If you own a debt instrument such as a bond, you will of course include the interest income from the instrument in your income for tax purposes. But what happens if you sell the debt before the next interest payment date, with accrued interest that you do not receive?
For income tax purposes, you must include the amount of interest that accrued up to the date of the sale. Typically, this is not problematic since the purchaser of the debt should compensate you for that interest by way of an increased purchase price (i.e. more than the debt’s face value). However, since the purchaser will be required to include in income the full amount of interest to the next interest payment date, the purchaser can deduct the interest accrued to the time of purchase.
Example
You own a bond with a principal amount of $100,000, carrying an annual simple interest rate of 3%, payable on December 31 of each year. You sell the bond on June 30 for $101,500. The purchaser receives $3,000 of interest on December 31.
You must include $1,500 as interest income that you are deemed to have received. The purchaser will include $3,000 but can deduct the $1,500 that accrued to the time of sale, for a net inclusion of $1,500 of interest income.
The above example was straightforward, because the amount paid by the purchaser exactly equaled the principal amount of the loan plus the accrued interest. But typically, the value of the bond will fluctuate as market interest rates fluctuate. If market interest rates increase, the value of the bond will normally decrease. Conversely, if market interest rates decrease, the value of the bond will normally increase. As a result, on the sale of the bond, in addition to the included interest, you will usually have a capital gain or loss.
Example
Assume the same facts as above, except that market interest rates have decreased so that the value of your bond has increased. Accordingly, the purchaser pays you $102,000.
As above, you will include the $1,500 interest that accrued to the time of sale. The remaining $100,500 of proceeds ($102,000 net of $1,500 interest) will be your proceeds of disposition for capital gains purposes. Assuming your cost of the debt was $100,000, you will also have a $500 capital gain, and half of that, or $250, will be included in your income.
The purchaser’s interest treatment will be as in the earlier example. The purchaser’s cost of the debt will be $100,500 (the $102,000 paid net of the accrued interest to the time of sale).