What tax implication faces investors with zero-coupon bonds?

What tax implication faces investors with zero-coupon bonds?

• A. Only capital gains tax applies upon sale
• B. The interest income is taxed each year
• C. No tax applies until maturity
• D. They are completely tax-exempt

Answer: (B)

Investors with zero-coupon bonds face the tax implication that the interest income is taxed each year, even though they do not receive any periodic interest payments. Zero-coupon bonds are issued at a discount to their face value and provide returns only at maturity when the bond's face value is paid to the investor. The Internal Revenue Service (IRS) treats the accretion of the bond's value as taxable interest income, accruing annually. This means that investors must report this imputed interest as income each year on their tax returns, which can result in a tax obligation despite the lack of cash flow until maturity. This tax treatment is essential for investors to understand as it affects their overall returns and tax planning strategies.

Investors with zero-coupon bonds face the tax implication that the interest income is taxed each year, even though they do not receive any periodic interest payments. Zero-coupon bonds are issued at a discount to their face value and provide returns only at maturity when the bond's face value is paid to the investor. The Internal Revenue Service (IRS) treats the accretion of the bond's value as taxable interest income, accruing annually. This means that investors must report this imputed interest as income each year on their tax returns, which can result in a tax obligation despite the lack of cash flow until maturity. This tax treatment is essential for investors to understand as it affects their overall returns and tax planning strategies.