Tax reporting of US Treasury Securities bought on the secondary market

[TurboLover2 · Accepted solution]

==UPDATE==

Having seen no response to my post below I am marking it (my own answer) as the best answer.

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I am again questioning whether the answers given to my question are correct. 

From IRS Publication 550:

"Market Discount Bonds
A market discount bond is any bond having
market discount except:
• Short-term obligations (those with fixed
maturity dates of up to 1 year from the date
of issue),
• Tax-exempt obligations you bought before
May 1, 1993,
• U.S. savings bonds, and
• Certain installment obligations.
Market discount arises when the value of a
debt obligation decreases after its issue date.
Generally, this is due to an increase in interest
rates. If you buy a bond on the secondary market, it may have market discount."

THEN IT SAYS:

"When you buy a market discount bond, you
can choose to accrue the market discount over
the period you own the bond and include it in
your income currently as interest income. If you
do not make this choice, the following rules
generally apply.
• You must treat any gain when you dispose
of the bond as ordinary interest income, up
to the amount of the accrued market discount. See Discounted Debt Instruments

..."

https://www.irs.gov/pub/irs-pdf/p550.pdf 

see pages 14 and 15

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So this is a "Market Discount Bond" and according to how I read the IRS rule relating to market discount bonds the gain is treated as ordinary interest income, NOT as a capital gain.

So it appears to me the answers that were given in this thread are incorrect.  And also, since the gain is treated as ordinary interest income that the state tax income exemption is preserved.

I welcome any correction or validation of my understanding but it appears to me that the previous answers were wrong.

[TurboLover2]

Double post removed by poster.

[Ninehalo]

Page 12 says that the market discount portion of a tax exempt bond is not tax exempt.

Possibly that means the state tax exemption would not be valid for the market discount portion (ie the gains to sales or redemption value as opposed to those from the coupon payments).  Maybe the answer to that is in your state tax code. 

[Ninehalo]

It also looks like, if you DO make the choice to accrue the value of your market discount annually as income, and then you sell your note before maturity, it’s a capital gain.  Per page 50. 

[ChristoKane]

Yes it wipes out the benefit of state exemption for income tax but my question is if it is then a capital gain rather than income doesn't this provide an even greater benefit to investors in the highest tax brackets?  For example me in Colorado would not get exemption from 4.4% state income tax.  However, because my marginal federal income tax bracket is the highest (37%) and instead I am paying capital gains (20%) I am actually way better off with this treasury note bought on the secondary market and below par, that I held for over a year because it is now long term capital gain.  The reason being I now pay 17% less taxes on the capital gain than I would have if it was treated as income (37-20=17).  Is this correct?

Also much thanks for this chain. very informative

[megank1]

When you hold til maturity, how you report that depends on how big or small is your market discount. Go search "de minimis".