Taxable Interest vs. Capital Gains

by Leslie McClintock

The Internal Revenue Service charges tax on two kinds of investment profit. Interest generated by bonds is generally taxed at ordinary income rates. The profit made when you sell a security or other investment is taxed under capital gains tax rules. If you held the asset for longer than a year, it usually qualifies for long-term capital gains treatment. The tax rate on long term capital gains is lower than it is for short-term capital gains -- that is, gains on securities or other assets you held for less than a year.


Let's use a corporate bond as an example. A corporate bond issued for a par value of $1,000 may generate 6 percent interest, payable in two payments of $30 each every six months for a total of $60 per year. If you bought that bond new and held that bond for a year and a day, you will pay ordinary income taxes on the $60 you received in interest payments during the year. However, suppose yields fell during the year, resulting in an increase in the bond's market price to $1,100. You would pay long-term capital gains tax the $100 in gain, in addition to the income tax on $60. Had you held the bond for less than a year, you would pay short-term capital gains tax on the difference in the bond price.

Tax-Free Bonds

Bonds issued by state and local governments, school districts and other similar agencies are known as "municipal bonds." Interest on these bonds is usually free of federal income tax. Some state municipal bonds are also free of state income taxes in the state of issue. These bonds may be attractive to investors in high tax brackets, since tax-free bonds often pay a higher rate of interest than comparable taxable bonds, once you take income taxes into account. You will still have to pay tax on any gains in bond prices, however.

Market Discounts on Bonds

If you buy a bond at a discount from the face amount, or par value, of the bond, your gain would be taxable. For example, if a bond was originally issued at a par value of $1,000, a market discount would apply to any market price of less than $1,000. If you buy the bond for $900, you bought the bond at a 10 percent discount from par value. When this occurs, and you sell the bond for more than you bought it for, you must report any profit attributable to the market discount as ordinary interest income, rather than as capital gains. This applies to all bonds bought after April 30, 1993.

Imputed Interest

You don't have to receive interest on a bond for bond interest to generate a tax liability. Some bonds, called "zero coupon bonds," don't pay regular cash interest payments. Instead, they are issued at a deep discount from their face value, or redemption value at maturity. In this case, the IRS still taxes you on the "imputed interest." That is, you are taxed on the interest you would have received had the bond paid an income. These bonds are taxed under income tax rules, rather than capital gains rules, unless the bond price strays above the par value.


If you have securities or other investments you can sell at a loss, you can use capital losses to offset an unlimited amount of capital gains. If you have excess capital losses, you can use these losses to offset up to $3,000 of income per year each year until you use up your entire loss.

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