If a long-term bond is originally issued at a price that is less than its maturity value, OID is equal to the amount of the difference. If you own an OID bond, you must include a portion of the OID in interest income annually. Due to the compounding of interest, the amount of OID will increase each year. You should add the amount of OID recognized for tax purposes to your basis in the bond. This increase in basis will decrease the amount of any gain you may recognize when you dispose of the investment.
Keep in mind that the market price of zero coupon bonds fluctuates more than regular coupon bonds with the same maturity and, therefore, may not be suitable for all investors.
- Municipal bonds that are issued at a discount generate interest income that is generally exempt from federal income tax. Most states also treat interest from their own bonds as tax-exempt to residents of their state. Although not taxable, the accrued OID is added to the bond's basis for determining taxable gain or loss on sale. Remember, although tax-exempt municipal bond interest is exempt from tax, it is still reportable on your tax return. Some investors may be subject to the Alternative Minimum Tax.
- Government obligations issued before July 2, 1982, and discounted obligations with an original maturity of one year or less (for example, Treasury bills or short-term CDs) are excluded from the OID rules. The interest income is taxable at maturity. If you expect to be in the same or a lower tax bracket next year, you may want to defer ordinary income by buying short-term discount obligations that mature in the following year.
Market Discount Bonds
Market discount occurs as a result of forces in the secondary market pushing a bond's price below its adjusted issue price. For example, a $1,000 bond bearing a 5% coupon might sell for $950 because of an increase in the prevailing interest rates. The amount of market discount is $50.
Market discount on taxable bonds issued after July 18, 1984, is taxed as ordinary interest income to the extent of the accrued market discount when you dispose of the bond. However, you can elect to include market discount in income as it accrues on all your bonds.
Market discount on bonds issued on or before July 18, 1984, is taxed as a capital gain upon disposition or redemption. The rules also apply to taxable bonds issued on or before July 18, 1984, and purchased after April 30, 1993.
The market discount rules apply to tax-exempt bonds purchased after April 30, 1993. (The election to currently accrue market discount does not apply.)
Premium Bonds
Prevailing interest rates may also cause bonds to trade at a premium. If you purchase a bond at a premium, you can elect to amortize the premium paid in acquiring a taxable bond and use it to currently offset taxable interest income. If you choose not to amortize the premium, the tax basis of the bond will include the premium. (Keep in mind, the election will apply to all bond positions held in your portfolio.) Therefore, it will decrease any capital gain or increase any capital loss upon disposition. For bonds acquired after December 31, 1987, the premium amortization is an offset against interest income.
Unlike taxable bonds, premium on a tax-exempt bond must be amortized; you do not have a choice. The amortization is not deductible, yet it reduces your basis in the bond.