Accrued market discount from Treasury bills and notes

[clomein1]

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. 

[fjsingel]

PA and NH here

Talked to my friend who is a CPA and has a Master's Degree in Taxation.
He said that you do not pay tax on the AMD in either state.  He said that it really isn't up to the state as states are prevented from taxing US government interest under Article VI, Clause 2, of the US Constitution. See McCulloch v. Maryland, Osborn v. Bank of the United States, and Weston v. Charleston. In the Weston case the court explicitly held that states cannot tax interest on US bonds and other securities.  He said that AMD is considered interest.

For me,  I have spent enough time researching this.  Now, I am just going to figure out how I am going to override TT to exclude this interested from state taxation.

[odyinpdx]

@clomein1  Thanks for the thorough and informative response.   I am going to file my state return treating AMD as tax-exempt on the state level.  I will put a tickler on my calendar to follow-up on this post with either a yay or nay on whether I hear from Oregon.  (not hearing doesn't mean its the correct treatment, but at least its a data point).  

Your analysis of yield spreads on muni's and treasuries makes sense, but I'm not sure States will consider financial markets when making decisions on taxability.  I would think the market would adapt (as it did for munis). 

Seems like we got a vote for non-taxable from NH and PA.  

[greg_s]

For MA,  the AMD appears on the Massachusetts Interest Income Worksheet.  I overrode and cleared the entry under Regular Interest and re-entered it under U.S. Govt Interest.

[TurboLover2]

@clomein1 

I like your market based answer and as a matter of fact made a similar case in another forum.  It is logical.  But unfortunately still not conclusive or authoritative.

@fjsingel 

“PA and NH here

Talked to my friend who is a CPA and has a Master's Degree in Taxation.
He said that you do not pay tax on the AMD in either state.  He said that it really isn't up to the state as states are prevented from taxing US government interest under Article VI, Clause 2, of the US Constitution. See McCulloch v. Maryland, Osborn v. Bank of the United States, and Weston v. Charleston. In the Weston case the court explicitly held that states cannot tax interest on US bonds and other securities.  He said that AMD is considered interest.”

I wish you had not said that because I was just getting to my happy place on another site with the opinion of a tax attorney who states that AMD is NOT exempt from state income taxes (I have not asked the question yet but his comment seemed imply that it is not exempt in ANY state).

[notAnAspiringAccountant]

@greg_s Another option is to go to the end of the MA flow and then enter it under "other excluded interest/dividends income," or something along those lines. Then it'll show up on MA Form 1-NR/PY "Other Interest and Dividends Excluded Statement."

[tfgatlin]

I finally broke down and called the Alabama Department of Revenue and talked to one of their auditors. She had to do some research, but called me back today and said that in their opinion, Accrued Market Discount is treated like interest and is tax-exempt by Alabama when tied to a US Treasury.

Here's my tally:

3 CPA's --- exempt

Alabama DOR -- exempt

experts on the internet --- non-exempt 

[TurboLover2]

You are lucky.

The New York Department of Taxation and Finance would not answer the question as to whether or not the amount of Accrued Market Discount on form 1099-B Box f for a US Treasury Note was exempt from NY state income tax.  Their answer was that you have to ask a CPA.

[Payer06]

How treasury AMD is treated by states varies by states.  Some states exempt it, some don't.  For example, a poster on bogleheads.org reports a written response from California that it is exempt and posters in this report it is exempt in their states after talking to the state, while North Carolina has a court decision that it is not exempt.

TurboTax should allow filers to choose whether or not to enter treasury AMD on the relevant interest on treasuries line of their state return, rather than not allowing them to e-file if they put it on the treasury interest line by overriding, as TT does for NY. TT does allow treasury AMD to be reported on a general subtractions line in NY, but that does not appear to be the correct line according to many. Not everyone agrees how to treat it in NY, so TT should not take a position that may be incorrect and less favorable to the taxpayer.

EDIT: In NY:

You're required to electronically file your return if you meet all three of the following conditions:

• you use software to prepare your own personal income tax return; and
• your software supports the electronic filing of your return; and
• you have broadband Internet access.
• https://www.tax.ny.gov/pit/efile/efile_mandate_for_individuals.htm

A poster on another forum reports that Lacerte, Intuit's professional tax software, treats treasury AMD as exempt from state tax, at least in California.  TurboTax should not take an inconsistent position.

[fjsingel]

Well, this is from PA.   I had to ask the question several different ways, receiving several different answers to get this close, but they did try to answer it which isn't bad.

From PA
"For Pennsylvania personal income tax purposes, a premium paid on a bond is deemed to be an investment in the bond to obtain the higher bond interest rate. The amortization amount taken for federal income tax purposes must be added back on Line 3 of PA-40 Schedule A, Interest Income, while the Pennsylvania amortization amount is deducted on Line 8 of PA-40 Schedule A.

Market discount is the amount discounted from the face amount of a bond at purchase, meaning purchased at less than face amount. Interest that accrues on the bond is taxable.  When the bond is sold/redeemed the taxable interest that has been reported each year becomes part of the cost of the bond. This creates a low to no gain on the transaction because of the increased cost basis at the time of redemption.

The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis (reduces the interest income being reported)."

 End of From PA

My question was only related to AMD on Government Treasury Notes.  They talk about lines 3 and 8 on PA Schedule A.  For AMD for Government Treasury Notes, TT converts that to interest and puts it on US Schedule B as interest.  That in turn is transferred to Line 1 of PA Schedule A (Interest Income reported on your Federal Return).  Line 3 of PA Schedule A is just "Other Additional Adjustments" to that interest, which should be 0 because it is already included on line 1 of PA Schedule A.  

After this,  PA Schedule A adds up all your interest lines, which is just Line 1 for me, they then offset it.
Line 7 of PA Schedule A pulls out the "Interest Income from direct obligations for the US Gov't", which is interest payments you get from the US Notes.  Then there is Line 8, which they talk about in the response.  That is where I put my AMD for the US Notes so it gets subtracted from interest income.

I am not 100% sure this is right, and I am not an expert, but based on all of the feedback, and the logic around one of the major reasons people buy US Notes (to avoid state taxes), this is the way I decided to go.

[17499]

I too am not a tax expert but accrued market discount was paid for by the seller that sold it at discount. It in not interest being paid for by the US government and therefore not tax exempt on state returns.

[17499]

As an example of the above, very simply consider one bond paying 2% for one year and neglect interest during the year. Lets say the market is now at 5%. The seller would have to discount the bond $30 to give a 5% return to the buyer.

So the US government is still paying you $20 while the seller is paying you $30. The $30 was not interest paid by the US government and therefore is not tax free in a state.

[TurboLover2]

@17499

I am not a lawyer.  These are just my personal views after researching this topic the best I am able.

"So the US government is still paying you $20 while the seller is paying you $30. The $30 was not interest paid by the US government and therefore is not tax free in a state."

The reasoning is correct and the same reasoning I have used in other forums.  However the conclusion that the AMD is therefore not state tax exempt is not necessarily correct.

You cannot necessarily conclude that because a particular argument seems logical that it means that state tax code is written that way or in fact is written on that topic at all.

Tax code is sometimes illogical and contrary to reason.   Also there may be counter arguments to the reasoning above.  It ultimately boils down to whether or not there is specific state level tax code addressing this matter and if not whether or not there are any court rulings on it.

In the absence of either, I think it is sensible to assume that exempting it from state interest is a good faith effort to comply with the rules since it is treated as interest for federal tax purposes.  Although if it is challenged that may not help you escape paying it or paying interest and maybe even penalties as well unless you are willing to spend millions of dollars on legal fees to try to establish a precedent and then win the case.

To the best that I have been able to determine, NY tax code is silent on this issue and there are no court cases that address it.  I don't know about other states.

[notAnAspiringAccountant]

IMO, this is the bottom line -

Nobody really knows, unless:

1) they are a lawyer (and even then, different lawyers could have different opinions)

2) they are a CPA (and even then, different CPAs could have different opinions)

3) they work for a state's tax dept (though not all reps will have been trained equally)

4) they are a taxpayer who has done it wrong in the past and has been audited by their state for it

So basically, flip a coin this year, especially if you don't have huge amounts of interest from AMD, and don't buy any treasuries notes/bonds on the secondary market for next tax year. Plenty of zero-coupon treasury bills to be bought with the same interest but without the tax hassle. This is my plan.

[fjsingel]

I agree.  My state's tax department (PA) vaguely alluded to me being able to exempt them, so that is what I am doing.  Not trying to break the law, just trying to do my taxes.

 Little did I know when I bought them on the secondary market that I would have to figure this out.  Buying them on the primary market with an OID is much simpler on the tax return.  That is what I am doing moving forward.  I also don't purchase anything with a K-1 with post tax money for the same reason.