TIPS is a short name for bonds or notes called Treasury Inflation Protected Securities. They are issued by the U.S. Government. Unlike a regular bond, you don't know what the principal value will be at maturity because it depends on the rate of inflation.
The TIPS bond pays a semi-annual coupon rate of interest in cash and also adds an adjustment to the principal value for the CPI (Consumer Price Index) inflation or deflation that period. The bond holder is taxed currently on the CPI adjustment, even though it is not received in cash.
This CPI adjustment is called "phantom income" because it is income you have not yet received in cash, but you still must pay income tax on it now.
No income tax is owed when you collect the CPI inflation adjustments at bond maturity, since you have already been taxed on the adjustments each year over the life of the bond.
To determine your cost basis for a TIPS bond, you must record the phantom income each year as an increase in your cost basis. The phantom income is reported as "OID" or Original Issue Discount on your Form 1099 by the broker/dealer holding your TIPS bond.
If deflation occurs, the adjustment will be negative. A special feature of TIPS bonds is that the principal value at maturity will never be reduced below initial par value for CPI deflation adjustments.
Because of the complications of phantom income and OID adjustments, many people avoid the whole thing by only buying TIPS inside their IRA so they don't have to worry about keeping track of the cost basis.
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Information provided is intended solely for U.S. individual cash-basis taxpayers and is believed to be accurate for most cases. Always consult your personal tax advisor about your own situation. Suggestions are most welcome. Please e-mail webmaster @ costbasis.com or write to us at P O Box 11022, Chicago IL 60611 with your comments.