How Are CMOs Taxed? A Detailed Look at Tax Treatment
Understand how CMOs are taxed, including income classification, reporting rules, and key factors that impact tax treatment at federal and state levels.
Collateralized Mortgage Obligations (CMOs) are fixed-income securities backed by pools of mortgages. Investors are drawn to them for their structured cash flows, but the tax implications can be complex. Understanding how CMOs are taxed is essential for accurate reporting and avoiding penalties.
Tax treatment depends on interest payments, principal repayments, and whether the security was purchased at a discount or premium. Each of these factors affects taxable income differently.
Ordinary Income or Capital Gains
Interest payments from CMOs are taxed as ordinary income, similar to bond interest, and subject to federal income tax at rates ranging from 10% to 37% in 2024. If held in a tax-advantaged account like an IRA, taxes are deferred until withdrawal.
Selling a CMO before maturity results in a capital gain or loss. If held for more than a year, gains are taxed at long-term capital gains rates of 0% to 20%. If held for a year or less, gains are taxed as short-term capital gains at ordinary income tax rates. Losses can offset capital gains, and if they exceed gains, up to $3,000 can be deducted against ordinary income annually, with any remaining losses carried forward.
Original Issue Discount
When a CMO is issued below face value, the difference between the purchase price and the amount received at maturity is considered an original issue discount (OID). The IRS requires investors to recognize this discount as taxable income over the life of the security, even if they do not receive corresponding cash payments each year.
OID income is calculated using the constant yield method, which spreads the discount over time by accounting for compounding interest. Investors receive IRS Form 1099-OID detailing the amount to report. If no form is provided, taxpayers must still calculate and report OID income.
Partial Principal Payments
CMOs distribute cash flows based on repayments from the underlying mortgage loans. Unlike traditional bonds that return principal in a lump sum at maturity, CMOs often make periodic principal payments as homeowners make mortgage payments or prepay loans.
These principal payments are not taxable income but instead reduce the investor’s cost basis. For example, if an investor buys a CMO for $10,000 and receives $2,000 in principal payments, the adjusted cost basis decreases to $8,000. This lower basis affects capital gains or losses when the CMO is sold or matures.
Mortgage prepayments complicate tax calculations. Faster-than-expected prepayments return principal sooner, affecting cash flow projections and taxable events. Since each principal payment lowers the cost basis, selling a CMO before full repayment may result in a larger taxable gain. Conversely, slower prepayments delay capital recovery and tax consequences.
Reporting Requirements
Investors must track income and cost basis adjustments to comply with IRS regulations. Brokerages provide tax documents, but investors are responsible for verifying accuracy.
Form 1099-INT reports taxable interest income but does not reflect cost basis adjustments from principal payments or gains and losses from sales. If a CMO is sold before maturity, Form 1099-B reports the proceeds, but investors must ensure the cost basis accounts for prior principal reductions to avoid miscalculating taxable income.
CMOs purchased at a premium require additional reporting. Investors can elect to amortize bond premiums annually, reducing taxable interest income over time. This election, governed by IRS Publication 550, must be applied consistently across all premium bonds held. If not elected, the full premium remains part of the cost basis, affecting the final gain or loss upon sale.
State Tax Treatment
State and local taxes on CMOs vary based on residency and income type. Some states conform to federal tax treatment, while others impose different rules on interest income, capital gains, and OID.
States like Texas and Florida do not impose state income tax, so CMO interest income and capital gains are only subject to federal taxation. In contrast, states like California and New York tax CMO interest income at rates exceeding 10%, reducing after-tax returns. Some states exempt interest from government-backed mortgage securities, such as those issued by Ginnie Mae or Fannie Mae, but this typically does not apply to CMOs, which are structured securities rather than direct government obligations.
Most states follow federal guidelines for capital gains, distinguishing between short- and long-term gains. However, some states impose a flat tax rate on all capital gains, regardless of holding period. Others require separate reporting of OID income, even if it is already included in federal taxable income. Investors should review state tax codes or consult a tax professional to understand how these rules apply to their holdings.