The IRS taxes debt instruments primarily by treating the interest they pay as ordinary income, reported in the year it becomes available to you and taxed at your regular federal rate, which runs from 10 to 37 percent in 2026.1Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates Layered on top of that baseline are separate rules for bonds bought at a discount or premium, for gains and losses when you sell, for a 3.8 percent surtax on investment income, and for below-market loans between related parties. Understanding how debt instruments are taxed by the IRS means working through each of those layers, because any one of them can change your effective return by several percentage points.
Interest as Ordinary Income
Interest from a corporate bond, bank CD, Treasury security, or private loan is ordinary income. You report it on your Form 1040 in the year you can access it, whether or not you actually take the cash out. If your total taxable interest exceeds $1,500 for the year, you have to attach Schedule B.2Internal Revenue Service. Instructions for Schedule B (Form 1040)
One preventable trap: if you don’t give your broker or bank a correct taxpayer identification number on Form W-9, the payor must withhold 24 percent of your interest and send it to the IRS as backup withholding.3Internal Revenue Service. Instructions for the Requester of Form W-9 (Rev. January 2026) You recover it as a credit at filing, but the cash is out of your hands until then.
Government Debt: The Built-In Breaks
Two types of government debt get preferential treatment that has nothing to do with your bracket.
Treasury bills, notes, and bonds are subject to federal income tax but exempt from state and local income tax.4Internal Revenue Service. Topic No. 403, Interest Received If you live in a high-tax state, that alone can add meaningful yield compared with a corporate bond paying the same coupon.
Municipal bonds go further. Under Section 103, interest on most state and local bonds is excluded from federal gross income entirely.5Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds You still have to report the tax-exempt interest on your return, because the IRS uses it to figure eligibility for certain credits and deductions, but you don’t pay federal tax on it. Municipal interest also stays out of the net investment income tax base, which matters once your income crosses the thresholds discussed further down.
Original Issue Discount
When a debt instrument is issued below its face value, the difference is original issue discount. A zero-coupon bond sold for $800 that redeems at $1,000 has $200 of OID baked in. The IRS treats that spread as interest and requires you to pick up a slice of it in income each year you hold the bond, using the constant yield method: the bond’s adjusted issue price at the start of each accrual period multiplied by its yield to maturity, minus any stated interest paid.6Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
The annual inclusion grows as the adjusted price climbs toward face value. Investors call it phantom income, because tax is due on money that hasn’t yet been paid. Each year’s inclusion also bumps up your basis in the bond, which reduces your gain when you eventually sell or redeem it. If your OID for the year hits at least $10, the issuer or brokerage sends you Form 1099-OID.7Internal Revenue Service. About Form 1099-OID, Original Issue Discount
Market Discount
Market discount is different. It arises when you buy a bond on the secondary market for less than its remaining redemption value. You don’t have to accrue it annually. The bill arrives when you sell, redeem, or otherwise dispose of the bond: any gain up to the accrued market discount is taxed as ordinary income, not capital gain.8Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income Partial principal payments trigger the same recharacterization to the extent they don’t exceed accrued discount.
You can elect to include market discount in income currently rather than defer it. Doing so raises your basis each year and avoids the ordinary income hit at sale, but once made the election covers every market discount bond you acquire from then on.
A de minimis rule helps with small discounts. If the discount is less than one-quarter of one percent of face value multiplied by full years remaining to maturity, it’s treated as zero, and gain within that range stays capital.9Office of the Law Revision Counsel. 26 USC Subchapter P, Part V, Subpart B – Market Discount on Bonds
Amortizable Bond Premium
If you paid more than face value for a taxable bond, usually because its coupon exceeds current market rates, Section 171 lets you elect to amortize the premium over the bond’s remaining life. Each year’s amortization amount directly offsets the interest income you’d otherwise report, dollar for dollar.10Office of the Law Revision Counsel. 26 USC 171 – Amortizable Bond Premium
The election is sticky. Once made, it applies to every taxable bond you hold and every one you buy later, and you can’t revoke it without IRS approval. Each year’s amortization also reduces your basis, so the reduction in reported interest today is partly paid back through a larger capital gain (or smaller loss) at sale. For investors in higher brackets, cutting ordinary income now generally beats deferring a capital gain later. You make the election by offsetting interest income on your return for the first year and attaching a statement.
Selling or Redeeming a Bond
When you sell before maturity or redeem at maturity, you compare the proceeds to your adjusted basis. That basis is what you paid, plus any OID already included in income, minus any premium you’ve amortized.11Internal Revenue Service. Instructions for Form 8949 Keeping that number correct is the fiddliest part of owning individual bonds.
Held more than a year, any gain above the market discount recapture is long-term capital gain. In 2026, long-term rates are 0 percent, 15 percent, or 20 percent depending on taxable income, with the 0 percent bracket ending at $49,450 for single filers and $98,900 for joint filers, and the 20 percent rate kicking in above $545,500 single or $613,700 joint.1Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates Held a year or less, the gain is short-term and taxed at ordinary rates.
A loss offsets capital gains dollar for dollar. Losses beyond your gains can offset up to $3,000 of ordinary income per year ($1,500 if married filing separately), with the excess carried forward indefinitely.12Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses You report the sale on Form 8949 and Schedule D.13Internal Revenue Service. Topic No. 409, Capital Gains and Losses
Wash Sales on Bonds
Section 1091 applies to “stock or securities,” and bonds are securities. If you sell a bond at a loss and buy a substantially identical one within 30 days before or after, the loss is disallowed.14Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities The disallowed loss shifts to your basis in the replacement bond, and your holding period carries over.15Internal Revenue Service. Publication 550, Investment Income and Expenses
Where bond wash sales differ from stock wash sales is what “substantially identical” means. Two bonds from the same issuer can carry different coupons, maturities, and credit terms, and tax advisors generally treat meaningfully different terms as not substantially identical. The IRS has not drawn a bright line, so switching issuers or moving to a materially different maturity is the safer approach when harvesting a loss.
The 3.8 Percent Net Investment Income Tax
Once your modified adjusted gross income clears a threshold, a 3.8 percent surtax applies to net investment income. The thresholds don’t adjust for inflation:
- $250,000 for married filing jointly or a qualifying surviving spouse
- $200,000 for single or head of household
- $125,000 for married filing separately
The tax is 3.8 percent of the lesser of your net investment income or the amount your MAGI exceeds the threshold.16Internal Revenue Service. Topic No. 559, Net Investment Income Tax
Taxable bond interest, capital gains from bond sales, and OID inclusions all count as net investment income. Municipal bond interest does not.17Internal Revenue Service. 18Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
The applicable federal rate for a demand loan is the short-term rate the IRS publishes monthly. For a term loan, it’s the rate on the day the loan was made, matched to the loan’s duration. As of April 2026, those rates are 3.59 percent short-term, 3.82 percent mid-term, and 4.62 percent long-term.19Internal Revenue Service. Rev. Rul. 2026-7 – Applicable Federal Rates
Two exceptions keep small loans out of these rules. Gift loans, compensation-related loans, and corporation-shareholder loans are exempt on any day the total outstanding balance between the same parties stays at or below $10,000, unless a principal purpose of the loan is tax avoidance. And for gift loans between individuals up to $100,000, the imputed interest the borrower is treated as paying back to the lender is capped at the borrower’s net investment income for the year; if that net investment income is $1,000 or less, it’s treated as zero.18Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
When a Debt Goes Bad
If someone owes you money on a genuine loan and the debt becomes uncollectible, you may deduct it as a nonbusiness bad debt. The IRS requires three things: the loan had to be a real loan at the outset rather than a disguised gift, the debt has to be totally worthless (no partial deductions on nonbusiness bad debts), and you must have taken reasonable collection steps, though you don’t have to sue if a judgment would clearly be uncollectible.20Internal Revenue Service. Topic No. 453, Bad Debt Deduction
You report a worthless nonbusiness bad debt as a short-term capital loss on Part 1 of Form 8949, no matter how long the debt was outstanding. Enter the debtor’s name, your basis in the debt, and zero for proceeds, and attach a statement describing the debt, the debtor, your relationship, the collection efforts, and why you concluded it was worthless. Because it’s a capital loss, it’s subject to the same $3,000 annual limit on offsetting ordinary income. Claim it in the year the debt becomes worthless, not the year it was originally due.
Foreign Bond Holdings
If any of your debt investments sit in a foreign account, two separate reporting regimes may apply on top of the tax rules above.
FBAR (FinCEN Form 114) is required when the combined value of all your foreign financial accounts exceeds $10,000 at any point during the year. It’s due April 15, with an automatic extension to October 15, and it goes to FinCEN rather than the IRS.21Internal Revenue Service. Report of Foreign Bank and Financial Accounts (FBAR)
FATCA (Form 8938) applies at higher thresholds and files with your return. For single U.S. residents, the trigger is $50,000 in foreign financial assets on the last day of the year or $75,000 at any point; for joint filers, $100,000 year-end or $150,000 at any point. Taxpayers living abroad get substantially higher limits.22Internal Revenue Service. Summary of FATCA Reporting for U.S. Taxpayers
The two overlap but don’t substitute for each other. Filing one does not satisfy the other, and penalties for missing either can be assessed even when no additional tax is owed.