How Corporate Bonds Are Taxed
The following basic information addresses the tax aspects for individuals of investing in corporate bonds. For advice about your specific situation, you should consult your tax adviser.
The interest you receive from corporate bonds is subject to federal and state income tax. (If you own shares in bond mutual funds, your interest income will come to you in the form of “dividends” from the fund, but these are fully taxable and are not eligible for the maximum 15% tax rate that otherwise applies to dividends.)
Gains and Losses
You may generate capital gains on a corporate bond if you sell it at a profit before it matures. If you sell it up to a year from purchase, the gains are taxed at your ordinary rate. If you sell it more than a year from purchase, your capital gains are considered long-term and are currently taxed at a maximum rate of 15%.
Conversely, if you sell a bond for less than you paid, you may incur a capital loss. You may offset an unlimited amount of such losses dollar-for-dollar against capital gains you have realized on other investments (bonds, stocks, mutual funds, real estate, etc.). If your losses exceed your gains, you may currently deduct up to $3,000 of net capital losses annually from your ordinary income. Any capital losses in excess of $3,000 are carried forward and can be used in future years. (These rules apply to the sale of shares in bond funds as well as to individual bonds.)
When bonds are issued at substantially less than par (face) value, the difference between the face amount and the initial offering price is known as original-issue discount. Zero-coupon bonds are the best-known variety of this category of bonds.
The tax treatment of original-issue-discount bonds is particularly complicated, so if you plan to invest in them, it is essential to consult your tax attorney or adviser. During the time you own original-issue-discount bonds, you will pay tax each year on a portion of the discount (even though you do not receive it in cash). However, if you hold them to maturity, you do not pay capital gains or other taxes on the amount by which the face value you receive exceeds the discounted amount you paid for the bonds. The reason is that you paid taxes on that excess incrementally each year that you held the bonds.