Is an Accrued Market Discount Taxable by State?

[dhoyt]

Hello all. I hope your tax season is off to a good start.

I have a client with a number of US Treasury Note redemptions reported on 1099-B with Accrued Market Discount reported on 1f. I've entered it all in ProSeries and the AMD correctly flows to Schedule B as interest.  My understanding is it is interest on a US Obligation, which is not taxable by the State (in this case Arizona). But Proseries doesn't seem to give any option to subtract it on the State like it automatically does with Treasury Obliations reported on Schedule B directly. And I can't find any way to make an adjustment on the Arizona return unless I perform an override to put in on Line 28 of the AZ 140 ( Interest on US Obligations such as U.S. Savings Bonds and Treasury Bills).

So is Accrued Market Discount taxable by the State? And if not, any idea how to subtract that on the Arizona state return in ProSeries? I appreciate any help.

[BobKamman · Accepted solution]

What is the source of your understanding that it's interest on a US obligation not taxable by the state?  I would agree with that if it were OID, but "market discount" means the client was buying these Treasury notes on the secondary market.  That's ordinary income (or at least, STCG).  Adding it to interest on Schedule B is a convenience to avoid Schedule D, but it's not really federal interest.  Cough up the 2.5% and be glad it's not California.  

[dhoyt]

I appreciate your clear and prompt explanation. Thank you very much

To be honest, my original source was a CPA friend of mine. He is a pretty knowledgeable tax guy so I usually trust him. He told me it gets subtracted on AZ as US interest. I've never done that before, but I can't say I have seen accrued market discount's very often, and certainly not in the amounts that this particular client has. So I started reserching and couldn't find a clear answer. I found lots of people and forums that make arguments both ways. Some say it is treated as US Income for federal purposes, so it is treated that way for state purposses, too. Others make similar arguments to what you said (although you stated it much more succintly). But no one can cite a definitive source for the answer.  

I just found this in AZ Instructions

"U.S. Government obligations include obligations such as savings
bonds and treasury bills. You cannot deduct any interest or
other related expenses incurred to purchase or carry the
obligations."

I'm not sure if that second part of that instruction is refereing to AMD. I'm trying to research and understand more about how AMD and the secondary market works.

[BobKamman]

When interest rates go up, bond prices decline.  So, a $1,000 bond can be bought for $900, and the lower interest it pays is compensated by the eventual gain of $100 when it matures.  That $100 has nothing to do with whether it is federal or corporate interest, and on the 1040 it doesn't make any difference where it gets reported.  (Well, I suppose it would be to the taxpayer's advantage to put it on Schedule D, if there were carryover losses to offset it.  I think actually you can do that, if you elect not to amortize the discount over the entire holding period.  I think I once had a client who elected to do that, a former stockbroker who then went to law school.)  

What happens with municipal bonds?  As I recall, if you sell them at a loss before maturity, you can't claim it, but if you buy them at a discount and hold them to maturity, that gain is considered municipal interest.  And if you buy them at a premium and hold them to maturity, you can't claim the loss or reduce your interest income.  By analogy, maybe that's what some people want to do with Treasury bonds.  But I don't think trading profits are the same as interest.  

Baird has a good discussion of some of these issues at 

https://www.bairdwealth.com/globalassets/pdfs/help/tax-treatment-bond-premium-and-discount.pdf 

[dhoyt]

Thank you for taking the time to answer my question and provide some education for me. I'll study up a bit more on this. I agree with your take on the taxation in AZ. It makes sense. And I know ProSeries isn't perfect, but the fact that I can't even find a way to make it non-taxable to the state in the software is a good indicator that this is the proper treatment as well.

Thanks again for your help!