Taxes From A To Z (2017): J Is For Junk Bonds

It’s my annual “Taxes from A to Z” series! If you’re wondering whether you can claim wardrobe expenses or whether to deduct a capital loss, you won’t want to miss it.

J Is For Junk Bonds.

Let’s start with the basics: junk bonds are bonds. Bonds are promises to pay back money that you lend to a company or organization (the borrower) in exchange for interest. What sets junk bonds apart from regular bonds is that they are issued by borrowers who are considered a credit risk (those with a credit rating of BB or lower). Since there’s a higher chance of default, meaning that you might not get your money back, the borrower agrees to pay a higher yield (interest) in exchange for your taking a chance on their bad credit. What makes junk bonds appealing is that higher yield.

Junk bonds are generally taxed just like regular bonds. When you receive interest from the borrower, you’ll report the interest on your federal income tax return at line 8a (or 8b if it’s tax-exempt interest); you may also need to complete a Schedule B, Interest and Ordinary Dividends (downloads as a PDF).

Taxable interest is taxed as ordinary income.

Since junk bonds tend to throw off more income than regular bonds, investors like to stash them away in tax-deferred accounts. Remember, however, that junk bonds are more of an investment risk: counting on them for retirement can be risky. Be sure to check with your financial advisor before making such a move.

When you buy a bond, you agree that you’ll redeem the bond when it matures. If you sell it (or otherwise dispose of it) before the redemption date, you may have a capital gain or loss.

If you sell or dispose of a bond at a profit and you’ve owned it less than a year, you have a short term gain (if you sell or dispose of a bond at a loss, it’s a short term loss). Short term capital gains are taxed as ordinary income, just like interest.

If you sell or dispose of a bond at a profit and you’ve owned it more than a year, you have a long term gain (if you sell or dispose of a bond at a loss, it’s a long term loss). There are three long term capital gains brackets, depending on your tax bracket: 0%, 15% and 20%.

You can typically net gains and losses against each other – that’s sometimes called harvesting losses. However, if your losses exceed your gains, you can offset up to $3,000 of losses against your ordinary income. If you have capital losses which total more than $3,000, your losses are limited but you can carry the excess forward to other tax years.

The tax treatment of bonds can be tricky, depending on the terms and the kind of bonds. They can be especially complicated to report if you bought the bond for less than face value and Original Issue Discount (OID) is involved. If you’re not sure how to report a bond at redemption or disposition, check with your tax professional.

For more Taxes A to Z, check out: