4.15 Reporting Interest on Bonds Bought or Sold

When you buy or sell bonds between interest dates, interest is included in the price of the bonds. If you are the buyer, you do not report as income the interest that accrued before your date of purchase. The seller reports the accrued interest. Reduce the basis of the bond by the accrued interest reported by the seller. The following Examples illustrate these rules.

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Accrued Interest
When you buy bonds between interest payment dates and pay accrued interest to the seller, this interest is taxable to the seller. The accrued interest is included on the Form 1099-INT you receive, but you should subtract it from your taxable interest; see Example 1 in 4.15.
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EXAMPLES
1. Purchase. On April 30, you buy for $5,200 a $5,000 corporate bond bearing interest at 5% per year, payable January 1 and July 1. The purchase price of the bond included accrued interest of $88.33 for the period January 1–April 30.
Interest received on 7/1 $125.00
Less: Accrued interest     83.33
Taxable interest  $ 41.67
Form 1099 sent to you includes the $83.33 of accrued interest. On Schedule B of Form 1040, you report the total interest of $125 received on July 1 and then on a separate line subtract the accrued interest of $83.33. Write “Accrued Interest” on the line where you show the subtraction.
Your basis for the bond is $5,117 ($5,200 − $83.33) for purposes of figuring gain or loss on a later sale of the bond.
2. Sale. On April 30, you sell for $5,200 a $5,000 5% bond with interest payable January 1 and July 1. The sales price included interest of $83.33 accrued from January 1–April 30. Your cost for the bond was $5,000. On your return, you report interest of $83.33 and capital gain of $117.
You receive $ 5,200.00
Less: Accrued interest         83.33
Sales proceeds $ 5,116.67
Less: Your cost    5,000.00
Capital gain $ 116.67, or $117

Redemptions, bankruptcy, reorganizations.

On a redemption, interest received in excess of the amount due at that time is not treated as interest income but as capital gain.

EXAMPLE
You hold a $5,000 9% bond with interest payable January 1 and July 1. The company can call the bonds for redemption on any interest date. In May, the company announces it will redeem the bonds on July 1. But you may present the bond for redemption beginning with June 1 and it will be redeemed with interest to July 1. On June 1 you present the bond and receive $5,225 − $5,000 principal, $187.50 interest to June 1, and $37.50 extra interest to July 1. The $37.50 is treated as a capital gain; the $187.50 is interest.

Taxable interest may continue on bonds after the issuer becomes bankrupt, if a guarantor continues to pay the interest when due. The loss on the bonds will occur only when they mature and are not redeemed or when they are sold below your cost. In the meantime, the interest received from the guarantor is taxed.

Bondholders exchanging their bonds for stock, securities, or other property in a tax-free reorganization, including a reorganization in bankruptcy, have interest income to the extent the property received is attributable to accrued but unpaid interest; see Internal Revenue Code Section 354(a)(2)(B).

Bonds selling at a flat price.

When you buy bonds with defaulted interest at a “flat” price, a later payment of the defaulted interest is not taxed. It is a tax-free return of capital that reduces your cost of the bond. This rule applies only to interest in default at the time the bond is purchased. Interest that accrues after the date of your purchase is taxed as ordinary income.

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