Sunday, April 12, 2015

US taxation of Euro-dominated bonds bought at market discount

This was a lucky year for me, as my bet on Cyprus government bonds did pretty well. (It was clear to me that the Eurozone wouldn’t allow a government default, but would screw the Russian investors instead).

For Spain, the taxation is pretty straightforward: any interest received this year plus the difference between purchase and disposal (in my case, I bought at 90% and was redeemed at 100%) counts as regular old interest. It’s not exactly clear to me what happens if the bond is not in Euros.

For US citizens, things are more complicated:

  • The market discount (10%) can be either accrued throughout the year, or can be treated as a lump sum interest when you redeem the bond.
  • If you sold the bond before maturity, a part of the sale is treated as a capital gain/loss:
    • You calculate the yield taking into account the market discount to maturity.
    • You use this same yield to calculate the accrued interest between when you bought and sold the bond.
    • The capital gain is the different between the amount you sold it and the accrued interest in the market discount.
    • Essentially this rule is saying: if you bought an investment that yielded 10% (taking into account the interest and market discount), and the investment increases in price so that now it yields 5%, this difference is a capital gain.
  • If you held to maturity, don’t worry about that.
  • You convert the market discount at maturity back into USD. So for example, if you bought a bond at 900 euros and redeemed it at 1000, you would have 100 euros in interest income at redemption, converted into USD on the day of redemption (even if the Euro had a very different value when you bought it at 900 euros).

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