4.27 Treasury Bills, Notes, and Bonds

Interest on securities issued by the federal government is fully taxable on your federal return. However, interest on federal obligations is not subject to state or local income taxes. Interest on Treasury bills, notes, and bonds is reported on Form 1099-INT.

Treasury bonds and notes.

Treasury notes have maturities of two, three, five, seven or 10 years. Treasury bonds have maturities of 30 years. Interest on notes and bonds is paid every six months and is taxable when received on your federal return. Treasury bonds and notes are capital assets; gain or loss on their sale, exchange, or redemption is reported as capital gain or loss on Schedule D (Chapter 5). If you purchased a federal obligation below par (at a discount) after July 1, 1982, see 4.19 for the rules on reporting original issue discount. If you purchased a Treasury bond or note above par (at a premium), you may elect to amortize the premium (4.17). If you do not elect to amortize and you hold the bond or note to maturity, you have a capital loss.

Treasury inflation-protected securities (TIPS).

These pay interest semiannually at a fixed rate on a principal amount that is adjusted to take into account inflation or deflation. The interest is taxable when received and any increase in the inflation-adjusted principal amount while you hold the bond must be reported as original issue discount (OID) (4.19). Your basis in the bond is increased by the OID included in income. On a sale or redemption before maturity, any gain is generally capital gain, but if there was an intention to call before maturity, gain is ordinary income to the extent of the previously unreported OID; see “Corporate bonds with OID issued after May 27, 1969, and government bonds with OID issued after July 1, 1982” (4.23).

Treasury bills.

These are short-term U.S. obligations with maturities of four weeks, 13 weeks, 26 weeks, or 52 weeks. On a bill held to maturity, you report as interest income the difference between the discounted price and the amount you receive on a redemption of the bills at maturity.

Planning Reminder

Tax Deferral: T-Bill Maturing Next Year

If you are a cash-basis taxpayer, you may postpone the tax on Treasury bill interest by selecting a Treasury bill maturing next year. Income is not recognized until the date on which the Treasury bill is paid at maturity, unless it has been sold or otherwise disposed of earlier.

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Treasury bills are capital assets and a loss on a disposition before maturity is taxed as a capital loss. If you are a cash-basis taxpayer and have a gain on a sale or exchange, ordinary income is realized up to the amount of the ratable share of the discount received when you bought the obligation. This amount is treated as interest income and is figured as follows:

Any gain over this amount is capital gain; see the Example below. Instead of using the above fractional computation for figuring the ordinary income portion of the gain, an election may be made to apply the constant yield method. This method follows the OID computation rules shown in IRS Publication 1212 for obligations issued after 1984, except that the acquisition cost of the Treasury bill would be treated as the issue price in applying the Publication 1212 formula.

Accrual-basis taxpayers and dealers who are required to currently report the acquisition discount element of Treasury bills using either the ratable accrual method or the constant yield method (4.20) do not apply the above formula on a sale before maturity. In figuring gain or loss, the discount included as income is added to basis.

Interest deduction limitation.

Interest incurred on loans used to buy Treasury bills is deductible by a cash-basis investor only to the extent that interest expenses exceed the following: (1) the portion of the acquisition discount allocated to the days you held the bond during the year; and (2) the portion of interest not taxable for the year under your method of accounting. The deferred interest expense is deductible in the year the bill is disposed of. If an election is made to report the acquisition discount as current income under the rules for governmental obligations (4.21), the interest expense may also be deducted currently. The election applies to all future acquisitions.