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No. of Recommendations: 10
First off, thank you for providing another object lesson in why you can't just download a 1099 from your broker into a tax program and figure everything is going to be just fine. You need to look at both the 1099 and the results and think about them, as you have wisely done.

The right way to report bonds is to amortize any premium or discount at the time of purchase and adjust the reported interest income by that amortization. That annual amortization then adjusts your basis in the bond.

If you are lucky, you can take a look at the supplemental information your broker might provide with the official 1099. Some will calculate that amortization for you and include the information there.

In your specific case, the principal being returned to you is the same as selling part of your bond. Therefore, the broker must report it as if it were a sale. You would need to calculate your amortized basis in the bond, then report the appropriate portion as the cost basis in this return of capital. The holding period would begin when you purchased the bond.

Because your bond was originally purchased before brokers were required to report basis, your broker is not reporting the basis on the 1099. So the 1099 reporting is correct. Again, if you are lucky, there will be supplemental information with the 1099 telling you your basis so you can report the basis yourself.

If you are not so lucky, you'll need to amortize your original premium or discount from the purchase until today. You'll also need to account for any basis that should have been reported with previous years return of principal. Needless to say, this can get pretty messy pretty fast.

Depending on how large a bond we're talking about, I would certainly be tempted to just report it with the basis matching the return of capital (so no gain or loss). For a small enough bond, there is no functional difference. I would certainly do it for a $5000 bond, and I certainly would NOT take the shortcut on $1 million of original bond. Somewhere in between is a switchover point.

I believe the IRS also has some de minimis rules, such that a small enough premium or discount doesn't need to be amortized. Unfortunately, I hate bonds (from a tax preparation standpoint - they're a perfectly fine investment), so I do my best to avoid them. Therefore, I haven't memorized any de minimis rules.

--Peter
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