7640 / How are inflation-indexed bonds treated for tax purposes?

A bond is considered inflation-indexed for federal income tax purposes if: (1) it was issued for U.S. dollars and all payments on the instrument are denominated in U.S. dollars; (2) each payment on the debt instrument is indexed for inflation and deflation except for a minimum guarantee payment (defined below); and (3) no payment on the debt instrument is subject to a contingency other than the inflation contingency, a minimum guarantee payment, or certain inflation-indexed payments under one or more alternative schedules.¹ A minimum guarantee payment is an additional payment that is made at maturity if the total amount of the inflation-adjusted principal paid on the bond is less than the bond’s stated principal amount.²

Holders and issuers of inflation-indexed debt instruments, including Treasury Inflation-Protection Securities (see Q 7639), are required to account for interest and original issue discount (or OID, inflation adjustments) with constant yield principles using either the coupon or discount bond methods described in Q 7641 and Q 7642.

Deflation Adjustments

Under the coupon and discount bond methods, a deflation adjustment reduces the amount of interest otherwise includable in a bondholder’s income with respect to the bond for the taxable year. “Interest,” for this purpose, includes original issue discount, qualified stated interest, and market discount.³ If the amount of the deflation adjustment exceeds the amount of interest otherwise includable in income by the holder for the taxable year with respect to the bond, the excess is treated as an ordinary loss for the taxable year. However, the amount treated as an ordinary loss is limited to the amount by which the holder’s total interest inclusions on the bond in prior taxable years exceed the total amount treated by the holder as an ordinary loss on the bond in prior taxable years. If the deflation adjustment exceeds the interest otherwise includable in income by the holder with respect to the bond for the taxable year and the amount treated as an ordinary loss for the taxable year, this excess is carried forward to reduce the amount of interest otherwise includable in income with respect to the bond for subsequent taxable years.⁴

Miscellaneous Rules

If a bond features a minimum guarantee payment, the payment is treated as interest on the date it is paid. However, under both the coupon and discount bond methods, the minimum guarantee payment is ignored until such a payment is made.⁵