Treasury Bond interest accrues tax free. However, when you sell your bond (or bond fund), it is a fully taxable event.
Capital Gains realized from selling a bond are subject to federal and state taxes. The short-term or long-term capital gain, or loss, on a bond sale, is the difference between the selling price of the bond and the original purchase price of the bond.
Here's more details and Guide to Investment Bonds and Taxes.
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