Bond Funds: taxable income=actual income?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Bond Funds: taxable income=actual income?

Post by skanney »

Say I buy an out of state municipal bond fund (I live in NY). Say the underlying bonds have a coupon of 4.25% and a price of 104. Say they mature on average in 1 year and are held to maturity. Although the math is oversimplified, say the yield is 0.25%. At the state level, am I paying tax on the full 4.25% coupon income? If so, my tax rate is 17x the tax rate I should get on the 0.25% income. Somehow this doesn't strike me as fair.

If I am only paying tax on the 0.25%, what is the mechanism? Is the 4 point premium considered a capital loss? Is the 4 points paid out as a dividend considered a non-taxable return of capital? Would that be because the income earned at the company level is 0.25%, and anything over that is considered a return of capital? How does this work? Thanks.

Steve
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
ogd
Posts: 4876
Joined: Thu Jun 14, 2012 11:43 pm

Re: Bond Funds: taxable income=actual income?

Post by ogd »

While I don't know how it works with state laws, see http://www.pdxfis.com/taxable-bonds-pur ... a-premium/. I also don't know exactly what the rules are for funds, but I'd be very surprised if a fund specifically designed for tax efficiency did a boneheaded thing like paying too much interest upfront.
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

I found this in publication 550.
If you pay a premium to buy a bond, the premium is part of your basis in the bond. If the bond yields taxable interest, you can choose to amortize the premium. This generally means that each year, over the life of the bond, you use a part of the premium to reduce the amount of interest includible in your income. If you make this choice, you must reduce your basis in the bond by the amortization for the year.

If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year.
This is for federal tax, not NY state. Note that this comes into play at maturity, as redemption is a sale and you need the basis for your capital gain or loss.
A redemption or retirement of bonds or notes at their maturity generally is treated as a sale or trade.
I will let you read what NY says. Is a capital loss at the federal level also a capital loss at the NY level?
DSInvestor
Posts: 11647
Joined: Sat Oct 04, 2008 11:42 am

Re: Bond Funds: taxable income=actual income?

Post by DSInvestor »

skanney wrote:Say I buy an out of state municipal bond fund (I live in NY). Say the underlying bonds have a coupon of 4.25% and a price of 104. Say they mature on average in 1 year and are held to maturity. Although the math is oversimplified, say the yield is 0.25%. At the state level, am I paying tax on the full 4.25% coupon income? If so, my tax rate is 17x the tax rate I should get on the 0.25% income. Somehow this doesn't strike me as fair.
I'm not a bond expert but you're taxed on dollars not percentage. Say you buy a bond for $100 that pays 4.25%, that's $4.25. You pay tax on that $4.25 income. If you buy the same bond for $104, your yield to maturity is lower (because you paid a premium) but you're still getting $4.25 in income.
Wiki
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: Bond Funds: taxable income=actual income?

Post by grabiner »

When you buy a fund, the fund reports taxes in the same way you would, but based on when the fund bought the bond. If the fund bought the bond with a 4.25% yield at par, and the bond is now at a price of 104, a $104 investment in the fund will pay a $4.25 dividend for a 4.09% distribution yield (and the remaining $4 will become a capital loss if the bond is held to maturity, which will reduce either the share price or the capital gain distribution).
Wiki David Grabiner
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

ok, so the maturity of a BOND is treated as a sale. This actually forces NY and the IRS to have different systems of taxing bonds. If I amortize the premium, then my basis is lower at the IRS. In the mean time, NYS does not allow premium amortization unless I itemize taxes. So when the bond matures, it has a different basis for federal and state purposes. I didn't think we were allowed to have different systems of taxation.

But then the bond in the mutual fund may or may not be treated as a sale when it matures. Mutual fund rules may be different than individual rules. If that were the case, then the mutual fund would use the NYS system of taxation.
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

I missed the fund part. My mistake.
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

grabiner wrote:When you buy a fund, the fund reports taxes in the same way you would, but based on when the fund bought the bond. If the fund bought the bond with a 4.25% yield at par, and the bond is now at a price of 104, a $104 investment in the fund will pay a $4.25 dividend for a 4.09% distribution yield (and the remaining $4 will become a capital loss if the bond is held to maturity, which will reduce either the share price or the capital gain distribution).
Is it considered a return of capital (which would reduce the cost basis) or a reduction in capital gain? If there is no capital gain to offset, I would assume the $4 capital loss does not reduce taxes at all...
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: Bond Funds: taxable income=actual income?

Post by grabiner »

skanney wrote:
grabiner wrote:When you buy a fund, the fund reports taxes in the same way you would, but based on when the fund bought the bond. If the fund bought the bond with a 4.25% yield at par, and the bond is now at a price of 104, a $104 investment in the fund will pay a $4.25 dividend for a 4.09% distribution yield (and the remaining $4 will become a capital loss if the bond is held to maturity, which will reduce either the share price or the capital gain distribution).
Is it considered a return of capital (which would reduce the cost basis) or a reduction in capital gain? If there is no capital gain to offset, I would assume the $4 capital loss does not reduce taxes at all...
It shows up in the fund share price; it won't be distributed as a return of capital. If there are no capital gains, the $4 won't affect your taxes this year unless you sell the fund yourself and take a $4 capital loss. (However, the $4 capital loss can be carried over; if the fund has $5 in capital gains the next year, it offsets them with the $4 loss and distributes $1 rather than $5.)
Wiki David Grabiner
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

ok, so say if the bond matures in 2 years instead of 1, I get the capital loss of $4 in year 2. If I owned the bond outright, I would get the $4 as premium amortization split between year 1 & 2. So the difference is one of timing only, but I get the complete tax deduction eventually.
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
#Cruncher
Posts: 3977
Joined: Fri May 14, 2010 2:33 am
Location: New York City
Contact:

Re: Bond Funds: taxable income=actual income?

Post by #Cruncher »

Your tax is based on whatever ordinary dividends the fund distributes, skanney. And it will distribute as an ordinary dividend whatever is its interest income. grabiner is correct that the interest income of the 4.25% bond will depend on the price the fund paid for it. For example, if it bought it at par sometime in the past, then the entire 4.25% coupon will be interest income and will be distributed. However, if it bought the bond today at the current market price of 104%, then the interest income over the final year would be only 0.25% (4.25% coupon less amortization of the 4% purchase price premium).

Here is a comparison of that portion of the fund represented by $100 face value of the bond in question. The "Par" case assumes the bond was bought at a price of 100%. The "Prem" case assumes it was bought at a premium price of 104%.

Code: Select all

  Par     Prem
------   ------
104      104       Net Assets at beginning of year (market value of bond)
  4.25     4.25    Coupon interest collected
  0.00    (4.00)   Amortization of Purchase Premium
  4.25     0.25    Interest income distributed
100      100       Cash from Redemption
100      104       Net Assets at end of year (cash)
In the Par case, the fund distributes $4.25 and loses $4.00 in net assets. * In the Prem case it distributes only $0.25 but loses nothing in net assets because $4.00 of the coupon interest it receives offsets the decline from $104 market value of the bond at the beginning of the year to the $100 redemption.

By the way, the dependence of interest income and dividend distributions on the price the fund pays for a bond is the same for all types of bonds the fund holds. I.e., it would apply to Treasury or corporate bonds as well as municipal bonds.

* grabiner is incorrect in saying this $4.00 reduction might reduce any capital gain distributions the fund makes. Since the fund paid $100 for the bond, it will have no gain or loss when it is redeemed for $100. Thus any other capital gains or losses it might have will be unaffected.
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

From what I am getting, grabiner says the $4 is a reduction in capital gains and #cruncher says it is amortized and not recorded as dividend income. Is that right?
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: Bond Funds: taxable income=actual income?

Post by grabiner »

skanney wrote:From what I am getting, grabiner says the $4 is a reduction in capital gains and #cruncher says it is amortized and not recorded as dividend income. Is that right?
#Cruncher is correct here. Since the fund paid $100 for the bond, not $104, the fund has no capital gain or loss when it redeems the bond for $100 at maturity. The share price of the fund will drop by 4% as the bond's current value drops from $104 to $100, so you won't get a benefit from the decline unless you sell the fund yourself for a capital loss.
Wiki David Grabiner
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

but my question is really if the fund bought the bond at 104. I was under the impression dividends were strictly the coupon income. but #cruncher seems to be saying no.
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: Bond Funds: taxable income=actual income?

Post by grabiner »

skanney wrote:but my question is really if the fund bought the bond at 104. I was under the impression dividends were strictly the coupon income. but #cruncher seems to be saying no.
And this is correct. Funds have to follow the same accounting practices as individuals when they buy and sell bonds, passing through any tax costs (however, you can't deduct a fund's capital losses, only use them to offset capital gains in the same fund). Thus, you must pay tax on a capital gain when the fund sells a bond for a profit, and you pay tax on amortized premiums and discounts the same way the fund does.
Wiki David Grabiner
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

Since it is a tax exempt fund, there is no deduction of the amortization against income for the fund, just as there is not for an individual.
This amortized amount is not deductible in determining taxable income.
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

grabiner wrote:
skanney wrote:but my question is really if the fund bought the bond at 104. I was under the impression dividends were strictly the coupon income. but #cruncher seems to be saying no.
And this is correct. Funds have to follow the same accounting practices as individuals when they buy and sell bonds, passing through any tax costs (however, you can't deduct a fund's capital losses, only use them to offset capital gains in the same fund). Thus, you must pay tax on a capital gain when the fund sells a bond for a profit, and you pay tax on amortized premiums and discounts the same way the fund does.
If a fund pays tax the same way as I do, then the dividend is not strictly coupon income. The dividend is what is reported as taxable income for an out of state municipal bond in NY. The way I pay income if I itemize deductions in NY, and the way I pay federal taxes is to amortize the premium and report taxable income as dividends net of such amortization. Then when the bond matures, the cost basis is the same as the maturity value. There seems to be an internal contradiction in what you are telling me.

Does anyone know where I can find the instructions in the tax code directly? Thanks.
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

Re: Bond Funds: taxable income=actual income?

Post by grabiner »

skanney wrote:
grabiner wrote:
skanney wrote:but my question is really if the fund bought the bond at 104. I was under the impression dividends were strictly the coupon income. but #cruncher seems to be saying no.
And this is correct. Funds have to follow the same accounting practices as individuals when they buy and sell bonds, passing through any tax costs (however, you can't deduct a fund's capital losses, only use them to offset capital gains in the same fund). Thus, you must pay tax on a capital gain when the fund sells a bond for a profit, and you pay tax on amortized premiums and discounts the same way the fund does.
If a fund pays tax the same way as I do, then the dividend is not strictly coupon income. The dividend is what is reported as taxable income for an out of state municipal bond in NY. The way I pay income if I itemize deductions in NY, and the way I pay federal taxes is to amortize the premium and report taxable income as dividends net of such amortization. Then when the bond matures, the cost basis is the same as the maturity value. There seems to be an internal contradiction in what you are telling me.
And the fund does the same thing. If a fund buys a bond at a premium, it distributes the coupon minus the amortization, not the full coupon.
Wiki David Grabiner
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

If a fund buys a bond at a premium, it distributes the coupon minus the amortization, not the full coupon.
I spoke with the etf guys at spdrs. They went back to their tax people and told me that is exactly incorrect. The dividend is precisely the coupon income and they write off the premium as a capital loss at maturity. If they sell it before a maturity, they take it as a capital loss or gain at that time. I am not sure where you are getting your information from...
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

Say I buy an out of state municipal bond fund (I live in NY).
What part of you don't get to deduct amortization on a muni-bond (or fund) am I reading incorrectly?
If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year.
Basis is not income. You do the basis, but you don't do the income. That's how I read for the feds. I have no idea what NY does.

What if 15% of the assets of the fund are in NY bonds, and 10% of the income comes from NY?
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

sscritic,

your entire thrust is for federal tax. this question is about out of state municipal bonds for state tax purposes in nys.
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

So let's concentrate on NY. A bond fund incorporated in Delaware buys a California state bond at 104. How does NY tax the Delaware corporation on its income from that bond as opposed to all the other bonds that it holds? Is that your question?
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

So let's concentrate on NY. A bond fund incorporated in Delaware buys a California state bond at 104. How does NY tax the Delaware corporation on its income from that bond as opposed to all the other bonds that it holds? Is that your question?
Not exactly. The fund (Delaware Corporation) should not be taxed by NY or the IRS. Taxes should be passed through to the owner's, which in this case is a NY resident.

So I understand the coupon income from the California bond purchased by the fund at 104 will be distributed as dividend income and taxed by NY as an out of state municipal income. What happens to the 4 point premium? It is a real economic loss. How is it accounted for from a tax standpoint by NY?
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
User avatar
#Cruncher
Posts: 3977
Joined: Fri May 14, 2010 2:33 am
Location: New York City
Contact:

Re: Bond Funds: taxable income=actual income?

Post by #Cruncher »

skanney wrote:
grabiner in [url=http://www.bogleheads.org/forum/viewtopic.php?p=1977224#p1977224]this post[/url] wrote:If a fund buys a bond at a premium, it distributes the coupon minus the amortization, not the full coupon.
I spoke with the etf guys at spdrs. They went back to their tax people and told me that is exactly incorrect. The dividend is precisely the coupon income and they write off the premium as a capital loss at maturity. ... I am not sure where you are getting your information from...
If what the fund company says is correct, then what grabiner and I (in this post) have said is wrong. However, I don't see how what you heard from the fund can be correct. It contradicts what sscritic, in this post quoted from IRS Publication 550 - Bond Premium Amortization:
If the bond yields tax-exempt interest, you must amortize the premium. ... each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year. (underline added)
If the IRS were to allow the fund to ignore the above rule and to not amortize the premium, ordinary dividends would be increased and capital gain dividends would be decreased by equal amounts. Since the former are tax-exempt, while the latter are taxable, the IRS would end up collecting less tax.
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

#cruncher,

a mutual fund will report dividends, capital gains, etc based upon mutual fund taxation (I think section M of the IRC). Publication 550 is for individuals. It is not relevant.
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

skanney wrote:#cruncher,

a mutual fund will report dividends, capital gains, etc based upon mutual fund taxation (I think section M of the IRC). Publication 550 is for individuals. It is not relevant.
A 1 M I (Subtitle, Chapter, Subchapter, Part)
http://www.law.cornell.edu/uscode/text/ ... r-M/part-I
An exempt-interest dividend shall be treated by the shareholders for all purposes of this subtitle as an item of interest excludable from gross income under section 103 (a).
But as you say, this is irrelevant to what NY taxes. What have you found in the NY code?
a) General. The New York adjusted gross income of a resident individual means his federal adjusted gross income as defined in the laws of the United States for the taxable year, with the modifications specified in this section. (b) Modifications increasing federal adjusted gross income. There shall be added to federal adjusted gross income: (1) Interest income on obligations of any state other than this state, or of a political subdivision of any such other state unless created by compact or agreement to which this state is a party, to the extent not properly includible in federal adjusted gross income;
...
(5) Expenses paid or incurred during the taxable year for (i) the production or collection of income which is exempt from tax under this article, or (ii) the management, conservation or maintenance of property held for the production of such income, and the amortizable bond premium for the taxable year on any bond the interest on which is exempt from tax under this article, to the extent that such expenses and premiums are deductible in determining federal adjusted gross income.
...
(10) Ordinary and necessary expenses paid or incurred during the taxable year for (i) the production or collection of income which is subject to tax under this article but exempt from federal income tax, or (ii) the management, conservation or maintenance of property held for the production of such income, and the amortizable bond premium for the taxable year on any bond the interest on which is subject to tax under this article but exempt from federal income tax, to the extent that such expenses and premiums are not deductible in determining federal adjusted gross income and are attributable to a trade or business carried on by the taxpayer.

The version of the code I can find is practically unreadable, as no one has ever heard of a paragraph or a line feed. But still, I have to ask, is your trade or business trading municipal bonds?
Topic Author
skanney
Posts: 40
Joined: Fri Dec 21, 2012 1:42 pm
Contact:

Re: Bond Funds: taxable income=actual income?

Post by skanney »

A 1 M I (Subtitle, Chapter, Subchapter, Part)
http://www.law.cornell.edu/uscode/text/ ... r-M/part-I
An exempt-interest dividend shall be treated by the shareholders for all purposes of this subtitle as an item of interest excludable from gross income under section 103 (a).
I found this and suspect it contains the answer to my question, but I couldn't make heads or tails of it.

In NY the instructions for MUTUAL FUNDS say:"New York additions
Line 20 – Interest income on state and local
bonds and obligations
Do you have interest income from state and local bonds and
obligations from states other than New York State or its local
governments? If No, go to line 21.
If Yes, enter any such interest income that you received or that
was credited to you during 2013 that was not included in your
federal AGI. This includes interest income on state and local
bonds, interest and dividend income from tax-exempt bond
mutual funds, and tax-exempt money market funds that invest in
obligations of states other than New York."

I am sure capital gains for mutual funds are handled as any. Therefore, if I know what goes into dividend reporting and what goes into capital gains reporting, I understand the full accounting.

I understand what it is like to look at the NYS code. Try using search on your browser...helps a lot...
All discussion is designed to educate so you can make your own decisions; no investment advice is given.
sscritic
Posts: 21853
Joined: Thu Sep 06, 2007 8:36 am

Re: Bond Funds: taxable income=actual income?

Post by sscritic »

skanney wrote: Try using search on your browser...helps a lot...
How do you think I found the two uses of the word amortization and the two uses of the word amortizable? Try amort.
Post Reply