SPECIAL TAX CONSEQUENCES OF DISCOUNT AND PREMIUM BONDS

When you buy a bond at a discount, the difference between your purchase price and its par is considered interest for tax purposes. Your broker will issue an original issue discount (OID) for you to report your taxable interest amount each year. For example, if you buy a $1,000 bond at a discount price of $900, and it matures in five years, your OID is $100. You must report $20 of OID income each year. IRS Form 1099-OID shows the amount of OID income you owe for each year you own the bond. If you buy a bond at a premium, you do not report the difference on your current tax return.

You may owe capital gains taxes if you earned money from selling your bond at a premium. Short-term gains (on bonds held 12 months or less) are taxed as regular income. Long-term gains (on bonds held more than 12 months) are taxed at rates slightly lower than those of regular income.

To determine whether you have earned capital gains, you must first determine your basis. When you first purchase a bond, its basis is equal to the original price you pay for it. The difference between what you receive for the bond when you sell it and its basis is the amount of your taxable gain or loss.