Bond interest is taxed at the rate of regular income in the year in which it is earned, whether received as cash or accrued for a future payout. Internal Revenue Service rules depend on several factors that can make tax calculations complex, including the type of bonds, whether investors buy bonds in the secondary market or when originally issued, and the price paid. Capital gains or losses may also come into play, as they can determine the timing of sales and thus the amount of interest received.
Original Issue Discount
An original issue discount bond does not pay cash interest when it accrues; instead, it is sold at a discount and is redeemable at face value at a stated future date. For example, if a bond's issue price is $4,000 with a redemption price of $5,000, the OID is $1,000. The IRS imputes the taxable interest each year based on that amount, either evenly amortized over the life of the bond or calculated with the constant-yield method. This involves complex calculations that account for any premium paid over face value, the chosen interest accrual periods, interest rate and annual yield. A number of securities are exempt from OID requirements, including short-term bonds of less than one year, tax-exempt bonds and U.S. savings bonds.
A market-discount bond is bought in the secondary market (on a public exchange or through private sale after the original issue date) for less than par value, which is its stated worth at maturity. The IRS treats this discount amount — in addition to any cash or accrued interest — as taxable interest. This amount is generally calculated using the ratable accrual method, which divides the discount by the time between the purchase price and the bond's maturity, multiplied by how many days the investor actually owned the bond. A market-discount bond may also carry original issue discount, a transaction that incorporates OID tax rules for accrued interest.
Return of Capital
When an investor purchases a bond in the secondary market in between the dates of regular interest payments, the price includes the accrued interest up to that day. This represents the interest earned but not yet paid. The IRS considers this amount a return of capital, which lowers the bond's reportable cost, also known as its basis. When the investor sells a bond of this type, he must report the accrued interest part of the sale price as taxable interest income.
A bond sold prior to maturity or purchased in the secondary market may carry a capital loss or gain, an amount that subtracts the bond's redemption price from its cost. Investors who buy or sell bonds that come with accrued interest must factor that amount into their cost basis as well. According to the IRS, "If you sell a bond between interest payment dates, part of the sales price represents interest accrued to the date of sale. You must report that part of the sales price as interest income for the year of sale." For example, consider an investor who buys a bond for $1,000 with a $70 semiannual interest payment, and sells it for $1,050 before receiving the first payment. If the date of sale occurs after three months, the accrued interest of $35 is taxed as ordinary income, which leaves a capital gain of $15.