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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.
Question: What are zero coupon bonds, and how are they taxed?
Answer: A zero coupon bond is a debt obligation payable at a fixed maturity date without interest. Because it earns no interest, the bond is issued at a discount.
For example, an ordinary bond might look something like this: an investor loans a corporation $10,000 for a note promising to pay him 4% interest ($400) per year for 10 years, and repay the original $10,000 after 10 years. On the other hand, with a zero coupon bond, the investor loans the corporation $6,756 for a note promising no interest; instead, it pays back $10,000 in 10 years.
Zero coupon bonds are taxed similarly to ordinary bonds; that is, (1) the earned interest is taxed as ordinary income and (2) any change in the value of the bond (due to changes in market interest rates) would be taxed as a capital gain or loss upon the disposition of the bond. Since zero coupon bonds have no stated interest, the original issue discount ($3,244 in the example above) is treated as imputed interest and taxed as ordinary income throughout the loan period.
Suppose your client purchased the zero coupon bond in the example above for $6,756. He determines that the bond’s yield to maturity is 4%, compounded annually, resulting in an imputed interest of approximately $270 (4% of $6,756) in the first year, on which he must pay ordinary income taxes. In the second year, he has an imputed interest of $281 (4% of the sum of $6,756 and $270), and so on until the bond matures, at which point he would have paid ordinary income taxes on the entire $3,244 original issue discount.
However, if he sells before maturity, he stops paying taxes on the imputed interest, and instead would incur a capital gain or loss on the disposition. For example, assume he sells after two years, at which point his basis in the bond has increased from $6,756 to $7,307 ($6,756 + $270 + $281).
Let’s say market interest rates have increased since your client purchased the bond, and he sells after the second year for $7,000. Your client would recognize a capital loss of $307 (the difference between $7,307, his adjusted basis, and $7,000, his amount realized.
Keep in mind that we purposefully kept the examples simple, and that the bond owner can choose different accrual periods and schedules (as opposed to the yearly compounding interest we used), resulting in slightly different numbers.
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