3.4.4.8.4. Zero Coupon Bonds
Treasury bills, Separate Trading of Registered Interest and Principal of Securities (STRIPS), and corporate zeros are all considered zero coupon bonds because they do not pay annual interest over the life of the bond. Instead, they are bought at a deep discount and mature at the bond’s par value. Even though the bond does not pay interest payments, the IRS considers the discount that the bond was bought at to be taxable interest. The taxpayer must divide the discount by the bond’s maturity to come up with the bond’s annual “phantom” interest. The bondholder will then pay taxes on this phantom interest at her ordinary tax rate. She will also adjust the cost basis of the bond by adding the annual phantom amount each year. This process is called accretion, and the adjusted cost basis of the bond will accrete (increase) until it is equal to the par value at maturity.
Example: Sally buys a $1,000 zero for $750. It will mature in five years. The amount of the discount is $250. Annual phantom income is $50 ($250 / 5 = $50). The adjusted cost basis will change according to the following schedule:
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