 2, 1998, if the holder elected to amortize bond premium under IRC Section 171 and that election was effective on March 2, 1998. If the holder is deemed to have made such an election, the regulations under IRC Section 171 apply to bonds acquired on or after the first day of the taxable year containing March 2, 1998. (1aa)

Substitution of debt instruments. For the revised rules governing the treatment of bond premium when there is a substitution of newly issued bonds for outstanding bonds, see Rev. Proc. 2001-21. (2aa)

7742. How is the amount of amortizable bond premium determined?

The amortizable premium on taxable bonds acquired on or after January 1, 1958 is the excess of the individual's tax basis for determining loss on sale or exchange of the bond (determined at the start of the year) over the amount payable at maturity, or in the case of a callable bond, the earlier call date if using the earlier call date would result in a smaller amortizable amount being allocated to the year. (3aa) It makes no difference whether the premium is original issue premium or "market" premium (generally reflecting a higher coupon interest rate on the bond than the market interest rate for bonds of similar quality). See Q 7743 in the case of a convertible bond with amortizable bond premium.

Under regulations generally in effect for bonds acquired on or after March 2, 1998, a holder acquires a bond at premium if the holder's basis in the bond immediately after its acquisition by the holder exceeds the sum of all amounts payable on the bond after the acquisition date (other than payments of qualified stated interest); the excess is bond premium, which a holder amortizes. (4aa) Bond premium is allocable to an accrual period based on a constant yield that is used to conform the treatment of bond premium to the treatment of original issue discount (see Q 7737). (5aa) Under a transition rule, the use of a constant yield to amortize premium does not apply to a bond issued before September 28, 1985. (6aa) See Q 7741 for an explanation of the effective date of the regulations.

In general, the holder's basis in the bond is the holder's basis for purposes of determining loss on the sale or exchange of the bond. This determination of basis applies only for purposes of amortizing premium; a holder's basis in the bond for purposes of amortizing premium may differ from the holder's basis for purposes of determining gain or loss on the sale or exchange of the bond. (7aa)

For purposes of determining the amount amortizable, if the bond is acquired in an exchange for other property and the bond's basis is determined (in whole or in part) by the basis of the property, the basis of the bond is not more than its fair market value immediately after the exchange. (8aa) This rule applies to exchanges occurring after May 6, 1986. (9aa) A special rule applies to a bond acquired in a bond-for-bond exchange in a corporate reorganization. (10aa)

If the bond is transferred basis property and the transferor had acquired the bond at a premium, the holder's basis in the bond is the holder's basis for determining loss on the sale or exchange of the bond reduced by any amounts that the transferor could not have amortized (under the basis rules or because of an election to amortize in a subsequent taxable year), except to the extent that the holder's basis already reflects a reduction attributable to the nonamortizable amounts. (1ab) Transferred basis property is property having a basis determined in whole or in part by the basis of the transferor. (2ab)

For a detailed explanation of the effective dates for the regulations under IRC Section 171 (as amended December 30, 1997), see Q 7741.

Calculation of Annual Deduction or Offset

Bonds Issued After September 27, 1985

Except as provided in regulations (see below), the determination of the amount of the deduction or offset in any year is computed on the basis of the taxpayer's yield to maturity by using the taxpayer's basis in the bond (for purposes of determining loss) and by compounding at the close of each accrual period. Generally, an accrual period is the same as used in determining original issue discount (see Q 7737). If the amount payable on a call date that is earlier than maturity is used for purposes of determining the yield to maturity, the bond is treated as maturing on the call date and then as reissued on that call date for the amount payable on the call date. (3ab) If a taxpayer had an election to amortize bond premium in effect on October 22, 1986, the election applies to bonds issued after September 27, 1985 only if the taxpayer so chooses (as may be prescribed in regulations). (4ab)

Under regulations generally in effect for bonds acquired on or after March 2, 1998, a holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to the accrual period. This offset occurs when the holder takes the qualified stated interest into account under the holder's regular method of accounting. (5ab) The accrual period to which qualified stated interest is allocable is determined under the regulations to IRC Section 446 (relating to the general rule for methods of accounting). (6ab) For a detailed explanation of the effective date of the regulations, see Q 7741.

The bond premium allocable to an accrual period is calculated using the following three steps.

Step one: Determine the holder's yield. The holder's yield is the discount rate that, when used in computing the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to the holder's basis in the bond. The remaining payments include only payments to be made after the date the holder acquires the bond. The yield calculated as of the date the holder acquires the bond must be constant over the term of the bond, and must be calculated to at least two decimal places when expressed as a percentage. (7ab)

Step two: Determine the accrual periods. An accrual period is an interval of time over which the accrual of bond premium is measured. Accrual periods may be of any length over the term of the debt instrument, provided that each accrual period is no longer than one year and each scheduled payment occurs on the final day of an accrual period or on the first day of an accrual period. (1ac)

Step three: Determine the bond premium allocable to the accrual period. The bond premium allocable to an accrual period is the excess of the qualified stated interest allocable to the accrual period over the product of the holder's adjusted acquisition price at the beginning of the accrual period and the holder's yield. In performing this calculation, the yield must be stated appropriately taking into account the length of the particular accrual period. (2ac) The adjusted acquisition price of a bond at the beginning of the first accrual period is the holder's basis (see below). Thereafter, the adjusted acquisition price is the holder's basis in the bond decreased by (1) the amount of bond premium previously allocable (as calculated above), and (2) the amount of any payment previously made on the bond other than the payment of qualified stated interest.

If the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is treated by the holder as a bond premium deduction for the accrual period. However, the amount treated as a bond premium deduction is limited to the amount by which the holder's total interest inclusions on the bond in prior accrual periods exceeds the total amount treated by the holder as a bond premium deduction on the bond in prior accrual periods. A deduction determined under this rule is not subject to the 2% floor on miscellaneous itemized deductions. (3ac) If the bond premium allocable to an accrual period exceeds the sum of the qualified stated interest allocable to the accrual period and the amount treated as a deduction for the accrual period, the excess is carried forward to the next accrual period and is treated as bond premium allocable to that period. (4ac)

Additional rules apply to determine the amortization of bond premium on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules, and a bond that provides for remote or incidental contingencies. (5ac)

The final regulations are generally effective for bonds acquired after March 2, 1998, but certain transition rules may apply. See Q 7741.

Bonds Issued On Or Before September 27, 1985

The amount of the deduction or offset each year may be determined under any reasonable method of amortization, but once an individual has used a method, he must consistently use the same method. (The Service has approved use of the "yield" method of amortizing bond premium. (6ac)) Instead of any other method, he may use the straight line method set forth in regulations (in effect for bonds acquired before March 2, 1998, or held before a taxable year containing March 2, 1998). Under that method, the amount of premium that is deductible or offset each year is an amount that bears the same ratio to the bond premium as the number of months in the tax year the bond was held by the individual bears to the number of months from the beginning of the tax year (or, if the bond was acquired in the tax year, from the date of acquisition) to the date of maturity or to an earlier call date if appropriate. A fractional part of a month is counted only if it is more than one-half of a month and then it is counted as a month. (1ad) The additional final regulations, amended December 30, 1997, do not include the above rules.

Under regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998), if the premium is solely a result of capitalized expenses (such as buying commissions), an individual using the straight line method provided in the regulations may amortize the capital expenses; if such expenses are a part of a larger premium, he must treat them as part of the premium, if he uses the straight line method. (2ad) The regulations, as amended December 30, 1997, do not include the above rule.

Earlier Call Date

If the bond is called before maturity, the amount of premium amortizable in that year is the excess of adjusted basis for determining loss over the greater of the amount received on call or the amount payable on maturity. (3ad)

Under regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998), the earlier call date (if it is used to determine amortizable premium) may be the earliest call date specified in the bond as a day certain, the earliest interest payment date if the bond is callable at such date, the earliest date at which the bond is callable at par, or such other call date, prior to maturity, specified in the bond as may be selected by the taxpayer. (4ad) Where amortization is determined with respect to one of alternative call dates, if in fact the bond is not called on that date, the premium must be amortized to a succeeding date or to maturity. The additional final regulations, amended December 30, 1997, do not include the above rules.

Basis Adjustment

Regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998) provided that, in determining each year the amount of premium to be amortized, the basis was adjusted for amortizable premium previously deducted or offset. (5ad) Also, an adjustment had to be made for premium not amortized in years the individual held the bond before he elected to amortize. However, this adjustment was made only for the purpose of determining the amortizable amount; the amount not amortized before the election did not affect basis for determining gain or loss on sale or exchange. (6ad) If the bond was acquired by gift (or the individual's basis is for some other reason determined by reference to the basis in the hands of another), the same adjustment must include the period the bond was held by the other person. The regulations, as amended December 30, 1997, do not include the above rules.

Amortization Disallowed

The Service will disallow amortization in situations that lack economic substance. (1ae) A deduction for amortization was disallowed where sales were not bona fide sales; (2ae) and where an individual who put up no margin, signed no note and intended to sell the bonds to cover his liability, was ruled not to be the owner of the bonds for purposes of deducting a part of the premium. (3ae)

Amortization of premium on tax-exempt bonds is discussed in Q 7747.

7743. How is amortizable bond premium determined in the case of a convertible bond?

The amount of amortizable bond premium on a convertible bond may not include any amount attributable to the bond's conversion features. (4ae) Under regulations generally in effect for bonds acquired on or after March 2, 1998 (see Q 7741), the holder's basis in the bond is reduced by an amount equal to the value of the conversion option. The value of the conversion option may be determined under any reasonable method. For example, the holder may determine the value of the conversion option by comparing the market price of the convertible bond to the market prices of similar bonds that do not have conversion options. (5ae)
   On January 1, 2005, John Smith purchases for $1,100 a convertible
   bond maturing on January 1, 2008, with a stated principal amount of
   $1,000, payable at maturity. The bond provides for unconditional
   payments of interest of $20.00 on January 1 and July 1 of each
   year. In addition, the bond is convertible into 15 shares of the
   corporation's stock at the option of the holder. On January 1,
   2005, the corporation's nonconvertible, publicly-traded, 3-year
   debt with a similar credit rating trades at a price that reflects a
   yield of 4.50%, compounded semiannually.

   Mr. Smith's basis for determining loss on the sale or exchange of
   the bond is $1,100. As of January 1, 2005, discounting the
   remaining payments on the bond at the yield at which the
   corporation's similar nonconvertible bonds trade (4.50%, compounded
   semiannually) results in a present value of $985. Thus, the value
   of the conversion option is $115. Mr. Smith's basis is $985
   ($1,100--$115) for purposes of the rules and regulations of IRC
   Section 171. The sum of all amounts payable on the bond other than
   qualified stated interest is $1,000. Because Mr. Smith's basis
   (under IRC Section 171) does not exceed $1,000, he does not acquire
   the bond at a premium.


Regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998) provided that the value of the conversion features is determined as of the date of acquisition by adjusting the price of the bond to a yield determined by comparison with the yields of bonds of similar character without conversion features that are sold on the open market. (6ae) The above language is not included in the regulations, as amended December 31, 1997.

Under the regulations, if a convertible bond is acquired in exchange for other property and the holder's basis in the bond is determined in whole or in part by reference to the holder's basis in the other property, the holder's basis in the bond may not exceed its fair market value immediately after the exchange reduced by the value of the conversion option. (1af)

The amount of premium amortizable in a year is discussed in Q 7742. The tax treatment of the amount is explained in Q 7741.

Municipal Bonds

7744. Is interest on obligations issued by state and local governments taxable?

Interest paid on certain bonds issued by or on behalf of state or local governments is not tax-exempt. These are generally private purpose bonds (such as industrial development bonds and "private activity" bonds) and arbitrage bonds. For tax purposes, such non-exempt issues are government bonds taxed like Treasury bonds (see Q 7719 to Q 7722).

Interest on certain categories of private purpose bonds is tax-exempt, although tax-exempt interest on some private activity bonds is a tax preference item for both the individual and corporate alternative minimum tax (see Q 7745, Q 7548). (2af)

Interest on general purpose obligations of states and local governments (i.e., states, territories, possessions of the United States, or political subdivisions of any of them, or the District of Columbia) issued to finance operations of the state, local government, or instrumentality is generally tax-exempt. In addition, some obligations are tax-exempt under special legislation.

In a case of first impression, the issue in Department of Revenue of Kentucky v. Davis was Kentucky's system of exempting from state income taxes the interest on bonds issued by Kentucky or its political subdivisions, but not on bonds issued by other states and their subdivisions-and specifically, whether that differential tax violated the Commerce Clause of the United States Constitution. After paying state income tax on out-of-state municipal bonds, the taxpayers (George and Catherine Davis) sued for a refund claiming that Kentucky's differential taxation of municipal bond income impermissibly discriminated against interstate commerce in violation of the Commerce Clause. The trial court granted judgment for the Commonwealth of Kentucky, but the Kentucky Court of Appeals reversed the trial court's ruling, finding that Kentucky's system of taxing only extraterritorial bonds ran afoul of the Commerce Clause. (The Supreme Court of Kentucky denied the motion for discretionary review by Commonwealth of Kentucky.) The Supreme Court of the United States (in a plurality opinion) reversed the judgment of the Kentucky Court of Appeals, and remanded the case. Relying primarily on recent precedent (United Haulers Assn, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 550 U.S. 330 (2007)), the Court stated that issuing debt securities to pay for public projects is a quintessentially public function with a venerable history, likely motivated by legitimate objectives distinct from simple economic protectionism. The Court determined that Kentucky's tax exemption system favored a traditional government function, without any differential treatment favoring local entities over substantially similar out-of-state interests and, thus, concluded that this type of law does not impermissibly discriminate against interstate commerce for purposes of the dormant Commerce Clause. (3af)

Whether a particular issue meets the requirements for tax exemption can involve complex legal and factual questions. Law firms specializing in municipal debt offerings, often called "bond counsel," provide legal opinions concerning the validity of bond issues that generally include the exemption of interest from federal income tax. (For the proposed regulations applicable to practitioners rendering opinions concerning the tax treatment of municipal bonds, see Prop. Treas. Reg. [section]10.35(b)(9); REG159824-04. (1ag)) These opinions are customarily printed on the bonds. It has been held that where bonds issued by a city as tax-exempt were later found invalid under state law, the interest on them was not excludable from gross income under IRC Section 103(a). (2ag) Where a county housing authority refused to pay a rebate to the federal government relating to bonds that were ruled to be arbitrage bonds by the Service and not tax-exempt, the interest was not excludable from the gross income of bondholders under IRC Section 103(a). (3ag)

Where tax-exempt bonds trade "flat" because interest is in default, see Q 7754.

Bonds issued after June 30, 1983, must be in registered form in order to be tax-exempt (see Q 7772 and Q 7773).

Tax-exempt interest is included in the calculation made to determine whether Social Security payments are includable in gross income. (4ag) It has been determined that although this provision may result in the indirect taxation of tax-exempt interest, it is not unconstitutional (see Q 7514). (5ag)

Every person who receives tax-exempt interest (and who is required to file an income tax return) must report for informational purposes the amount of tax-exempt interest received during the tax year on that return. (6ag) The Code requires the reporting of tax-exempt interest paid after December 31, 2005. (7ag) The Service has released transitional guidance regarding the new information reporting requirements for payments of tax-exempt interest on state or local bonds. (8ag)

Build America Bonds

ARRA 2009 created the new Build America Bond program (under IRC Section 54AA), which authorizes state and local governments to issue Build America Bonds as taxable governmental bonds in 2009 and 2010 to finance any governmental purpose for which tax-exempt governmental bonds could be issued. State and local governments may, at their option, issue two general types of Build America Bonds and receive federal subsidies for a portion of their borrowing costs. The subsidies take the form of either tax credits provided to holders of the bonds (tax credit type) or refundable tax credits paid to state and local governmental issuers of the bonds (direct payment type). (9ag)

"Build America Bond" means any taxable state or local governmental bond (excluding a private activity bond) that meets the following requirements: (1) the interest on such bond would (but for IRC Section 54AA) be excludable from gross income under IRC Section 103; (2) the bond is issued before January 1, 2011; and (3) the issuer makes an irrevocable election to have IRC Section 54AA apply. (1ah)

In general, Build America Bonds (tax credit type) may be issued to finance any governmental purpose for which tax-exempt governmental bonds (excluding private activity bonds) could be issued and must comply with all requirements applicable to the issuance of tax-exempt governmental bonds. (2ah)

If a taxpayer holds a Build America Bond on one or more interest payment dates of the bond during any taxable year, a credit is allowed against the regular income tax liability in an amount equal to the sum of the credits determined under IRC Section 54AA(b) with respect to those dates. (3ah) The amount of the credit determined under IRC Section 54AA(b) with respect to any "interest payment date" for a Build America Bond is 35% of the interest payable by the issuer with respect to such date. (4ah) "Interest payment date" means any date on which the holder of record of the Build America Bond is entitled to a payment of interest from such bond. (5ah) Accordingly, the tax credit that a taxpayer may claim with respect to a Build America Bond (tax credit) is determined by multiplying the interest payment that the bondholder is entitled to receive from the issuer (i.e., the bond coupon interest payment) by 35%. (6ah)

The credit allowed under IRC Section 54AA(a) for any taxable year cannot exceed the excess of (1) the sum of the regular tax liability plus the alternative minimum tax liability, over (2) the sum of the credits generally allowable against the regular income tax (excluding the refundable credits and the Build American Bond tax credit). (7ah) Any excess is carried over to the succeeding taxable year and added to the credit allowable under IRC Section 54AA(a) for the taxable year. (8ah) Unused credit may be carried forward to succeeding taxable years. (9ah)

Original issue discount (OID) is not treated as a payment of interest for purposes of determining the credit. (10ah)

Interest on any Build America Bond is includible in gross income. (11ah)

7745. Is tax-exempt interest treated as an item of tax preference for purposes of the alternative minimum tax?

Except in 2009 and 2010 (see below), tax-exempt interest on private activity bonds other than qualified 501(c)(3) bonds is a tax preference item for both the individual and corporate alternative minimum tax (see Q 7548). The interest may be reduced by any deduction not allowable in computing regular tax that would have been allowable if the interest were includable in gross income (e.g., amortizable bond premium). (1ai) The preference item includes exempt-interest dividends paid by a mutual fund to the extent attributable to such interest. (2ai)

The alternative minimum tax applies to such bonds issued after August 7, 1986 (or on or after September 1, 1986, in the case of bonds covered by the "Joint Statement on Effective Dates of March 14, 1986"). Interest on bonds issued to refund immediately pre-August 8, 1986 bonds is not an item of tax preference. (3ai)

Temporary modification of AMT limits on tax-exempt bonds issued in 2009 and 2010. The American Recovery and Reinvestment Act of 2009 (ARRA 2009) provided a temporary tax break for private activity bond interest. For private interest activity bonds issued during 2009 and 2010, interest from such bonds is not treated as a tax preference item for alternative minimum tax purposes. (4ai)

7746. How is gain or loss taxed on sale or redemption of tax-exempt bonds issued by a state or local government?

The seller may recover an amount equal to his adjusted basis tax free. If the bond was purchased at a premium, the seller's basis for determining gain or loss is adjusted to reflect the amortization of the premium. (see Q 7747).

With respect to a bond both issued after September 3, 1982 and acquired after March 1, 1984, the owner's basis is increased by the amount of tax-exempt original issue discount that accrued while he owned the bond (subject to an adjustment if he purchased the bond at a price in excess of the issue price plus original issue discount accrued up to the time he acquired it). (5ai) Original issue discount accrues daily at a constant rate as it does generally for taxable original issue discount bonds issued after July 1, 1982 (see Q 7737), except that discounts of less than % of 1% (.0025) times the number of years to maturity are accounted for. (6ai) For obligations with a maturity of one year or less, discount will accrue daily on a ratable basis, as it does for taxable short-term government obligations (that is, by dividing discount by the number of days after the day the taxpayer acquired the bond up to and including the day of its maturity); however, the taxpayer apparently may make an irrevocable election to use a constant rate (under regulations) with respect to individual short-term obligations. (7ai)

With respect to any bond acquired on or before March 1, 1984 or any bond issued on or before September 3, 1982, whenever acquired, the seller's basis is not adjusted to reflect annual accrual of original issue discount. Consequently, loss on sale is determined without regard to original issue discount accrued up to the date of sale. (8ai) Nonetheless, to the extent there is gain on sale or redemption, an amount equal to original issue discount allocable to the period the investor held the bond is excludable as tax-exempt interest that accrued over the period it was held. The amount of tax-free discount apportioned to any holder is the amount that bears the same ratio to the original issue discount as the number of days he held the bond bears to the number of days from the date of original issue to the date of maturity, assuming there was no intention at issue to call the obligation before maturity. (1aj) If the bond is redeemed before maturity, any unaccrued original issue discount realized is taxable as capital gain, not excludable interest, except that in the case of a bond issued before June 9, 1980, it is recovered tax free as tax-exempt interest. (2aj)

Stated interest that is unconditionally payable at maturity on short-term tax-exempt bonds may be treated as includable in the stated redemption price at maturity or as qualified stated interest, at the choice of the taxpayer, provided all short-term tax-exempt bonds are treated in a consistent manner. This guidance is effective for tax-exempt bonds issued after April 4, 1994, and until the Service provides further guidance. (3aj) Scheduled instrument payments are not unconditionally payable when, under the terms of a debt instrument, the failure to make interest payments when due requires that the issuer forgo paying dividends, or that interest accrue on the past-due payments at a rate that is two percentage points greater than the stated yield. (4aj)

If the buyer paid the seller any stated interest accrued, but not yet due at the date of the sale, that amount is recovered tax free as return of capital. (5aj)

Gain in excess of tax-exempt interest will generally be capital gain, including gain from any premium paid on call (see Q 7749). See Q 7524 regarding the treatment of capital gains and losses.

If the bond was bought on the market at a discount reflecting a decline in value of the obligation after issue, this market discount does not represent tax-exempt interest paid by the issuer. (6aj) Market discount is the amount by which the purchase price is less than the face value of the bond (or, in the case of a bond originally issued at a discount, less than the issue price plus the amount of original issue discount apportioned, as above, to the previous holders).

With respect to tax-exempt bonds purchased after April 30, 1993, market discount recovered on sale is treated as taxable interest instead of capital gain. (7aj) For tax-exempt bonds purchased before May 1, 1993, gain attributable to market discount has generally been treated by the Service as capital gain. (8aj) Capital gain is not exempt from federal income tax. (9aj)

If a loss is realized on the sale or redemption, it is a capital loss. However, if "substantially identical" obligations were acquired (or a contract to acquire them was made) within 30 days before or 30 days after the sale, the loss will be subject to the "wash sale" rule discussed in Q 7651.

The IRS concluded that a modification of tax-exempt revenue bonds constituted a deemed exchange under IRC Section 1001 because the modified bonds, which had been issued in an exchange, were materially different from the original bonds; thus, the modified bonds would be treated as newly issued securities for federal income tax purposes. (10aj)

The installment method for recognizing and taxing gain is not available for securities traded on an established securities market. As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year. (1ak)

If the bond traded "flat" because interest was in default, see Q 7754.

Bonds issued after June 30, 1983 must be in registered form in order to deduct loss on sale or to treat gain as capital (as opposed to ordinary) gain (see Q 7772, Q 7773).

If the bond was held as part of a tax straddle, see Q 7698 to Q 7705. If the bond was held as part of a conversion transaction, the additional rules discussed in Q 7706 and Q 7707 will apply.

If the transfer is between spouses, or between former spouses and incident to divorce, see Q 7555.
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Title Annotation:TAX FACTS ON INVESTMENTS: Part 1
Publication:Tax Facts on Investments
Geographic Code:1U6KY
Date:Jan 1, 2011
Words:18328
Previous Article:Part V: Straddles and other transactions.
Next Article:Part VI: Bonds.
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