Interest income is not taxed at capital gains rates. The IRS treats interest, whether it comes from a savings account, a CD, a corporate bond, or a personal loan, as ordinary income at your marginal rate, which runs up to 37% federally. Capital gains rates only enter the picture when you sell the underlying asset, such as a bond, for more than you paid. The same bond can produce both kinds of taxable income in the same year, and they are reported and taxed separately.
Why Interest Is Ordinary Income
Federal tax law lists interest as a category of gross income alongside wages, dividends, and business profits.1Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined Interest is compensation for lending your money, and the code taxes it the way it taxes your paycheck: stacked on top of your other income and hit at whatever bracket the total lands in.
For 2026, ordinary rates run from 10% to 37% across seven brackets. Long-term capital gains, by contrast, are taxed at 0%, 15%, or 20% depending on income.2Internal Revenue Service. Topic No. 409, Capital Gains and Losses The gap is large enough that people sometimes assume interest must somehow qualify for the friendlier rate. It doesn’t. The periodic payments you collect from a bond, note, or deposit account are ordinary income every year they land in your account.
When Selling a Bond Creates a Capital Gain
A bond itself is a capital asset. Federal law defines capital assets broadly, with specific carve-outs like inventory and business receivables that don’t cover investment bonds.3Office of the Law Revision Counsel. 26 U.S. Code 1221 – Capital Asset Defined So if you sell a bond on the secondary market for more than you paid, that profit is a capital gain, reported separately from any interest the bond paid you along the way.
A simple example. You buy a corporate bond for $1,000. Over two years you collect coupon payments; those are ordinary interest. Rates then drop, your fixed coupon looks attractive, and you sell for $1,100. The $100 profit is a capital gain. Because you held the bond more than a year, it’s long-term and taxed at the preferential rate.4Office of the Law Revision Counsel. 26 U.S.C. 1222 – Long-Term and Short-Term Capital Gains and Losses Defined Sell within a year of purchase and the gain is short-term, taxed at ordinary income rates.2Internal Revenue Service. Topic No. 409, Capital Gains and Losses
This is the clean case. The tax code has two important places where it deliberately pulls what looks like a bond gain back into ordinary income territory.
Original Issue Discount
Some bonds are issued below face value. A zero-coupon bond might sell for $800 with $1,000 payable at maturity. That $200 gap is an original issue discount, or OID.5Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount It looks like a capital gain waiting to happen at maturity. It isn’t. The IRS treats OID as interest, because it functions as prepaid compensation for the loan.
You also don’t get to wait until maturity to pay. Federal law makes you report a portion of the OID as ordinary income each year, using a constant-yield method that accounts for compounding.6Office of the Law Revision Counsel. 26 U.S.C. 1272 – Current Inclusion in Income of Original Issue Discount Investors call this phantom income: a real tax bill on money that hasn’t arrived. Each annual accrual increases your cost basis in the bond, so you’re not taxed twice if you sell before maturity.
A small exception: if the discount is less than one-quarter of one percent of face value multiplied by the number of full years to maturity, the IRS treats it as zero.5Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount On a 10-year bond, the discount has to exceed 2.5% of face value before annual OID reporting kicks in. Below that, any gain at maturity or sale gets capital gains treatment.
Market Discount
Buying a bond on the secondary market below its face value creates a related but distinct problem. Say you pay $950 for a $1,000 face-value bond and hold it to maturity. The intuitive answer is that the $50 is a capital gain. Usually it isn’t.
Federal law reclassifies gain on a market discount bond as ordinary income up to the amount of accrued market discount.7Office of the Law Revision Counsel. 26 U.S.C. 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income Only profit above the accrued discount qualifies for capital gains treatment. The statute treats that reclassified gain as interest for most purposes. This catches investors off guard because the transaction feels like a sale at a profit, and the paperwork often looks like one until the discount rule is applied.
Accrued Interest When Bonds Change Hands
Most bonds pay interest on a fixed schedule, often every six months. When a bond is sold between payment dates, the price includes accrued interest, the amount built up since the last coupon. This creates a reporting quirk.
If you sell, that accrued interest portion is ordinary interest income to you, even though it arrived as part of the sale price rather than as a separate coupon. If you buy and pay accrued interest to the seller, you can subtract that amount when you collect the next full interest payment, because you’re reimbursing the seller for time they held the bond rather than earning new income.8Internal Revenue Service. Instructions for Schedule B (Form 1040) Skipping the adjustment means paying tax on what was really a return of your own purchase cost.
Interest That Escapes Federal Tax
Two categories of interest sit outside the ordinary-income rule, and they matter enough to note even in an article focused on how interest is taxed.
Interest on bonds issued by state and local governments is generally excluded from federal gross income.9Office of the Law Revision Counsel. 26 U.S.C. 103 – Interest on State and Local Bonds Residents of the issuing state often escape state tax too. The exemption has edges: interest on certain private activity bonds can trigger the alternative minimum tax, and if you sell a municipal bond at a profit, that gain is a taxable capital gain like any other. Municipal interest also counts toward the modified AGI figure the IRS uses to decide whether your Social Security benefits are taxable.
Interest on U.S. Treasury bills, notes, and bonds is fully federally taxable but exempt from state and local income tax.10Office of the Law Revision Counsel. 31 U.S.C. 3124 – Exemption From Taxation The same treatment applies to U.S. savings bonds and debt issued by certain federal agencies, such as the Tennessee Valley Authority and Federal Home Loan Banks.
The 3.8% Net Investment Income Tax
High earners face an additional 3.8% surtax on net investment income, which includes both interest and capital gains from bond sales. The tax applies when modified adjusted gross income exceeds:11Office of the Law Revision Counsel. 26 U.S.C. 1411 – Imposition of Tax
- $250,000 for married filing jointly
- $200,000 for single or head of household
- $125,000 for married filing separately
The 3.8% applies to whichever is smaller: your total net investment income or the amount your income exceeds the threshold. A single filer with $220,000 of modified AGI and $50,000 of investment income owes the tax on $20,000, not on the full $50,000. The thresholds aren’t indexed for inflation, so more taxpayers cross them each year.
Losses on Bond Sales
When a bond sale produces a loss, you can offset capital gains from other investments dollar for dollar. If losses exceed gains for the year, you can deduct up to $3,000 of the excess against ordinary income ($1,500 if married filing separately).2Internal Revenue Service. Topic No. 409, Capital Gains and Losses Unused losses carry forward indefinitely.
Watch the wash sale rule. If you sell a bond at a loss and buy a substantially identical security within 30 days before or after the sale, you cannot claim the loss.12Office of the Law Revision Counsel. 26 U.S.C. 1091 – Loss From Wash Sales of Stock or Securities The disallowed loss gets added to the basis of the replacement security, so the tax benefit is deferred rather than lost. The window runs in both directions, giving you a 61-day period to keep in mind.
How This Gets Reported
Financial institutions send you separate forms for interest and for bond sale proceeds, and the IRS receives its own copies. Both usually arrive in late January or early February.
Form 1099-INT reports taxable interest of $10 or more, with tax-exempt interest listed separately.13Internal Revenue Service. About Form 1099-INT, Interest Income Form 1099-B reports proceeds from bond sales, along with your cost basis and sale date, which you use to figure the capital gain or loss and whether it’s long-term or short-term.
If your taxable interest or ordinary dividends exceed $1,500 for the year, you file Schedule B with your return, listing each payer and the corresponding amount.8Internal Revenue Service. Instructions for Schedule B (Form 1040) Interest goes on that schedule regardless of whether the payer sent a 1099; you’re required to report interest income whether or not you receive a form.
The practical takeaway across all of this: interest and bond sale gains live in two different tax boxes, they’re taxed at different rates, and several rules push what looks like a gain back into the interest box. Treating them as one thing on your return is the fastest way to either overpay or draw an IRS notice.