Taxation of TIPS

Treasury Inflation Protected Securities are designed to protect the investor from inflation.

TIPS have a stated maturity date and pay a fixed coupon rate. The principal amount is adjusted daily by factoring in the Consumer Price Index (CPI). Since the coupon is paid on the outstanding principal value, the semi-annual payments will fluctuate as well. Increases in consumer prices are reflected in higher principal and interest payments to TIPS holders.

Semi-annual interest payments on TIPS are subject to federal income tax. However, increases in a TIPS principal value, as a result of inflation adjustments, are also taxed as income in the year they occur, even though those increases are not realized until the TIPS are sold or mature. This is known as taxation of “Phantom Income.”

In periods of high inflation, for high-tax-bracket investors (if purchased in taxable accounts) TIPS may result in a negative after-tax cash flow as the increase in principal value will exceed the net coupon payments.

When the TIPS matures, the principal of the bond will be higher than the purchase price of the bond (assuming that inflation is positive over that time).

My question concerns the taxation of the change in principal, both the annual “Pantom Income” and the return of principal at maturity.

Is this considered interest income or capital gains?

Wendy

1 Like

It would depend on the accounting methodology used to calculate the value of other assets when filing taxes. Nothing prevents the use of “constant value dollars” to value assets–if using the same valuation methodology for any other assets on the same tax return. So it might make sense to have the TIPS in a separate tax entity for that purpose. That should eliminate any gain/loss on the principal value because that capital gain/loss received is based on changes in value of the currency due to inflation (or deflation). IMO, interest would likely be taxable when received–again, depending on how the other income in that tax return is valued.

@jerryab2 oh boy, now I’m really confused. I don’t know what you are talking about.

Thanks for trying. :slight_smile:
Wendy

Simple: Do NOT try to mix asset valuation strategies on the same tax return–unless it is permitted. Business does it (think accelerated depreciation schedules for certain assets) because that is permitted. The same is not permitted in individual tax returns.

TIPS ‘phantom income’ is more properly known as “Original Issue Discount” (OID), and is reported to you on a 1099-OID, rather than a 1099-INT. From IRS Pub 1212 Publication 1212 (Rev. January 2022) (irs.gov)

In general, if you hold an inflation-indexed debt instrument, you must report as OID any increase in the inflation-adjusted principal amount of the debt instrument that occurs while you held the debt instrument during the tax year. You must include the OID in gross income whether or not you hold the debt instrument as a capital asset. Your basis in the debt instrument is increased by the OID you include in income.

So, you would add any OID income to your basis, and would not have to pay capital gains taxes on it - since you’ve already paid ordinary income taxes on it.

I would disagree with @jerryab2’s suggestion about using constant dollars. Constant dollars are appropriate for measuring real appreciation when you want to adjust for buying power. However, the IRS doesn’t allow individuals to use constant dollars when calculating capital gains.

AJ

6 Likes

@aj485 thank you so much. As always, you are a gem.
Wendy