When you buy a bond, you take on the responsibility of paying the taxes on the income you receive. Unless it’s a tax-free municipal bond, you’ll have to include bond interest in your taxable income. You also may amortize any bond premium or discount, which can affect your tax bill. A sinking fund affects how long you’ll be able to hang onto the bond.
A bond sells at a discount if its purchase price is less than its face value. Bond discount is a form of interest. The discount decreases as the bond approaches its maturity date. On that date, the issuer will pay you the face value and retire the bond. The Internal Revenue Service distinguishes between original issue discount, or OID, and market discount. OID occurs when the issuer’s original issue price is below face value. Market discount develops when bonds lose value after issuance, typically because of a rise in interest rates.
Amortizing the Discount
You must amortize OID. You may choose to amortize market discount. To amortize discount, you divide the discount amount into a number of yearly installments. Use the number of years until the bond’s maturity date. Each year, add the amortized amount to the cost basis of your bond and to your taxable income -- unless the bond is a tax-free municipal. The IRS describes different ways to calculate the annual amortization amount. If you sell an amortized bond before maturity, you earn a capital gain or loss. If you sell a market discount bond you’ve chosen not to amortize, treat your gain or loss as ordinary income.
A premium bond sells for more than its face value. You may choose to amortize the premium amount. You subtract the amount you amortize each year from the bond cost basis. You also deduct this amount from your taxable income, assuming the bond is not tax free. If you sell the bond before maturity, you can take a capital gain or loss on the difference between the cost basis and the sale price, whether or not you amortize the premium.
A sinking fund is money the bond issuer puts aside to retire a bond before maturity. Bonds linked to sinking funds are callable. Each year, the issuer calls back a portion of the outstanding bonds using the sinking fund to pay off the bondholders. If the issuer calls your bond, you’ll receive the bond’s face value or a little more. This is the redemption price. When determining your gain or loss, treat the call as if you sold the bond for the redemption price.
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