Treasury STRIPS are regular Treasury bonds stripped apart to become zero-coupon bonds. Stripped Treasury bonds provide a way to invest for a guaranteed future lump-sum return. Although it's possible to earn capital gains with a stripped Treasury bond, the gain on one of these bonds is usually taxed as ordinary interest.
Treasury Strip Function
Stripped Treasury bonds are formed when an investment bank takes regular Treasury bonds and sells off the future payments as separate investments. Each interest payment and the final principal payment become separate bonds an investor can buy. An investor buys a future maturity payment — which could be either original interest or principal — at a discount from the final value. For example, currently a $100,000 Treasury Strip maturing in 20 years has a cost of $57,963, for a yield to maturity of 2.73 percent. The U.S. Treasury does not sell these stripped bonds directly, but does register the stripped Treasury bonds and thus the official name — Separate Trading of Registered Interest and Principal of Securities (STRIPS).
Reporting Interest Earnings
Even though you do not receive regular interest payments from a Treasury strip, the tax rules require that your report interest earnings each year as if you had received an interest payment. This phantom interest — called imputed interest — will be reported to you and to the IRS by your broker each year using a Form 1099-OID. You will include the imputed interest in your taxable income each year. When your Treasury strip matures, you will have paid taxes on the entire amount of interest earned from the price you originally paid for the bond.
Selling Before Maturity
If you sell a Treasury strip before it reaches maturity, you'll likely have a capital gain or loss. Your cost basis in the bond will be the initial cost plus the total of imputed interest earned since the purchase. If you receive a price higher than your computed cost basis, you will have a reportable capital gain — a taxable profit from the sale of an investment — from the Treasury strip investment. You can only have a capital gain or loss on a stripped Treasury bond if you sell the bond before it matures.
Changing Interest Rates
The price you pay for any bond — including Treasury STRIPS — is dependent on current interest rates. The price of a bond changes as interest rates change. Bond prices move in the opposite direction of rates. To get a capital gain from an investment in a Treasury strip, the market interest rate must have declined from when you purchased the bond. Zero-coupon bonds such as stripped Treasury bonds have the highest price sensitivity to changing interest rates, so a Treasury strip can be bought and sold for capital gains in a falling-interest-rate environment.