State tax filing

I've been following this thread looking for an answer to this question as well. So odyinpdx, from your research, do you think AMD is 'taxable' or is 'tax-exempt' on the STATE level?

I can understand why many believe Accrued Market Discount or AMD is taxable on the state level because it is treated as ordinary interest income on the FEDERAL level. However, I would like to point out that ALL treasury interest income is treated and taxed as ordinary interest income on the FEDERAL level. It is only TAX-EXEMPT on the STATE level. In most of the responses on this tread regarding AMD being treated as taxable interest income seems to refer to the tax rules surrounding municipal securities, which are generally tax-exempt on BOTH the federal and state level. For munis, the federal gov is indicating AMD would be considered taxable interest income while coupon payments are tax-exempt, so different tax treatment. However, for treasuries, coupon payments and AMD are treated the same, as taxable income.

Like everyone else, I have been unsuccessful in finding an expert opinion that can point me to a white paper or source that clearly states whether AMD for treasury bond transactions is taxable on the STATE level. It is my opinion that it is TAX-EXEMPT on the STATE level. I am NOT a CPA but an investment professional that trades fixed income securities. I am coming at this from a different perspective.

The reason I believe AMD is tax-exempt on the state level is because if it was not, the treasury market will not be the most liquid fixed income market in the world. Treasury bonds of a similar duration can generally be purchased or sold at a very similar yield. If AMD was taxable on the state level, there should be a wider "spread" or bigger difference in yield between lower coupon treasury bonds versus higher coupon treasury bonds. In the current market, there would be a much higher preference for higher coupon or premium treasury bonds. Since a significant majority of TSY bonds currently trade at a discount now (below par), that means almost all TSY sales and maturities will result in AMD. The entire market would effectively freeze up and become less liquid if the tax implications were different for different coupon treasury bonds. Sellers would prefer to own and sell higher coupon treasury bonds to reduce the potential AMD state tax hit (which can be 10%+ in NY and CA), effectively making lower coupon treasury bonds less liquid. If you take a look at the municipal bond market, the market is generally a buy and hold market where liquidity is not a priority like the treasury market. To avoid AMD, most municipal securities are issued as high coupon premium securities to avoid the tax implications from OID and AMD. A discount municipal bond with a low coupon versus a high coupon premium muni bond for the same maturity would trade at significantly different yields in the secondary market (e.g. Muni 2% 12/31/29 would offer a much higher yield than a Muni 5% 12/31/29 bond). Bloomberg, the professional trading system traders use have a bunch of functionality and tools built in to help money managers decide which muni bond is best for a client based on different tax situations and length of ownership. No such tools exist for analysis of tax implications of treasury bond transactions. For example, a TSY 3% 8/15/52 trades at ~$76.50 while a 3 month longer higher coupon TSY 4% 11/15/52 trades at ~$92.75, or a yield of ~4.47% vs ~4.45%, respectively. I would imagine the 3% coupon bond would trade at a meaningfully higher yield if AMD was state taxable on the sale. If more of the income was considered taxable via AMD, the bond would be considered less attractive, thereby affecting liquidity and result in a higher spread differential between the two bonds maturing in 2052.

Again, I am not a CPA and tax rules are not always logical or make sense to the lay person. I am thinking about this with a investor 'hat' on. It is my impression that professional money managers would make quite a fuss over this if AMD is indeed taxable on the STATE level or becomes STATE taxable in the future.