The market rate is 8% interest. I purchase a bond with a 7% coupon, 1000 par value. Since the coupon rate is lower than the market rate, I insist on paying a discounted price.
n=3 years
i=8%
PMT = 70
FV = 1000
Therefore, PV = -$974.23
1 . So I’m BUYING the bond for $974.23, right?
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The coupons of of $70 per year are taxable as interest income. This part is easy.
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The gain from $974.23 to $1000 par is $25.77.
Page 15 states that this could be treated as long-term capital gain when sold. Makes perfect sense to me so far.
However, the chapter summary states “the increase in value toward par from original discount value is considered interest incom e”
So which is it?
I know that for zero-coupon bonds in the US, you’re taxed as if you received coupon payments semiannually (at the original YTM, I’d assume). They probably do the same here: you’re taxed based on the YTM, not based on the actual cash coupon payments.
That said, if you sell the bond, any difference between the (clean) sales price and the carrying value will be treated as a capital gain.
Okay, but doesnt that mean that bond investors (who presumably get lower tax rates on capital gains) could game the system by selling their bonds at a gain the day before the bonds mature?
I don’t see how that’d game the system.
If you sell the day before the bond matures you’ll get paid for the bond (clean price) and for the accured interest. The clean price will essentially be par – there’s only one day left till maturity – so the capital gain will be the same as if you held it another day, and the accrued interest will essentially be the whole period’s interest – there’s only one day left till maturity – and will be taxed as interest income, not capital gains.