4.22 Stripped Coupon Bonds and Stock

Brokers holding coupon bonds may separate or strip the coupons from the bonds and sell the bonds or coupons to investors. Examples include zero-coupon instruments sold by brokerage houses that are backed by U.S. Treasury bonds (such as CATS and TIGRS).

The U.S. Treasury also offers its version of zero coupon instruments, with the name STRIPS, which are available from brokers and banks.

Brokers holding preferred stock may strip the dividend rights from the stock and sell the stripped stock to investors.

Caution

Recomputing Form 1099-OID Amount

Do not report the amount shown in Box 1 of Form 1099-OID for a stripped bond or coupon; that amount must be recomputed under complicated rules described in IRS Publication 1212. See 4.19 for reporting the recomputed OID on your return.

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If you buy a stripped bond or coupon, the spread between the cost of the bond or coupon and its higher face amount is treated as original issue discount (OID). This means that you annually report a part of the spread as interest income. For a stripped bond, the amount of the original issue discount is the difference between the stated redemption price of the bond at maturity and the cost of the bond. For a stripped coupon, the amount of the discount is the difference between the amount payable on the due date of the coupon and the cost of the coupon. The rules for figuring the amount of OID (4.19) to be reported annually are in IRS Publication 1212.

If you strip a coupon bond, interest accrual and allocation rules prevent you from creating a tax loss on a sale of the bond or coupons. You are required to report interest accrued up to the date of the sale and also add the amount to the basis of the bond. If you acquired the obligation after October 22, 1986, you must also include in income any market discount that accrued before the date you sold the stripped bond or coupons. The method of accrual depends on the date you bought the obligation; see IRS Publication 1212. The accrued market discount is also added to the basis of the bond. You then allocate this basis between the bond and the coupons. The allocation is based on the relative fair market values of the bond and coupons at the date of sale. Gain or loss on the sale is the difference between the sales price of the stripped item (bond or coupons) and its allocated basis. Furthermore, the original issue discount rules apply to the stripped item which you keep (bond or coupon). Original issue discount for this purpose is the difference between the basis allocated to the retained item and the redemption price of the bond (if retained) or the amount payable on the coupons (if retained). You must annually report a ratable portion of the discount.