How Are Treasury Notes Taxed? Federal & State Rules
Understand the unique tax framework for Treasury Notes. Learn how their earnings and sales are treated under various tax laws.
Treasury Notes are a type of government-issued debt security, representing a loan made to the U.S. government. These notes typically have fixed interest rates and mature within two to ten years. The earnings from Treasury Notes are subject to specific tax regulations.
Federal Income Taxation of Treasury Notes
Interest income from Treasury Notes is subject to federal income tax. This income is considered ordinary income and must be reported in the year it accrues or is received. The interest is taxed at an investor’s ordinary income tax rates, depending on their total taxable income and filing status.
When a Treasury Note is purchased at a discount from its face value, this difference is known as Original Issue Discount (OID). OID must be accrued and included in an investor’s gross income each year, even if no cash payment is received. This ensures the discount is recognized as interest income over the life of the note.
Conversely, if a Treasury Note is acquired at a premium (more than its face value), the investor can elect to amortize this premium. Amortization allows the investor to reduce their taxable interest income each year by a portion of the premium paid. This lowers the amount of interest reported for federal income tax purposes, spreading the cost of the premium over the note’s remaining life.
The Internal Revenue Service considers accrued OID as taxable interest, which is subject to federal income tax. If a note with OID is held, the investor will receive a Form 1099-OID detailing the amount of OID to be reported as income for the tax year. This ensures the discount income is recognized systematically rather than all at once at maturity.
State and Local Tax Treatment
A significant advantage of investing in Treasury Notes is their exemption from state and local income taxes. This exemption is mandated by federal law, 31 U.S. Code 3124, which states that obligations of the United States Government, including Treasury Notes, are exempt from taxation by states or their political subdivisions. While federal income tax applies, investors do not pay state or local income taxes on the interest earned.
This tax benefit can result in substantial savings, particularly for investors residing in states with high income tax rates. This exemption enhances the net yield of Treasury Notes, making them an attractive option for tax-conscious individuals.
The exemption applies consistently across all states and local jurisdictions, distinguishing Treasury Notes from many other types of investments, such as corporate bonds or certificates of deposit, which are typically subject to both federal and state income taxes.
This exemption extends not only to direct holdings of Treasury Notes but also to interest from Treasury securities held within certain investment funds, provided the fund meets specific criteria. Investors should verify how such funds report their income to claim this state and local tax exemption.
Taxation of Sales and Maturities
When a Treasury Note is sold before its maturity date, the transaction may result in a capital gain or loss. This is determined by subtracting the adjusted cost basis of the note from its sale price. The adjusted cost basis accounts for any OID previously included in income or premium amortized over the holding period.
The tax rate applied to capital gains depends on how long the Treasury Note was held. If held for one year or less, any profit is a short-term capital gain. Short-term capital gains are taxed at ordinary income tax rates.
If the Treasury Note was held for more than one year, any profit is a long-term capital gain. Long-term capital gains generally receive preferential tax treatment, with rates typically set at 0%, 15%, or 20%, depending on the investor’s overall taxable income.
Upon maturity, the principal repayment of a Treasury Note is not a taxable event, as it represents the return of the investor’s original capital. However, any accrued interest paid at maturity, including any OID that has not yet been taxed, is recognized as taxable interest income in that year.
Tax Reporting Requirements
Investors in Treasury Notes receive specific tax forms to assist in reporting their income and gains or losses. Form 1099-INT, Interest Income, is issued to report interest payments received from Treasury Notes during the year, detailing the amount subject to federal income tax.
For Treasury Notes issued with Original Issue Discount (OID), investors receive Form 1099-OID. This form reports the amount of OID that must be included in gross income for the tax year, even if no cash payment was made. It also indicates the portion of OID from U.S. Treasury obligations, which is exempt from state and local taxes.
Information from Form 1099-INT and Form 1099-OID is generally reported on Schedule B (Interest and Ordinary Dividends) of the federal tax return. Any capital gains or losses from selling Treasury Notes before maturity are reported on Schedule D (Capital Gains and Losses).
These forms provide the necessary details for investors to accurately file their federal income tax returns. Investors should retain these documents and report all taxable income and capital transactions related to their Treasury Note investments.