Zero-coupon bonds, or "zeroes," are bonds
that don't make interest payments in cash. Instead, you buy the bond at a
deep discount to face value. The value of the bond increases steadily as it
moves towards maturity, finally maturing at face value. You pay tax each
year on the "original issue discount," or OID--the interest accrued--even
though you get no cash distribution.
Your broker or
the bond issuer will report the amount of OID to include on your return with
Form 1099-OID. However, if you bought the bond at a premium (more than the
total of the issue price plus all accumulated OID), or your zero-coupon is a
"stripped" bond or coupon, you'll have to adjust the amount reported using
complicated rules set forth in
IRS Publication 1212, "List of Original Issue Discount Instruments."
Each year, as you report original issue discount, you add that amount to
your basis for figuring gain or loss on a sale. If you sell a zero-coupon
bond before maturity, you'll owe separate taxes on the portions representing
income and capital gains. The immediate tax bill on "phantom" income, along
with complicated rules for figuring how much income to report each year,
make taxable zero-coupons best suited for tax-deferred accounts. If you'd
like to use them in a taxable account, consider zero-coupon
Municipals Bonds.
