Investing in bonds, like any financial instrument, comes with tax implications. One key factor in your taxes is the "cost basis" of your bonds. Essentially, the cost basis is what you originally paid for them (plus commissions or fees), which is used to determine how much profit you've made when you decide to sell.
Key Takeaways
- The cost basis of a bond includes the purchase price plus any associated costs, such as broker fees.
- An accurate cost basis calculation, which applies to taxable and tax-exempt bonds, is critical for determining capital gains or losses for tax reporting.
- Bonds bought at a discount or premium require adjustments to the cost basis based on whether they are held to maturity or sold early.
- Adjustments may also be made if the bond is sold before maturity.
- While tax-exempt bonds offer income tax relief on interest income, calculating the cost basis is still essential for reporting capital gains or losses.
The cost basis is used to calculate capital gains or losses when you sell or redeem the bond, which you'll need for your tax return. It also affects how much interest income you need to report if you have taxable bonds.
Calculating the cost basis could sound complicated for some, but it's manageable once you know the steps. You take the purchase price of the bond and add any extra costs you had. It gets a bit more complex if you bought the bond at a premium or discount, but we'll cover that below, too. As we do, we'll walk you through the rest of the process of calculating the cost basis of your bonds. Whether you're an experienced investor or starting out, understanding this is key to making sound investment choices and accurately reporting income for your taxes.
Calculating Your Bond's Cost Basis
Calculating the cost basis of a bond involves a few straightforward steps. Let's break it down:
- Determine the initial purchase price: This is the amount you paid for the bond, not including the accrued interest. This would be the face or par value if you bought at issuance.
- Add extra costs: These include broker commissions and any fees from the purchase. These are part of your initial investment and should be added to the purchase price.
- Adjust when buying bonds at a premium or discount:
- If you purchased the bond at a premium (above par), you amortize the premium over the bond's life. This reduces your cost basis over time.
- If you bought the bond at a discount (below par), you accrete the discount, increasing your cost basis until it reaches the par value at maturity.
- Account for any reinvested interest: Add these to your cost basis if you have reinvested interest payments into the bond.
- Subtract any returns of capital: If you have received any noninterest payments considered returns of capital, you should subtract these from your cost basis (this is uncommon).
Let's look at how the mechanics differ for bonds bought at par, discount, and premium. Below is a table using an example to illustrate each scenario:
| Bond Cost Basis Calculation | |||||
|---|---|---|---|---|---|
| Bond Type | Holding Scenario | Purchase Price | Additional Costs | Adjustments | Final Cost Basis Calculation |
| At Par | To maturity | $1,000 | $10 | None | $1,000 + $10 = $1,010 |
| Sold early | " | " | None | $1,000 + $10 = $1,010 | |
| At Discount | To maturity | $950 | $10 | Full accretion of discount | $950 + $10 + the full accretion amount |
| Sold early | " | " | Partial accretion based on holding period | $950 + $10 + the partial accretion amount | |
| At Premium | To maturity | $1,050 | $10 | Full amortization of premium | $1,050 + $10 - the full amortization amount |
| Sold early | " | " | Partial amortization based on the holding period | $1,050 + $10 - the partial amortization amount | |
- At par: Whether the bond is held to maturity or sold early, the cost basis remains unchanged since there are no adjustments for premium or discount.
- At a discount:
- If held to maturity, the entire discount will be accreted on a cost basis.
- If sold early, the cost basis is increased by the portion of the discount accreted up to the sale date.
- At a premium:
- If held to maturity, the premium is amortized from the cost basis.
- If sold early, the cost basis is reduced by the portion of the premium amortized up to the sale date.
The purchase date is also important since 2008 legislation requires brokerage firms to track the cost basis on bonds sold after Jan. 1, 2014. Bondholders who sell investments acquired after that date will have an easier time calculating their tax liabilities because they'll get from their brokerage a copy of Form 1099-B.
Tax-Exempt Bonds
Tax-exempt bonds do not require investors to pay federal income taxes on interest earned. Sometimes, they are also exempt from state and local taxes, especially if you live in the state where the bond was issued. These include municipal bonds.
The primary difference between tax-exempt and taxable bonds is their tax treatment. While taxable bonds, like corporate bonds, come with federal (and sometimes state and local) income taxes on interest, tax-exempt bonds offer a tax break on this income. This difference significantly affects the investment's yield and attractiveness, especially for investors in upper tax brackets.
Why Cost Basis Still Matters
Even though tax-exempt bonds offer income tax relief on interest, understanding and calculating the cost basis is still necessary for a few reasons:
- Capital gains tax: If you sell a tax-exempt bond for more than its cost basis, you will owe capital gains tax on the difference. For bonds sold before maturity, the IRS requires reporting any gain or loss, even on tax-exempt bonds, which are determined on a cost basis.
- Accurate recordkeeping: Calculating the cost basis accurately ensures better tracking of your investment's performance, helping you make more informed investment decisions.
Like taxable bonds, how you calculate the cost basis for tax-exempt bonds depends on whether they were bought at par, discount, or premium and whether they were held to maturity or sold early.
The scenarios in this article assume that an investor bought their bond holdings in a single transaction and then likewise sold those holdings in a single transaction at a later date. When making several purchases or sales, investors must itemize each transaction to accurately determine the buy price and the resulting capital gains or losses.
Example of Calculating a Bond's Cost Basis
Let's go through an example of calculating the cost basis for a bond purchased at a discount and sold 30 days before its maturity.
Initial purchase details:
- Face value of the bond: $1,000
- Purchase price: $950 (i.e., at a discount)
- Original maturity: 5 years (or 60 months)
- Additional costs: $10 (e.g., broker fees)
Sale details:
- Sale price: $980
- Time held before sale: 4 years, 11 months (or 59 months)
- Total holding period (until maturity): 60 months
Step-by-Step Calculation:
- Calculate the total discount: Total discount = Face value - Purchase Price = $1,000 - $950 = $50
- Determine the monthly accretion rate: Monthly Accretion Rate = (Total Discount / Original Maturity Period [in months]) = $50 / 60 months = $0.833 per month
- Calculate the accreted value until sale: Accreted Value = (Monthly Accretion Rate × Holding Period in months) = $0.833 × 59 months about $49.15
- Adjust the Cost Basis for the Sale: Adjusted Cost Basis = (Purchase Price + Additional Costs + Accreted Value) = $950 + $10 + $49.15 = $1,009.15
Thus, the adjusted cost basis of the bond when sold 30 days before maturity is about $1,009.15.
The cost basis is adjusted to reflect the discount accretion until the sale. There would be a capital gain if the bond is sold for more than the adjusted cost basis. In our example, since the sale price is $980 and is less than the adjusted cost basis, it's a capital loss, even though it is sold nominally for $30 more than it was bought.
This example does simplify some aspects of bond accretion for clarity. In practice, bond accretion can involve more complex calculations, especially for bonds with irregular interest payments or other unique features. For a taxable bond, the accreted value ($49.15 in this example) represents taxable interest income over the holding period. This interest would be reported and taxed as income in the years earned.
How Does the Cost Basis of a Bond Change as Interest Payments Are Received?
Receiving bond interest payments doesn't typically change the cost basis of the bond itself. The cost basis is derived from the purchase price and any extra acquisition costs. Interest payments are instead considered income and are reported as such for tax purposes, which is separate from the cost basis of the bond. However, if you choose to reinvest the interest in additional bonds, the cost basis of these new bonds would include the reinvested interest amount.
If I Inherit Bonds, What Is the Cost Basis?
For inherited bonds, the cost basis is generally the market value of the bonds at the date of the original owner’s death, known as the “step-up in basis.” This can significantly differ from the deceased’s original purchase price. The step-up in basis can cut your capital gains tax charges if you decide to sell the bonds later.
Does the Cost Basis of a Bond Affect Its Yield to Maturity?
The cost basis does not directly affect the yield-to-maturity (YTM) calculation. YTM is a calculation of the bond's total expected return if held to maturity, based on its current price, face value, interest rate, and time to maturity. While the purchase price (which is part of the cost basis) is factored into YTM calculations, other components of the cost basis, like additional costs or adjustments for a premium or discount, are not considered in YTM.
What Happens to the Cost Basis of a Bond Called in By the Issuer?
Some bonds, known as callable bonds, can be redeemed by the issuer before maturity. If a bond is called early, the cost basis remains the same as what you calculated initially: the purchase price plus any associated costs. However, the call can affect your realized return on the bond. If the bond was bought at a premium and called before maturity, this could result in a loss relative to the cost basis. Conversely, an early call might result in a gain if bought at a discount.
The Bottom Line
Investing in bonds requires a good understanding of their financial and tax implications, with the cost basis being a central element. This cost basis, or the total of what you've paid for the bond plus associated costs, determines the profit or loss when the bond is sold and affects your tax obligation. While this may seem daunting, calculating the cost basis is pretty straightforward once you grasp the basics and recognize the distinctions among bonds bought at par, discount, or premium. This knowledge is essential for making informed investment decisions and ensuring accurate tax reporting, whether the bonds are tax-exempt or taxable.
Article Sources
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Internal Revenue Service. “Topic No. 409, Capital Gains and Losses.”
Internal Revenue Service. "Publication 550: Investment Income and Expenses." Pages 40-43.
Journal of Accountancy. "The Brave New World of Cost Basis Reporting."
U.S. Congress. "H.R.6049—Energy Improvement and Extension Act of 2008, Section 403."
Internal Revenue Service. "2023 Form 1099-B."
Internal Revenue Service. "Frequently Asked Questions: Gifts and Inheritance."
Securities and Exchange Commission. "Callable or Redeemable Bonds."
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