Bonds don't get as much attention in the investing world as stocks do, but they play an equally important function in investment portfolios. The predictable cash flows that bonds offer stand in stark contrast to the uncertain returns of stocks. Bonds have fixed dates on which the issuer can pay back the principal amount it owes, and when that happens, bondholders have to be prepared for the tax consequences. Below, we'll look more closely at how bond redemptions get taxed and how to calculate gain or loss.
Two kinds of bond redemptions
Bonds get paid back in two different ways. The most common is when a bond matures naturally. Every bond has a specified maturity date on which the bond issuer must repay the face value of the bond. On the date, bondholders have their bonds redeemed and receive a final cash payment.
The other type of bond redemption occurs before the stated maturity date. Some bonds have specific call provisions that allow the issuer to redeem the bond at specified dates prior to maturity at a stated price, which can be the same as or different from the bond's face value. In addition, companies sometimes do tender offers to buy back bonds on the open market, and when that happens, selling bondholders have their bonds redeemed in exchange for the agreed-upon payment.
Calculating gain or loss
In many cases, calculating the gain or loss on a bond redemption is fairly simple. If you take the redemption proceeds and subtract what you originally paid for the bond, then the difference will tell you the answer. If it's positive, then you have a gain. If it's negative, you've lost money on the bond.
Complicating the issue is that in some cases, your tax basis will be different from what you paid for the bond. For example, in bonds with what's known as original issue discount, the bondholder must claim a portion of the discount as taxable income each year. That income increases the tax basis in the bond, reducing the eventual gain upon redemption. In general, though, taking what you got in the redemption transaction and subtracting cost basis will give you your gain or loss.
Most bond investors choose their specific investments with the primary focus on finding ways to provide the regular income over the course of the bond's lifetime prior to maturity. Yet as important as interest income is, you also have to be prepared for what happens when the issuer redeems the bond. Otherwise, the tax consequences could take you by surprise.
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