Tax Savvy for Bondholders
Marilyn Cohen, Forbes Magazine, 04.05.99

CONGRESS HAS RESERVED some of the most tortured parts of the tax code for fixed-income investors. Herewith, some things to remember as you review your '98 return: Premium taxable bonds. Say you buy a high-coupon $1,000 Treasury bond for $1,100. The Treasury is destined to return you only $1,000 of principal some years hence. What about the $100 loss? You have the right to just wait and take it as a capital loss when you dispose of the bond.

It's smarter, though, to amortize the $100 over the life of the bond. If the bond has 20 years to run, you would get approximately $5 a year in writeoffs.

Of all the common bond-tax errors, the most surprising to me is neglecting to amortize premiums paid on taxable bonds.

Amortizing is better for two reasons. One is that it turns the $100 into ordinary deductions (as an offset to interest income from the bond) that you'll claim on Schedule B for bonds acquired after 1987. A long- term capital loss is worth only half as much in tax savings as an ordinary loss.

The other reason for amortizing is that it accelerates your tax benefits. Why wait until 2019 to claim your deduction?

There are some sticky rules regarding the date you bought the bond, the date it was issued and whether you use the constant-yield method or the straight-line method to amortize the premium. Let your accountant earn his fees by taking care of these details, and if he can't, get a new accountant.

Premium tax-exempt bonds. You pay $1,100 for a $1,000 California general obligation bond. Now there is no option. You must amortize. In this case, however, the amount amortized each year -- let's say it's $5 -- cannot be claimed against interest income because there is no interest income for federal tax purposes. The effect of the amortizing is simply to deny you a $100 capital loss if you hold the bond to maturity. If you sell the bond before maturity, you must use the amortization to calculate any capital gain or loss.

Discount taxable bonds. Say you pay $950 for a corporate bond that will be worth $1,000 at maturity in ten years. In the old days the $50 would be a capital gain -- taxable at favorable long-term rates when you cash the bond in in 2009. No longer. To raise some extra revenue, Congress has decreed that the $50 is ordinary income.

You can report the $50 when you dispose of the bond. This is usually smart. You have the option of reporting the $50, instead, over the life of the bond. This is usually a dumb idea.

Discount tax-exempt bonds. You pay $950 for a New York State Housing Authority bond due in ten years. When you cash it in, you have a $50 gain. In the old days the $50 would be a capital gain taxable at a low rate. Now the rule (for bonds bought after May 1, 1993) is that the $50 is ordinary income. Unfair, because the poor fellow who bought the bond for $1,000 and sold it at a loss to you gets a capital loss, not an ordinary deduction.

Bonds bought between coupon dates. Say that in November of 1997 you bought $50,000 face value of Shell Oil 6.7% bonds due Aug. 15, 2002. The $958 of accrued interest that you paid the seller is a deduction against your Feb. 15, 1998, coupon payment of $1,675. You'll take that deduction now as you file your 1998 return.
Do show your accountant the confirmation tickets for bonds you first collected coupons on last year. Why pay income tax on interest kept by the seller?

Consent money. An issuer of junk bonds paid you a few dollars per bond to consent to changes in the bond's terms. Logically, this should be a return of capital, but the IRStreats it as ordinary income. Unfair.

Margin interest. You can deduct it, up to the amount of investment income. Investment income is defined to include taxable dividends, interest, short-term capital gains and -- to the extent you agree to have them taxed at ordinary rates -- long-term capital gains.

Two cautions. One is that if you are a cash-basis taxpayer you should make sure to pay the interest rather than just let it accrue on your debit balance. The other is that the deduction is likely to be disallowed if it appears that you ran up the margin debt in order to finance a purchase of tax-exempt bonds.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at http://www.forbes.com/search/results.jhtml?RD=DM&MT=marilyn%2Bcohen&date=&author=&sort=.