How Interest Is Taxed On Treasuries Purchased On The Secondary Market

Capper | Oct 18, 2023 | 50 posts since 2018

If I buy a treasury note on the secondary market, for example a note with an approximate maturity of 5 years, that has a coupon rate of 1.5%, what is taxable each year and then at maturity? I am going to be collecting the 1.5% coupon rate annually. But if I hold to maturity and receive more than I paid for it, such as I would now, is that then taxed as a capital gain or just interest?

I am trying to figure this out because I am interested in investing in a treasury of about 5 years and I live in very high tax state so want to see the difference between purchasing a CD where the interest is fully taxable at the state level vs treasuries which are not.

Appreciate any insight the community here has on this.

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Answers

MAKNYC | Oct 18, 2023 | 323 posts since 2015

I’m highly confident of this answer, but not absolutely certain. But it has been a recent near term consideration for me because I have been purchasing a lot of municipal bonds at a discount (like paying 72 for a 3% tax free bond). And there, the issue is worse because tax free interest becomes fully taxable in that case-in my example 28 points is fully taxable at the federal level at maturity-as discussed below. But here it is:

Since the bond that you mention only has a 1.5% coupon which was set when rates were significantly lower, it will be currently trading at a meaningful discount to its par/maturity value. That difference between the purchase price and maturity value would be treated as ordinary income, if held to maturity. The holder has the option of declaring the annual accretion of the discount each year, or they can treat it as lump sum in the year of maturity. Lump sum is the default option. But some minor caveats that won’t likely apply here. If the bond had an OID (Original Issue Discount), that remaining amount could be deducted from the discount price that you did pay, and then you would consider whether the de minimus rules would apply. That rule states if you buy a bond at a discount to par but it’s less than 1/4 of 1 point for each full year remaining to maturity then you could consider the accretion of the discount a capital gain, and not ordinary income. An example would be buying a 5 (full) year treasury at 99. You would have a 1 point capital gain. Also, this tax treatment issue is specifically for bonds purchased at a discount to par. It would not apply to a bond that was issued at 110 but that you later bought it in the aftermarket at 101.

Also it gets a tad more complicated if you actually sell the bond. I believe you could have a capital/gain loss in that situation. For example, if you bought the bond at 90 and during the period that you actually held it the accreted discount brought your new basis to 95 on the date of sale but you sold the bond for 97, 2 points of the sale price would be capital gain and the balance of 5 would be ordinary income as discussed above. Again not certain, but confident. Good news is your broker would calculate these (unless you chose the annual accretion method)!

These comments are specific to federal taxes. I can’t comment on your states treatment.

https://www.bairdwealth.com/globalassets/pdfs/help/tax-treatment-bond-premium-and-discount-summary.p...

Capper | Oct 18, 2023 | 50 posts since 2018

Thank you, MAKNYC, for the detailed answer on this. Appreciate it.

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