TaxConnections

 
 

Access Leading Tax Experts And Technology
In Our Global Digital Marketplace

Please enter your input in search


Non-business Capital Gains and Losses—Government Debt Securities



Harold Goedde

This article discusses debt securities issued by the federal government—treasury securities and savings bonds and non-taxable bonds issued by states and municipalities.

U.S. Treasury Bonds and Notes

Non-inflation adjusted securities.

These 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 the discount or premium. Discount amortization increases interest income and increases the basis of the security.

Premium amortization reduces interest income and reduces the basis of the security. Some states do not tax interest received on federal government bonds and notes. If the security is sold or redeemed before maturity, the gain or loss is a capital gain or loss is determined the same way as commercial bonds. Gain or loss is determined the same way as commercial bonds. For examples of amortization, determining the adjusted basis and gain or loss on sale, see the author’s article Non-Business Capital Gains And Losses – Taxable Bonds.

Inflation Protected Securities (TIPS)

These pay interest semiannually at a fixed rate on the principal adjusted annually for inflation or deflation and are taxable on the federal return but some states do not tax the interest. 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 a capital gain or loss is determined the same way as commercial bonds. For examples of determining the adjusted basis and gain or loss on sale, see the author’s article Non-Business Capital Gains And Losses – Taxable 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.

Treasury bills

These obligations have maturities of 4, 13, 26, or 52 weeks. If the bill is held to maturity, you must report interest income for 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.

If you are a cash basis taxpayer, and they are sold for a gain, you must report ordinary income up to the amount of the ratable share of the discount when they were purchased that was not reported as interest income. The amount reported is determined by [number of days held divided by number of days from acquisition to maturity multiplied by the acquisition discount].

Example

Claire 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 report the acquisition discount annually using either the ratable accrual method (straight-line) or the constant yield method. For examples of amortization, determining the adjusted basis and gain or loss on sale, see the author’s article Non-Business Capital Gains And Losses – Taxable Bonds.

When the T bills are sold before maturity, the above formula is not used. The discount previously included as interest income is added to the purchase price to determine the capital gain or loss.

U. S. Savings Bonds

Series E

These bonds are no longer issued and matured in June 2010.

Series EE

These are purchased for less than maturity value and mature in 30 years from issue date. The discount represents interest over the life of the bond. Cash basis taxpayers 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 redeemed or at maturity (deferral method). 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. ACCRUAL basis taxpayers must report the proportionate amount each year using the straight-line method basis. Savings bond interest is subject to federal income tax, but usually 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, 1998, Joe purchased EE savings bonds for $25,000 with a $40,000 maturity value that mature in 30 years (January 1, 2028). 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, 2015 Joe elects to switch to the deferral method starting in 2016. From January 2, 1998 to December 31, 2015 (17 years) Joe 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, 2015, Joe elects to switch to annual reporting. On January 1, 2016, there are 12 years until maturity. Starting in 2016, Joe will report discount (interest income) of $1,250 ($15,000 / 12) each year until 2028.

Series EE-Redemption Before Maturity

The discount (interest income) reported each year will be the proportionate amount (straight-line basis) 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 redeemed 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. For examples of determining the adjusted basis and gain or loss on sale, see the author’s article Non-Business Capital Gains And Losses – Taxable Bonds.

Gifts 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. For information on determining the gain or loss on sale of securities received as a gift, see the author’s article Income Tax Aspects Of Non-Business Capital Gains And Losses Part III.

Note: When securities are given to someone, it is very important for the donor to let the donee know the purchase date, maturity date and the adjusted basis (purchase price plus reported discount) at the date of the gift. This is important because the donee has to report the remaining discount annually over the remaining life of the bonds or at maturity and know the donor’s holding period to determine if gain or loss is short-term or long-term capital gain when sold or redeemed by the donee.

Transfer to a Spouse or in Divorce

If EE bonds are transferred to a spouse or ex-spouse, as part of a divorce property settlement, the owner must report any unreported discount as interest income in the year of transfer.

Note: When securities are given to someone as a property settlement in a divorce, it is very important for the owner spouse to let the ex-spouse know the purchase date, maturity date and the adjusted basis (purchase price plus reported discount) at the date of the transfer. This is important because the ex-spouse has to report the remaining discount annually over the remaining life of the bonds or at maturity and know the donor’s holding period to determine if gain or loss is short-term or long-term capital gain when sold or redeemed.

Transfer to a Charity

The donor cannot avoid tax on the interest by reissuing them to a charity. The donor must report the previous non-reported accumulated interest in the year donated.

Transfer to a Trust

If all rights of ownership are transferred to a trust, the donor must report any unreported discount prior to the transfer, as interest income in the year of transfer. If the donor is also the owner of the trust and the interest earned before and after the transfer is taxable to the donor, then, the donor no longer has to repot the interest.

Transfer at Death

If an owner of an 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 decedent’s final tax return. In that case, the recipient will report only the remaining discount annually or at maturity. For details on sale of securities received from a decedent, see the author’s article Income Tax Aspects Of Non-Business Capital Gains And Losses Part III.

Note: When these securities are bequeathed to someone, it is very important for that the executor let the recipient know the maturity date and the adjusted basis (purchase price plus reported discount) at the date of death because the recipient has to report the remaining discount annually over the remaining life of the bonds or at maturity. Any gain or loss on sale or redemption will always be long-term, regardless of beneficiary’s holding period.

Series H

These bonds were first issued in 1980 but are no longer issued. They reached their maturity date in 2010. If a taxpayer received Series H bonds in exchange for Series E bonds, and did not report the interest on Series E bonds annually, the accumulated discount (interest) became taxable when the Series H bonds were redeemed or earlier, when they reached maturity 30 years from issue date.

Interest Series HH

These are bonds were issued at face value between January 1, 1980 and September 1, 2004. They were received in exchange for E or EE bonds or savings notes (“Freedom Shares”). They pay interest every six months at a fixed rate until maturity, 20 years after issue date. Interest is taxable in the year received. Gain or loss on the sale is the difference between sales price and face value.

Series I

These are 30 year bonds that are indexed to inflation and issued at face value. Similar to EE bonds, a taxpayer may defer reporting the increase in redemption value (face value adjusted for inflation) until redemption or maturity, whichever is earlier.

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 purchaser or guardian, on behalf of the child, can elect to report the interest annually or at maturity. If, in 2016, 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: See the author’s article on the kiddie tax.

Re-registration of bonds in a different name

Example 1

Barb purchases an EE bond that is registered in her name and her son as co-owners. Four years later Barb has the bonds re-registered solely her son’s name. Her son does not have to repot the accumulated discount (interest) at that time but will report the remaining discount as interest income in the year the bonds are sold or mature.

Example 2

Joe and Sue are married and each one paid one-half of the bonds purchase price of a $5,000 bond issued to them as co-owners. Five years later, they have the bonds reissued as $2,500 bonds in each one’s name. Neither spouse has to report the accumulated discount (interest) as interest income in year the bonds are reissued.

Example 3

If Joe purchased the bond with his own funds (Sue did not pay anything) but they were issued as co-owners, he must report one-half of the accumulated discount as interest income in year the bonds are reissued.

Example 4

Five years after purchase, Joe and Sue add their son Joey as a co-owner to be able to make a transfer to him when they die. The change in registration does not result in any taxable interest income.

U.S. Savings Bonds Tuition Plans

If Series E or I bonds are used to fund a Section 529 plan (tax free college savings account), the interest income can be reported annually or when the bonds mature. It may be advantageous to report the income annually on the child’s return because he or she will likely have much less taxable income due to reducing AGI by the standard deduction (which is limited if the parent claims the child as a dependent) or itemized deductions. Also, the child may not claim a personal exemption on his or her own return if the parent claims the child as a dependent.

State and Municipal Non-taxable Bonds

Interest Income

The interest on most of these is NOT taxable but must be reported on the federal return. On Forms 1040 and 1040A-line 8b (nontaxable interest, Form 1040 EZ-line 2, Next to the amount, put “TEI”, (tax-exempt interest) but do not include it in the amount reported for taxable interest on line 2. Exceptions (i.e., interest is taxable): (1) federally guaranteed obligations, (2) revenue bonds used to finance home mortgages, and (3) private activity bonds. There are some exceptions to all of 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 originally issued or purchased at a discount

The discount must be amortized, using the constant yield method (for examples of this see the author’s article Non-Business Capital Gains And Losses – Taxable Bonds), but the amortization is not reported on the tax return because the interest income is not taxable; however, you must annually increase the adjusted basis of the bonds basis by the discount 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; however, each year, you must reduce the adjusted basis by the premium amortization.

Sale or redemption of non-taxable bonds originally issued at a discount

For bonds originally issued at a discount (OID bonds) after September 3, 1982 and acquired after March 1, 1984, the accumulated discount must be added to the original basis to get the adjusted basis at time of sale. The gain or loss is the difference between the sales price and the adjusted basis.

Sale or redemption of non-taxable bonds purchased (not OID bonds) at a discount

If the bonds were purchased before May 1, 1993, the gain or loss is a capital gain or loss. For bonds issued after April 30, 1993, if the discount is not reported each year, any gain, to the extent of the accumulated discount not reported, is ordinary income. Any excess will be capital gain. If the bonds are sold for a loss (less than purchase price which was less than face (maturity) value and the discount is not reported each year, there would not be any accumulated discount because sales price is less than purchase price, which was less than maturity (face) value). The loss will be a capital loss.

Note: Some of the information for this article was obtained from J.K. Lasser’s Your Income Tax 2016.

Avatar

Dr. Goedde is a former college professor who taught income tax, auditing, personal finance, and financial accounting and has 25 years of experience preparing income tax returns and consulting. He published many accounting and tax articles in professional journals. He is presently retired and does tax return preparation and consulting. He also writes articles on various aspects of taxation. During tax season he works as a volunteer income tax return preparer for seniors and low income persons in the IRS’s VITA program.

Twitter LinkedIn