TIPs Inflation Calculation

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berntson
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TIPs Inflation Calculation

Post by berntson »

I just want to make sure that I understand how the inflation adjustment is calculated for TIPs. Suppose that I buy a 10-year TIP at the end of 2014. During 2015, there is 2% deflation. During 2016, there is just a bit over 2% inflation (so that there is 0% inflation over the two years). My understanding is that I would receive no inflation adjustment the first year and a 2% inflation adjustment the second year. Is that right? Thanks!
sscritic
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Re: TIPs Inflation Calculation

Post by sscritic »

Read this from treasury direct:
What happens to TIPS if deflation occurs?

The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.
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berntson
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Re: TIPs Inflation Calculation

Post by berntson »

Ah, excellent. Thanks!
Bill M
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Re: TIPs Inflation Calculation

Post by Bill M »

to expand on sscritic's response,

Suppose you bought $100K of TIPS in 2014, and their coupon rate was 1%. Assume the 2% deflation happened early in the year. During 2015 you would receive payments of 1% of the reduced principle ($98K), so $980. At the end of 2015 you would get two tax forms, 1099-INT showing $980, and 1099-OID showing -$2,000 interest. Put both on Schedule B, and you get to shelter $1020 of other ordinary income from the IRS.

Now 2% inflation in 2016 (changing your scenario slightly). The par value increases to $98K*1.02=$99960, and the payments $999.60. Your 1099-INT shows $999.60, and the 1099-OID shows $1960.

The safeguard (noted on TreasuryDirect web site): if inflation stayed at zero for the remaining life of the TIPS, you would receive $100K at maturity, not $99960, and the final year you'd get a 1099-OID for $40.
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berntson
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Re: TIPs Inflation Calculation

Post by berntson »

Thanks for your detailed explanation Bill M. I didn't realize that you could use a deflation adjustment to shelter ordinary income. That's useful.
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#Cruncher
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Re: TIPs Inflation Calculation

Post by #Cruncher »

Good post, Bill.
Bill M wrote:At the end of 2015 you would get two tax forms, 1099-INT showing $980, and 1099-OID showing -$2,000 interest. Put both on Schedule B, and you get to shelter $1020 of other ordinary income from the IRS.
I think this how most of us would do it. I just wish the rules covered the case where the negative OID exceeds the interest -- as in your example. Here is the only IRS instruction I could find:
IRS Publication 1212 wrote:Deflation adjustments. If your calculation to figure OID on an inflation-indexed debt instrument produces a negative number, you do not have any OID. Instead, you have a deflation adjustment. A deflation adjustment generally is used to offset interest income from the debt instrument for the tax year. Show this offset as an adjustment on your Form 1040, Schedule B …
Example 9 [ * ] … You use this deflation adjustment to offset the stated interest reported to you on the debt instrument. (underlines added)
This leaves unanswered the question of what to do when the "interest income from the debt instrument" is less than the absolute value of the deflation adjustment, and the two net to a negative number. Is is OK to offset the remaining negative balance against other interest income on Schedule B? What if that still isn't enough? Is it OK for the total on Schedule B to be a negative number?

It's possible for this to happen in real life. Take the case of the 0.625% 5-Year TIPS due April 15, 2013 bought at the 2nd auction and issued 10/31/2008. For each $1,000 of face value one would have a -$12.03 deflation adjustment (as well as a -$0.28 accrued interest credit) for 2008. But the purchaser collected no interest on this bond during 2008 (the Oct 31 purchase being after the Oct 15 payment date). So it provided no income against which to offset the total -$12.31 negative amount.

Also, don't assume all brokers will report a deflation adjustment on the form 1099-OID. Ones I've received from Schwab only list positive OID. I have to go digging in the supporting documents from Schwab to find negative amounts.

* By the way, examples 8 and 9 use the actual Index Ratios during 2005 for the 3.375% 10-Year TIPS due January 15, 2007, the first TIPS ever issued.
Bill M
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Re: TIPs Inflation Calculation

Post by Bill M »

#Cruncher wrote:
Bill M wrote:At the end of 2015 you would get two tax forms, 1099-INT showing $980, and 1099-OID showing -$2,000 interest. Put both on Schedule B, and you get to shelter $1020 of other ordinary income from the IRS.
I think this how most of us would do it. I just wish the rules covered the case where the negative OID exceeds the interest -- as in your example.
I was a little sloppy with that statement. With some further searching, regulation 26 CFR 1.1275-7(f)(1)(i) states:
A deflation adjustment reduces the amount of interest otherwise includible in income by a holder with respect to the debt instrument for the taxable year. For purposes of this paragraph (f)(1)(i), interest includes OID, qualified stated interest, and market discount. If the amount of the deflation adjustment exceeds the interest otherwise includible in income by the holder with respect to the debt instrument for the taxable year, the excess is treated as an ordinary loss by the holder 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 debt instrument in prior taxable years exceed the total amount treated by the holder as an ordinary loss on the debt instrument in prior taxable years. If the deflation adjustment exceeds the interest otherwise includible in income by the holder with respect to the debt instrument 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 includible in income by the holder with respect to the debt instrument for subsequent taxable years.
So it is an ordinary loss, but the the amount is limited to previous interest (paid or imputed) on the TIPS; any remainder is carried over into future years.
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Re: TIPs Inflation Calculation

Post by #Cruncher »

Bill M wrote:With some further searching, regulation 26 CFR 1.1275-7(f)(1)(i) states: … [ quote from the regulation ]
Thanks for tracking this down, Bill. Here is a link to the PDF file: 26 CFR Ch. I (4–1–12 Edition) page 618. Some of the wording is confusing, but to summarize, it appears that a deflation adjustment can be used to reduce ordinary income in the following order, but only "with respect to the debt instrument" itself:
  1. From the current year. If not entirely consumed, then the balance …
  2. From prior years. If not entirely consumed, then the balance …
  3. Carried forward to next year.
The quoted rule doesn't say what would happen to any remaining unused amount in the year the bond matures or is sold. But one can assume it should be used implicitly to increase the cost basis.

Let's see how this would work out by extending my example above of the 0.625% 5-Year TIPS due April 15, 2013. Assume $1,000 face value was purchased on 10/31/2008 at the 2nd auction and sold 12/31/2009 on the secondary market.

Code: Select all

         Interest    Accrued             Net Amt
        Collected   Interest     OID     Sched B   Balance
        ---------   --------   -------   -------   -------
2008        0.00      (0.28)   (12.03)     0.00    (12.31)
2009        6.32       1.35     (1.90)     0.00     (6.54)
                               -------
Total                          (13.93)
As explained above, none of the $12.31 negative OID and accrued interest could be applied in 2008. So it would all be carried forward to 2009. In 2009 $6.32 in interest was collected on 4/15 and 10/15. In addition $1.35 in accrued interest was received with the sale for the period 10/15/2009 - 12/31/2009. OID was again negative in 2009, specifically $-1.90 for the period 1/1/2009 - 12/31/2009. (See 12/31/2009 row on this web page for the accrued interest and the OID.) The investor is only able to use $7.67 of the carry-forward and the new negative OID in 2009, leaving a balance of -$6.54.

Positive OID increases the bond's cost basis and negative OID decreases it. If the investor had been able to offset all the negative OID, the cost basis would have been reduced $13.93. But since $6.54 wasn't able to be used, the cost basis is only reduced $7.39. So, in effect the $6.54 of negative OID unused to reduce ordinary income, is used to reduce capital gains (or increase the capital loss). In the case where the investor has a net long term capital gain -- which is taxed at a lower rate than ordinary income -- the benefit of the negative OID is therefore reduced.

It would be much simpler if the IRS allowed negative OID to be credited against any interest income. To allow it to only be credited against income on the the bond itself makes the taxpayers life needlessly complicated. It is also unfair. It makes me think of the rule I've heard that gambling losses can only be deducted to the extent of gambling winnings. However, as far as I know the IRS doesn't require that this rule be applied separately casino by casino!
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