Certificates of Indebtedness: Tax Implications

A certificate of indebtedness is a formal, written promise from an issuer to repay a specified sum to a holder at a future date. These instruments are a form of debt used by entities like corporations and governments to borrow money. The certificate functions as an IOU, detailing the terms of the loan, including the amount to be repaid and when that repayment is due. Historically, the U.S. Treasury issued certificates of indebtedness as short-term, coupon-bearing securities, but these were eventually replaced by Treasury bills. Today, the term is used more broadly to encompass a variety of debt instruments, such as corporate bonds and certain certificates of deposit.

Core Features of a Certificate of Indebtedness

A certificate of indebtedness is defined by several components that dictate its function and value. The principal amount, or face value, is the sum of money the issuer promises to repay to the holder. This is the core amount of the loan that will be returned at the end of the instrument’s term. The certificate also specifies an interest rate, which is the stated percentage of the principal that the issuer agrees to pay the holder for the use of their money.

The maturity date is the specific future date on which the issuer is obligated to repay the principal amount in full. The lifespan of these certificates can vary, but historically they were often short-term, maturing in one year or less. The issuer is the government or corporate entity that borrows the funds and creates the certificate, while the holder is the investor or creditor who purchases the certificate and is entitled to repayment. These features collectively form the contractual agreement between the borrower and the lender.

Tax Treatment of Interest Income

Interest from a certificate of indebtedness is taxable as ordinary income, meaning it is taxed at the same rates as wages or salary. If an investor earns more than $10 in interest from a single payer, that payer is required to send both the investor and the IRS a Form 1099-INT, which details the total interest paid during the year. This income is then reported on Schedule B of Form 1040.

The taxability of the interest depends on the issuer of the certificate. Interest from certificates issued by corporations or the U.S. Treasury is fully taxable at the federal level. However, interest from certificates issued by state and local governments, often called municipal bonds, is exempt from federal income tax. This tax-exempt status can make them particularly attractive to investors in higher tax brackets. Some U.S. government obligations are taxable only at the federal level, providing an exemption from state and local income taxes.

Advanced Tax Concepts

Original Issue Discount

Beyond stated interest, some certificates of indebtedness have what is known as Original Issue Discount (OID). OID is a form of interest that occurs when a debt instrument is issued for a price less than its stated redemption price at maturity. For example, if a certificate with a redemption price of $1,000 is issued for $950, the $50 difference constitutes OID.

The tax treatment of OID is distinct because it must be included in the holder’s income as it accrues over the life of the certificate, regardless of when the cash is actually received. The issuer reports the amount of OID that has accrued for the tax year to the holder and the IRS on Form 1099-OID. This means an investor will pay taxes on a portion of the OID each year they hold the certificate, even though the full amount is not paid out until maturity. For tax-exempt obligations, the OID is treated as tax-exempt interest. However, the accrued OID still affects the instrument’s basis, which is a factor when the certificate is sold or redeemed.

Market Discount

A market discount arises when a certificate is purchased on the secondary market for a price below its stated redemption price. This differs from OID because it is created by market factors, such as rising interest rates, rather than by the initial terms of issuance. For instance, if a bond with a $1,000 face value is later bought by a new investor for $970, the $30 difference is a market discount.

This discount is treated as taxable interest income when the bond is sold or redeemed. Unlike OID, the holder has a choice: they can either report the market discount as it accrues annually or wait to report the entire discount as ordinary income in the year of disposition.

Disposition of a Certificate

Redemption at Maturity

When a certificate of indebtedness is held until its maturity date, the repayment of the principal amount is considered a return of capital. This event is not taxable for the holder, as it simply returns the original amount invested. The transaction is treated as an exchange of the debt instrument, and since the amount received equals the face value, no gain or loss is realized on the principal itself.

The primary tax event at maturity often relates to any accrued market discount. If the holder elected not to report market discount income annually, the entire accrued discount becomes taxable as ordinary income in the year the certificate is redeemed.

Sale Before Maturity

If a holder sells a certificate of indebtedness before its maturity date, the tax consequences depend on the calculation of a capital gain or loss. The gain or loss is determined by subtracting the holder’s adjusted basis in the certificate from the sale price. The adjusted basis is a figure that prevents the double taxation of income that has already been reported.

The adjusted basis starts with the investor’s initial purchase price. This basis is then increased by any Original Issue Discount (OID) that the holder has included in their income. This upward adjustment ensures that the OID, which was already taxed as ordinary income, is not taxed again as part of a capital gain upon sale. For example, if a certificate was bought for $950 and $20 of OID was reported as income, the adjusted basis would increase to $970.