Taxation of Income

• Generally, the interest on a bond is taxable at ordinary income rates. Bond interest does not qualify for the more favorable long-term capital gains rates. Investors who are in very high tax brackets tend to seek to limit their exposure to bonds, except for municipal bonds, which are exempt from federal taxes.
  
  

Taxation of Capital Gains

• While the interest on a bond is generally taxable as income, the changes in a bond price are not. There is usually no tax liability on a bond if the bond price should rise in value until the investor sells it. At that time, the bond owner is potentially liable for a capital gains tax. If the bond was held for less than 12 months, it has generated a short-term capital gain which is usually taxed at ordinary income rates. If the bond was held for more than 12 months, the bond owner has generated a long-term capital gain, which qualifies for a lower tax rate under current law, as of 2010.
  
  

Offsetting Gains and Losses

• If a taxpayer sells a bond at a profit, he can offset his capital gain by selling another investment at a loss. There is no limit to the amount of gains that can be offset by capital losses, but the bond owner cannot repurchase bonds sold at a loss with the same or substantially identical debt security for at least 30 days from the sale. Otherwise, he will have violated "wash sale" rules and the IRS will disallow the loss. You can also claim capital losses on bond sales even when you don't have capital gains to offset. In this case, you can offset up to $3,000 per year in income taxes. However, you can carry forward your losses: If you sell bonds at a $9,000 loss, you can deduct up to $3,000 per year in ordinary income over the next three years, for example.
  
  

Original Issue Discount Bonds

• If you buy a bond at a steep discount, such as a zero coupon bond, you are taxed on "imputed interest," even though you don't receive the cash directly. For example, if you buy a $10,000 zero coupon bond, maturing in 10 years, for $5,000, you are taxed on the income the bond would have paid if it did pay annual interest payments to generate an equivalent return.
  
  

Alternative Minimum Tax Considerations

• While municipal bonds are generally free of federal income tax, certain kinds of municipal bonds, called "private activity bonds," do not qualify for tax-free treatment under alternative minimum tax rules. If you are subject to the alternative minimum tax, you will have to pay taxes on any income generated by these kinds of debt securities.