What Are the Tax Rules for Taxable Bonds?

A bond is a loan from an investor to a borrower, such as a corporation or government entity. In return, the borrower pays the investor periodic interest and returns the principal amount at a future date. For a taxable bond, the income generated is subject to federal income tax, and often state and local taxes. The tax treatment depends on the interest received and how and when the bond was acquired and sold.

Tax Treatment of Bond Interest

A bond’s most direct financial return is its interest, and this income is subject to tax rules based on the issuer. The tax treatment varies between corporate, U.S. Treasury, and federal agency bonds, which impacts an investor’s net earnings.

Corporate Bonds

Interest income from corporate bonds is taxable at the federal, state, and local levels. An investor must report this interest on their federal tax return, where it is taxed at their ordinary income tax rate. This rate can range from 10% to 37% depending on their income bracket.

U.S. Treasury Bonds

Interest income from U.S. Treasury securities, including bonds, notes, and bills, is subject to federal income tax but is exempt from all state and local income taxes. This exemption provides a significant benefit to investors in high-tax states. For example, an investor in a high-tax state might find a Treasury bond with a lower interest rate offers a higher after-tax return than a corporate bond.

Federal Agency Bonds

Federal agency bonds are issued by government-sponsored enterprises (GSEs), and their tax rules are not uniform. The rules depend on the specific issuing agency. Interest from some agency bonds, like the Government National Mortgage Association (Ginnie Mae), is taxable at all levels. However, interest from others, like the Federal Home Loan Banks (FHLB), is exempt from state and local taxes.

Taxation from Bond Price Adjustments

An investor’s tax liability can also be affected by the price at which a bond is purchased relative to its face value, also known as par value. When a bond is bought for more or less than its face value, it can create unique tax situations. The three main scenarios are original issue discount, market discount, and bond premium.

Original Issue Discount (OID)

Original Issue Discount (OID) occurs when a bond is first issued for a price less than its stated redemption price at maturity. This difference is treated as a form of interest, not a capital gain. The OID must be included in the investor’s taxable income as it accrues each year, even though no cash payment is received until maturity. This is sometimes called “phantom income” because investors pay taxes on income they have not yet received.

Market Discount

A market discount arises when an investor purchases a bond on the secondary market for a price lower than its stated redemption price. This typically happens if prevailing interest rates have risen since the bond was issued, making the older bond less valuable. The investor can elect to include the accrued market discount in their income annually as interest. Alternatively, they can defer reporting the income until the bond is sold or redeemed, at which point the accrued discount is taxed as ordinary income.

Bond Premium

A bond premium occurs when an investor buys a bond for a price higher than its face value, often because its fixed interest rate is higher than current market rates. An investor who pays a premium has a choice regarding its tax treatment. They can elect to amortize the premium over the remaining life of the bond, which reduces the amount of taxable interest income reported each year. If the investor chooses not to amortize, the entire premium can be claimed as a capital loss when the bond is sold or matures.

Capital Gains and Losses from Selling Bonds

When an investor sells a bond before its maturity date, the transaction can result in a capital gain or loss, a separate tax event from interest income. The gain or loss is determined by subtracting the bond’s adjusted cost basis from the sale proceeds. The initial cost basis is what the investor paid, but it must be adjusted. Specifically, the basis is increased by any Original Issue Discount (OID) or market discount included in income and decreased by any amortized bond premium.

The tax rate applied to a capital gain depends on how long the investor held the bond. If the bond was held for one year or less, the profit is a short-term capital gain taxed at the investor’s ordinary income rate. If held for more than one year, the profit is a long-term capital gain taxed at preferential rates of 0%, 15%, or 20% for 2025, depending on income and filing status. Capital losses can be used to offset capital gains and some other income.

Reporting Bond Transactions for Tax Purposes

Investors must report all income and transactions related to taxable bonds. The primary documents involved are Forms 1099-INT, 1099-OID, and 1099-B, which provide the information for Schedule B and Schedule D of Form 1040.

Investors receive Form 1099-INT, which details interest income, and Form 1099-OID, which reports the accrued Original Issue Discount for the year. This interest and OID are reported on Schedule B (Form 1040). Any bond premium amortization is also reported on Schedule B as a reduction from the total interest income.

When a bond is sold, the transaction details are reported on Form 1099-B. This information is used to complete Form 8949, Sales and Other Dispositions of Capital Assets, which lists each individual sale. The totals from Form 8949 are then carried over to Schedule D (Form 1040) to calculate the net capital gain or loss for the year.