Government Debt Securities
Interest on non-taxable bonds
The interest on most of these is not taxable but must be reported on the tax return. On form 1040 and 1040A, it is reported on line 8b (non taxable interest). On form 1040 EZ, on line 2, put “TEI” and then the amount, but do not include it in the amount reported for taxable interest on line 2. Exceptions (i.e., interest is taxable) are federally guaranteed obligations (there are some exceptions to these), revenue bonds used to finance home mortgages (there are some exceptions to these), and private activity bonds (there are some exceptions to these). Private activity bonds are those in which more than 10% of the proceeds are used by a private business whose property secures the bonds, or if at least 5% (or $5 million or less) are used as loans to parties other than governmental units.
Adjusted Basis of Non-Taxable Bonds
If you purchase non-taxable bonds at a discount, the discount must be amortized but, the amortization is not reported on the tax return because the interest income is not taxable but you must annually increase the adjusted basis of the bonds basis by the amortization. If you purchase non-taxable bonds at a premium, the premium must be amortized but the amortization is not reported on the tax return because the interest income is not taxable, but you must annually reduce the adjusted basis by the amortization.
Treasury Bonds and Notes
Treasury bonds have maturities of 30 years. Treasury notes have maturities of two, three, five, seven, or ten years. Interest on bonds and notes is paid semiannually. If these are purchased for a discount or premium, an election can be made to amortize and interest income is reported the same way as commercial bonds. Some states do not tax interest received on federal government bonds and notes.
Treasury inflation protected securities (TIPS)
These pay interest semiannually at a fixed rate on the principal adjusted annually for inflation or deflation and is taxable on the federal return. Any increase in the annual inflation adjusted principal is reported as interest income which increases the basis of the security. If the security is sold or redeemed before maturity, the gain or loss is capital and determined the same way as commercial bonds. If there was an intention to call the securities before maturity, any previously unreported increase in the annual inflation adjusted principal is ordinary income.
These obligations have maturities of 4, 13, 26, or 52 weeks. If the bill is held to maturity, you must report interest income the difference between the amount paid (these are sold for a discount) and the redemption price. If they are sold for a loss before maturity, a capital loss occurs. However, if you are a cash basis taxpayer, and they are sold for a gain, you must report as ordinary income up to the amount of the ratable share of the discount when they were purchased and is reported as interest income. The amount reported is determined by the following formula:
[number of days held) divided by (number of days from acquisition to maturity) multiplied by the acquisition discount].
A taxpayer purchases a $10,000 182 day (26 weeks) T bill for $9,800. It was sold 95 days later for $9,950. The $150 gain is taxed as follows:
(1) $104 interest income based on the above formula. [(95 days held) / (182 days from acquisition to maturity) x $200 purchase discount, (2) $48 short-term capital gain ($150 gain on sale – $104 interest income).
Accrual basis taxpayers and dealers are required to currently report the acquisition discount using either the ratable accrual method or the constant yield method (see previous article on non government debt for examples). When the T bills are sold before maturity, the above formula is not used. The discount included as interest income is added to the purchase price to determine the capital gain or loss.
[Note: The previous information on Treasury securities is from J.K. Lasser’s 2014 Your Income Tax]. U. S. Savings Bonds [J.K. Lasser’s 2014 Your Income Tax].
These are purchased at amount less than maturity value and mature in 30 years from issue date. The discount represents interest over the life of the bond. A taxpayer may report a proportionate amount each year (total discount divided by number of years to maturity) or make an election to report it in the year the bond is cashed in or at maturity (deferral method). However, accrual basis taxpayers must report the proportionate amount each year. A cash basis taxpayer may elect to switch from annual reporting of the discount (interest) to the deferral method, and from deferral method to annual reporting without IRS approval. Savings bond interest is subject to federal income tax, but not state and local income tax. If a bond is held beyond maturity date, it does not earn additional interest-is worth only its maturity value.
Example-1 annual reporting
On January 2, 1995, Joe purchased EE savings bonds for $25,000 with a $40,000 maturity value that mature in 30 years (January 1, 2025). The discount is $15,000 which Joe elects to report annually. He will report $500 [($40,000 – $35,000) / 30] interest income each year until the bonds mature or he cashes them in.
Example-2 switching from annual reporting to reporting at maturity
Assume the same fact as Example 1, but on December 31, 2012 Joe elects to switch to the deferral method starting in 2013. From January 2, 1995 to December 31, 2012 he will have reported $8,500 ($15,000 x 17/30) of the original $15,000 discount) as interest income. The $6,500 remaining discount will be reported the year the bonds mature.
Example-3 switching from reporting at maturity to annual reporting
Assume the same facts as Example 1, except Joe elected to defer the discount. On December 31, 2013, Joe elects to switch to annual reporting. On January 1, 2013, there are 13 years until maturity. Starting in 2013, Joe will report discount (interest income) of $1,154 ($15,000 / 13) each year until 2025.
Redemption before maturity
The discount (interest income) reported each year will be the proportionate amount earned from purchase date to the date cashed in. To redeem a bond before maturity, it must be held at least 12 months from purchase date. If they are cashed in any time before five years, they are subject to a three month interest penalty. You receive the value of the bond as of the last date interest was added. If it is cashed in between accrual months, you will not receive interest for the partial period-you only receive interest through the last payment date in the year redeemed.
There are no longer any of these bonds that earn interest. The last bonds issued matured in June 2010, 30 years from issue date.
These bonds reached their maturity date in 2010. If a taxpayer received Series H bonds in exchange for Series E bonds, and did not report annually the interest on Series E bonds, the accumulated discount (interest) became taxable when the Series H bonds were redeemed or earlier, when the Series H bonds reached maturity 30 years from issue date.
Bonds registered only in name of a child
The interest income is taxable to the child, regardless of who purchased them and is named as beneficiary. The child or purchaser or guardian, on behalf of the child, can elect to report the interest annually or at maturity. If, in 2013, the child is under age 18 and has over $2,000 investment income, the kiddie tax may apply. Under the kiddie tax, The excess investment income over $2,000 is taxed at the parent’s top tax rate. The income may reported either on the child‘s or the parents return. The kiddie tax may be avoided each year if the discount is deferred until maturity, but it will be applicable in that year if the child is under age 18, and the kiddie tax is still applicable. Note: I will writing an article on the kiddie tax in the near future.
Gift of Savings Bonds
If savings bonds are given to another taxpayer, they must be surrendered and re-registered in the name of the donee. In the year the bonds are reissued, the total interest earned since purchase that has not been previously reported, must be included in the donor’s income in the year of gift. The same rules apply if the bonds are donated to a charity.
Note: An important thing to remember for this situation is for the donor to let the donee know the maturity date and the adjusted basis (purchase price plus reported discount) at the date of the gift. This is important because the donor has to report the remaining discount annually over the remaining life of the bonds or at maturity.
If EE bonds are transferred to a spouse as part of a divorce settlement, the owner must report any unreported discount as interest in come in the year of transfer.
Transfer at death
If an owner of a EE bond elected to report the discount at maturity and dies before the bonds are redeemed, the unreported discount must be reported annually or at maturity by the recipient. However, the executor can make an election to include the unreported discount as income on the decedents final tax return. In that case, the recipient will report only the remaining discount annually or at maturity.
Note: An important thing to remember for this situation is to for the executor to let the recipient know the maturity date and the adjusted basis (purchase price plus reported discount) at the date of death. This is important because the recipient has to report the remaining discount annually over the remaining life of the bonds or at maturity.
Interest Series HH Bonds
These are bonds received before September 1, 2004, in exchange for savings bonds or savings notes (“Freedom Shares”), and pay interest every six months at a fixed rate of 1.5% per year until maturity 20 years after issue date.
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