Friday, February 15, 2013

Tax Consequences of Market-Linked CD Investing

On this last day of structured CDs week here on the SLCG blog, we're going to discuss the tax consequences of investing in market-linked CDs (or structured CDs). We should probably start a blog post on taxes with a general disclaimer that we are not tax professionals and you should consult a tax professional or CPA before making an investment decision based upon tax consequences.

That being said, taxes are a pretty complicated issue for structured CDs. As mentioned earlier this week, realization and accrual of interest is not simultaneous with structured CDs.   Most structured CDs that we've seen do not credit the investor with interest that is contingent upon market movements until, in the best case, the next interest accrual date or, in the worst case, until maturity.  For example, this JP Morgan market-linked CD (PDF) does not accrue interest until maturity while this JP Morgan market-linked CD (PDF) accrues interest on a quarterly basis.

For tax purposes, however, investors in these notes are usually "required to recognize interest income in each year at the 'comparable yield'" according to JP Morgan structured CD disclosures (see the examples above).   This is usually based upon a fixed rate and the payment the issuer expects to make at maturity.  This determines the Original Issuer Discount or (OID).  On the other hand, it is possible that no payment will be due at all when the product matures depending on market conditions during the term of the CD.

This results in a phenomenon known as "phantom income".  From the FDIC:
One of the key components of a market-linked CD is that, unlike most fixed-rate CDs, interest earned might only be accrued (unconditionally added to the account balance) when the CD matures. However, you may be required to include interest income in your taxable income each year that you receive a Form 1099-INT from the issuing bank, even though you were not paid interest during that year but will be paid the interest at the maturity of the CD. Paying tax on interest earned but not paid to you is commonly known as “phantom income.”  A tax advisor or CPA can explain the tax implications of “phantom income.”
Another idiosyncrasy with market-linked CDs is that, although these are long-term investments (sometimes fifteen years or more) and dependent upon the performance of some market index, the appreciation in value is not taxed as long-term capital gains but as ordinary income (which historically has been subject to a much higher rate).  Some of these complications might be avoided by holding structured CDs in a tax-deferred account such as an Individual Retirement Account (IRA), but in general, the market-linked component of structured CDs could be less optimal from a tax point of view than other forms of market-linked income.

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