Since a bond bought at a discount generates a capital gains tax liability at maturity, does it generate a capital loss deduction at maturity if bought above par?

-- Kenneth Sarno

Kenneth,

That depends on whether the bond is taxable or tax-exempt.

Before we get into that, let's review some terminology for readers less well-versed in it.

Bonds have a face value, typically some multiple of \$1000, which is the amount you get when the bond matures.

Bonds are quoted as a percentage of face value. A bond with a face value of \$1000 whose price is 98 costs \$980, plus any accrued interest due to the seller. That means if you buy a bond between the dates on which it makes coupon payments, you have to give the seller the portion of the next coupon payment he is due, based on how many days into the payment period he owned the bond.

Most new bond issues are sold at par, meaning at a price of 100.

Now, at a price of 100, a bond's yield -- the essential measure of a bond's value -- is equal to its coupon rate. Bonds pay interest on their face value at a fixed rate, their coupon rate. A bond with a 6% coupon and a face value of \$1000 pays \$60 a year. If that bond is purchased at par, it is bought at a yield of 6%.

But bonds are routinely bought and sold at prices above and below par in the bond market. The price an investor is willing to pay for a bond is a function of interest rates. If new bonds of a certain type are being issued at par with 7% coupons, at a yield of 7%, then an old bond of the same type with a 6% coupon has less market value. An investor would buy it only at a price below par -- at a discount. The discount compensates the investor for forgoing the extra coupon income he could earn by buying a new issue. By buying at a discount, the investor can get the same yield he could get by buying a new issue. The discount becomes a component of the yield. This is why a bond's yield goes up when its price goes down.

Similarly, if new bonds of a certain type are being issued at par with 5% coupons, an old bond of the same type with a 6% coupon has more market value. An investor would be willing to buy it at a price above par -- at a premium.

The tax treatment of a bond bought at par and held to maturity is fairly simple. If it's a taxable bond, you pay income tax on the coupon income. If it's a tax-free municipal bond, you don't.

The tax treatment of bonds bought at a discount or a premium and either held to maturity or sold is not simple. But it's possible to state a few basic rules, and thereby to answer your question.

In general, if you buy a bond at a discount, when the bond matures or when you sell it, assuming you are selling it at a higher price than you paid for it, you have to pay capital gains tax on the difference between the price you paid and either par (if you held to maturity) or the price you sold it for.

The rule gets more complicated for bonds bought at a deep discount, as readers of a recent Fixed-Income Forum on municipals already know. In essence, if the price at which you buy is below a certain threshold and you hold to maturity, your gain is taxable as ordinary income.

If you buy a bond at a premium, whether you incur a capital loss at maturity depends on whether it's a taxable or a tax-free municipal bond.

With a taxable bond bought at a premium, the investor can choose whether to amortize the premium. To amortize a premium is simply to adjust your cost basis in the bond downward by a certain amount each year, such that at maturity, it is equal to par. If you amortize the premium, then each year you can deduct that year's amortized portion of the premium from your income. In a simplified example, if you buy a five-year bond with a 6% coupon at a price of 105, and amortize one point of premium a year for the five years, then each year you can deduct \$10 of the \$60 of income payments from the bond.

If you sell a bond whose premium you have been amortizing, you will incur a capital gain if you sell it at a price above your adjusted cost basis, and you will incur a capital loss if you sell it at a price below your adjusted cost basis.

If you don't amortize the premium, then when the bond matures or you sell it for a lower price than you paid for it, you can declare the difference between the price you paid and what you received as a capital loss.

With a municipal bond bought at a premium, you must amortize the premium, and you don't get to deduct the amortized portion of the premium from your income.

The rationale is pretty simple. You're already earning tax-exempt income. You don't get any additional benefit from having paid a premium for it.

The same as with a taxable bond, you will incur a capital loss if you sell a tax-free muni at a price below your adjusted cost basis and a gain if you sell at a price above your adjusted cost basis.

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TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.