How the IRS Taxes Zero-Coupon Bonds and Treasury Securities

The IRS taxes zero-coupon bonds on interest you never receive

A zero-coupon bond is a bond that pays no interest during its life. Instead, you buy it at a deep discount — sometimes 50 cents or less on the dollar — and the issuer pays you the full face value when it matures. The IRS treats the difference between what you paid and what you receive as taxable interest income, even though you don't get any cash until maturity.

This creates a tax problem: you owe federal income tax on interest that accrues each year, but you won't have the money to pay that tax until the bond matures. The IRS calls this accrued interest "original issue discount" or OID. You must report it as income on your tax return every year you hold the bond, regardless of whether you've received any money.

The amount of OID you report each year is not the same every year. It grows as the bond gets closer to maturity, following a mathematical formula called the constant yield method. The issuer or your broker will send you Form 1099-OID showing how much OID to report for that tax year.

Key Takeaways

You report zero-coupon bond interest as taxable income each year even though you receive no cash until the bond matures.
The IRS requires you to use the constant yield method to calculate how much interest to report each year, and your broker reports this on Form 1099-OID.
Tax-exempt zero-coupon bonds issued by states and municipalities are not subject to federal income tax on the accrued interest.
Holding zero-coupon bonds in a tax-deferred retirement account like an IRA or 401(k) avoids the annual tax bill until you withdraw money.

How the constant yield method calculates your annual tax bill

The constant yield method spreads the total discount across the years you hold the bond, but not evenly. Instead, it calculates interest on interest — the same way a savings account compounds. In the early years, you report less OID. In later years, as the bond value grows, you report more.

Here is a concrete example: suppose you buy a zero-coupon Treasury bond for $500 that will pay $1,000 at maturity in 10 years. The total discount is $500. Using the constant yield method, you might report $30 of OID in year one, $33 in year two, $36 in year three, and so on, with the amount growing each year. By year 10, you report roughly $60 of OID. The total across all 10 years adds up to $500.

Your broker calculates this for you and reports the amount on Form 1099-OID, which arrives by January 31 of the following year. You report this amount on your tax return for the year it accrues, not the year you receive the cash.

Tax-exempt zero-coupon bonds work differently

If you buy a zero-coupon bond issued by a state or local government — often called a municipal bond — the accrued interest is generally not subject to federal income tax. However, you still must report the OID on your tax return, even though it is not taxable. This is reported on Form 1099-OID as well, but marked as tax-exempt interest.

Some municipal zero-coupon bonds are also exempt from state and local income tax if you live in the state that issued them. The rules vary by state, so check with your broker or the bond issuer about your specific situation.

One important detail: if you sell a municipal zero-coupon bond before maturity for more than you paid, the gain may be subject to capital gains tax. The tax-exempt status applies only to the accrued interest, not to profits from selling the bond.

Holding zero-coupon bonds in retirement accounts avoids annual taxes

If you own a zero-coupon bond inside a traditional IRA, Roth IRA, 401(k), or other tax-deferred retirement account, you do not report the OID as income each year. Instead, the accrued interest grows tax-free inside the account. You pay tax on the money only when you withdraw it from the account — and only if it is a traditional account, not a Roth.

This is one reason zero-coupon bonds are popular in retirement accounts. They solve the cash-flow problem: you do not have to find money each year to pay taxes on interest you have not yet received. The bond sits in the account, accruing value, until you are ready to withdraw.

If you hold a zero-coupon bond in a taxable account (not a retirement account), you cannot avoid the annual tax bill. You must report the OID every year, even if you do not sell the bond and receive no cash.

What happens when you sell a zero-coupon bond before maturity

If you sell a zero-coupon bond before it matures, you may owe capital gains tax on the difference between what you paid and what you received. The IRS treats this as a capital gain or loss.

Here is how it works: suppose you bought a zero-coupon bond for $500 and reported $150 of OID over three years. Your cost basis is now $650 (the original $500 plus the $150 you reported as income). If you sell the bond for $700, your capital gain is $50. If you sell it for $600, you have a $50 capital loss.

The OID you reported in prior years increases your cost basis, which reduces any gain or increases any loss. This prevents you from being taxed twice on the same interest.

Form 1099-OID and reporting on your tax return

Your broker or the bond issuer sends you Form 1099-OID by January 31 each year you hold a zero-coupon bond. This form shows the amount of OID you accrued during that tax year. You report this amount on your federal tax return, typically on Schedule B (Interest and Ordinary Dividends) if you file Form 1040.

The form also shows whether the interest is taxable or tax-exempt. If it is tax-exempt, you still report it on your return, but it does not increase your taxable income. If it is taxable, it does increase your taxable income and may push you into a higher tax bracket.

If you do not receive a Form 1099-OID but you held a zero-coupon bond during the year, contact your broker. You are still required to report the OID even if the form is missing, so you may need to calculate it yourself or ask the issuer for the amount.

Treasury STRIPS and other government zero-coupon bonds

The U.S. Treasury issues zero-coupon bonds called STRIPS (Separate Trading of Registered Interest and Principal of Securities). These are created by taking regular Treasury bonds and separating the interest payments from the principal repayment, then selling each piece separately. STRIPS function exactly like other zero-coupon bonds: you buy them at a discount and receive the full value at maturity.

The OID on STRIPS is taxable federal income, just like any other zero-coupon bond. You report it on Form 1099-OID each year. However, STRIPS are exempt from state and local income tax, which is a benefit of holding Treasury securities.

Some investors buy STRIPS specifically for retirement accounts to avoid the annual tax bill on accrued interest. Others buy them in taxable accounts if they expect to be in a lower tax bracket in future years, though this requires careful planning.

Frequently Asked Questions

Do I have to pay taxes on zero-coupon bonds every year even if I don't sell them?

Yes. The IRS requires you to report the accrued interest (OID) as income each year you hold the bond, even if you never sell it and receive no cash until maturity. This is true for taxable accounts. In retirement accounts, you defer the tax until you withdraw money.

What is the difference between OID and capital gains on a zero-coupon bond?

OID is the interest that accrues each year and is reported on Form 1099-OID. Capital gains occur if you sell the bond for more than your adjusted cost basis (original price plus OID reported in prior years). Both are taxable, but they are reported separately on your tax return.

Can I deduct losses on zero-coupon bonds?

If you sell a zero-coupon bond for less than your adjusted cost basis, you have a capital loss. You can use capital losses to offset capital gains, and up to $3,000 of net capital losses can offset ordinary income in a single year. Unused losses carry forward to future years.

Are zero-coupon bonds issued by my state tax-exempt?

Municipal zero-coupon bonds are generally exempt from federal income tax on the accrued interest. Many are also exempt from state and local income tax if you live in the issuing state, but this varies. Check with your broker or the bond issuer about the specific tax treatment of the bond you own.

Why would anyone buy a zero-coupon bond in a taxable account if they owe taxes every year?

Some investors buy them if they expect to be in a lower tax bracket in future years, or if they are buying tax-exempt municipal zeros. Others use them for specific financial goals, like funding a child's college education years in the future. The annual tax bill is a real cost, so most investors prefer to hold zeros in retirement accounts when possible.

This guide is for general information only and is not medical, financial, legal, or other professional advice. For decisions specific to your situation, consult a qualified professional. See our Editorial Policy.