Stripped Treasury bonds, or STRIPS, are U.S. Treasury bonds which do not pay regular interest payments. Instead, Treasury STRIPS are purchased for much less than maturity value. The difference between the price and the amount received when the STRIPS mature represents the interest on the bond. It is possible to earn capital gains as well as interest from STRIPS. Some bookkeeping is required to determine which type of gain you have earned from the investment.
The U.S. Treasury refers to stripped Treasury bonds as Separate Trading of Registered Interest and Principal of Securities -- STRIPS. The bonds consist of stripped off interest payments or principal payments stripped of interest of U.S. Treasury bonds. Future interest payments or the principal at maturity payment become the final maturity amounts for STRIPS. These pieces of Treasury bonds are sold as zero-coupon bonds, without regular interest payments. For example, a $100,000 face amount Treasury strip maturing in 15 years with a 5 percent yield costs $48,102. The $51,898 discount is the interest to be earned over the life of the bond. Regular Treasury bonds are stripped by large investment bankers and the resulting STRIPS bonds are sold to investors by brokers and dealers.
Imputed Interest Earnings
Even though you do not receive interest payments from a zero-coupon bond, you still must declare and pay taxes on the "imputed" interest for each year you own the bond. Even though you do not receive any interest until the bond matures, the tax rules require you to pay taxes on a proportional amount of the interest each year. The interest is not tax deferred until the bond matures. To assist with the tax reporting, you will receive an IRS Form 1099-OID from the bond issuer or your broker. The 1099-OID will list the imputed interest for the year, so you can claim the earnings on your tax return. The 1099-OID interest is classified as interest income, not as capital gains.
Cost Basis for Gains or Losses
The imputed interest reported on your taxes each year on STRIPS is added to your cost basis of the bond. For example, the bond for which you paid $48,102 would generate about $2,405 in imputed interest in the first year. You must declare and pay taxes on the $2,405. After that year, your new cost basis in the bond would be $50,507. If you then decided to sell the bond, you would incur a capital gain or capital loss if the proceeds from the sale were higher or lower than the $50,507 basis. For each year you own the stripped Treasury, your cost basis will increase and a capital gain or loss could be generated if you sold the bond at a price different from your cost basis. If you hold the bond until it matures, the entire discount will be classified as interest income.
Capital Gain Potential
It is very conceivable that you could earn a capital gain on a zero coupon Treasury bond you bought and later sold. If interest rates have declined since you purchased the bond, the market value will increase faster than the basis growth from imputed and taxed interest. For example, if a year after you purchased the 15-year bond returning 5 percent, rates have declined to 4 percent, the bond would be worth $57,747 in the bond market -- $57,747 grows to $100,000 in 14 years at a 4 percent rate. Your basis with imputed interest would be $50,507. If you sold the bond, you would have a capital gain of about $5,500. In the year of the sale you would report both imputed interest and a capital gain on your tax return.