Accrued Market Discount on Treasury Bonds State Taxability

[lali000]

Is there a list of states that disallow this subtraction? I am in GA.

[DawnC]

Each state handles income and deductions differently.   An investor also has the option to not accrue market discount for the period s/he held the bond. In this case, if the bond is held to maturity, the difference between the redemption price and the cost basis is added to the bondholder’s income. If the bond is sold before it matures, any gain made from the accretion in bond value is treated as interest income. To put another way, the gain realized on the disposition of a market discount bond must be recognized as interest income to the extent of the accrued market discount, and any remaining gain will be capital if the bond is a capital asset in the hands of the holder.

Accrued market discount from a US Treasury obligation is not deductible on your state return because the effective paid interest there was coming from a private party, not the US treasury.   If you buy the bond from the government, you can subtract the interest.   If you buy the bond from a 3rd party, the interest is not deductible. 

[leviton11]

Can you reference tax code that says this income is subject to state income tax?  To me, any income generated on treasury instruments should not be taxable by the states.  Many, many Treasury bonds are sold on the secondary market at a discount to par.  If you are saying that states can tax the income that accrues when the bonds reach par, that really hurts the attractiveness of the bonds.  The Fed does not want the state to tax this income because they do not want these to be less attractive investments. 

[baldietax]

The VA tax code/site - "Virginia law allows a subtraction for income (interest) derived from obligations or income (dividends and gains) derived from the sale or exchange of obligations of the United States".  This market discount is my gain on maturity (or sale, though I am generally holding to maturity).  Doesn't that cover this?

[bluepost22]

DawnC said: "Accrued market discount from a US Treasury obligation is not deductible on your state return because the effective paid interest there was coming from a private party, not the US treasury. If you buy the bond from the government, you can subtract the interest. If you buy the bond from a 3rd party, the interest is not deductible. "

When I buy a bond at a discount, the discount is the market's way of letting me the buyer get the current yield on bonds of similar time to maturity. It's an interesting idea to think of yield to maturity on the secondary bond market as being the sum of billions of compensatory gifts between 3rd parties. The effective paid interest is coming from an accounting method, not the 3rd party.  IRS Pub 550 says to treat AMD as interest, and TT does a good job of that on the Federal return. TT doesn't extend the treatment to the state return, maybe because many of the states are silent on AMD specifically, leaving ambiguity that made TT hesitant to implement the state treatment.  Don't forget that AMD, if you accrue as you go, doesn't appear in your bank account until maturity or sale, so it makes taxation at the state level even more vexing.  With the exception of NC, in all the threads on this topic, nobody AFAIK has provided a direct source to any state specifically denying tax-free treatment on Treasury accrued market discount.

At any rate, as stated in the Original Post, this thread is for people who intend to deduct AMD from their state income taxes and want ideas on how to get TT to do it. "How to", not "whether to".

[leviton11]

The ONLY state I have ever heard of is North Carolina.  And I think the Federal government should overturn that ruling because NC should NOT be allowed to tax income from obligations of the Federal government.  That violates Title 26 federal statute. 

[leviton11]

I completely agree with you.  There are lots of tax experts who also agree.  Interest income derived from investment in Federal obligations is exempt from being taxed at the state level. 

[CKONDO]

The problem is the way it is being phrased or looked at.

Certain states do not look at accrued market discount as "interest income derived from investment in Federal obligations". They look at that portion, because it is derived from a transaction with an individual, as NOT income related to the Federal obligation. Therefore taxable at the State level.

When I first commented on this I conferred with the individual who used to do my taxes (in CA). They said exactly what I said above and it was taxable at the CA State level. It was not an answer I wanted to get as it massively increased my taxes.

But other states may vary. I only live in CA so my investigation stopped there. And I have zero CA statutes or CA tax code references I can provide.

[leviton11]

It IS income related to a Federal obligation.  It does not matter that the bond was purchased on the secondary market.  The Federal statue treats the difference between purchase price and maturity price as Interest, not capital gains and Interest derived from Federal obligations is not supposed to be taxed by at the state level. 

[baldietax]

yes at this point the 'how' seems solved (leave Fed alone in TT, make a misc adjustment in state), if there is a different thread on 'whether' we can post the same arguments for and against doing it there.  There are similar hot threads on reddit, bogleheads etc on this same question.

It seems the answer could be different state by state, but some of the state tax codes are ambiguous and we're left with arguments as to what constitutes "interest" or not, and I understand the argument that AMD is not coming from the government etc.  I can also see why TT does not address this automatically in the software as they would have take a legal position on this for all states.

Notably per someone's comment on NC, seems they settled this explicitly in the courts - per NCDOR website "You cannot deduct distributions from United States obligations representing gain from the sale or other disposition of the securities" - https://www.ncdor.gov/interest-income-us-obligations

For VA the tax code explicitly refers to gain on sale that NC disallowed  ("Income derived from obligations, or on the sale or exchange of obligations, of the United States"); but OR does not use the same language ("Interest or dividends on obligations of the U.S. government.")

Notes are not necessarily issued at par so there should still be an OID component that should be state exempt it is not all market discount e.g. there is an auction of 4% 10-year notes issuing on Monday priced at 95.6 so if I buy that at say 96 on Tuesday from a broker isn't that all a government obligation...

Personally I am going to be buying higher coupon notes if available going forward to minimize this issue, meanwhile comfortable with the adjustment based on the VA tax code as written.  Sorry NC!

[bluepost22]

In reading the NC decision it seems the basis for their treatment of accrued market discount was lack of parity with how the IRS treats AMD on state tax exempt bonds. 

So it's probably worth reminding ourselves that if you buy a state tax exempt bond below par, the accrued market discount will be *taxable* on your Federal return.

Maybe the market adjusts for that in the pricing.  Don't know.