QUESTION: At a party recently, some people were talking about "deep discount bonds" as a good investment. Just what were they talking about?
ANSWER: A discount bond is a bond that is selling at a price lower than the face value (usually $1,000; and a deep discount bond is simply a bond priced substantially below the face value.
Bond prices generally tend to move inversely with interest rates; that is, if interest rates go up, bond prices go down (and vice versa).
This happens because the price buyers are willing to pay for a previously issued bond moves up or down so that the return on their investment is approximately similar to that of a new issue of the same quality. i
For a simplified example, let's say that a new utility bond rated "AA" reaches the market with an interest rate of ten percent. A similar bond issued some years ago and also rated AA may carry a coupon (fixed interest rate set when the bond was issued) of, say, five percent.
The old bond thus pays $50 a year interest (five percent of the $1,000 face amount). In order to get the same ten percent current yield that he could get by buying the new issue, an investor might only be willing to pay $500 for the old bond.
But another element must be factored into the calculations. If you buy the old bond and hold it to maturity, you will get the face amount of $1,000 back from the issuer, even though you only paid $500 to buy the bond.
So if the old bond is scheduled to mature in 1999, you are accumulating another $500 in value -- $25 a year for the next 20 years. Of course you don't get this money each year, but rather in a lump sum when the bond is redeemed at maturity.
In practice, the old bond would be priced somewhere between $500 and $1,000, to take into account both the $50 a year in current interest payments plus the present value of the difference between the face amount and the price.
The big attraction of deep discount bonds: With a few technical exceptions, that difference between purchase price and redemption value is favorably taxed as a capital gain when received at maturity. The annual interest payment, on the other hand, is fully taxable as regular income in the year received.
For a high-bracket taxpayer who doesn't need current income, this exchange of taxable annual income for a deferred capital gain can be quite attractive. But -- like every other investment medium -- it isn't right for everyone. Advantages and disadvantages must be weighed in the context of individual financial needs.
Q: Our house recently suffered some damage from a tornado. How do I determine the amount of loss to deduct on my tax return?
A: The loss that may be claimed on your return is the difference between the fair market value of the property immediately before the tornado and its value immediately afterwards.
Valuation by a qualified real property appraiser is the best way to establish those values. It's hardly likely, of course, that you would have had this done just before the storm. Recent sales prices of comparable homes in your neighborhood may help establish the pre-loss value of the dwelling.
The appraiser's fee is not a part of the casualty loss, but may be taken as a miscellaneous deduction on Schedule A, along with the cost of photographs and any other expenses directly related to establishing the amount of the loss.
Unfortunately, the cost of temporary housing or similar expenses while waiting for repairs to be completed is not deductible anyplace.
The cost of repairs or replacement does not determine the amount of the loss. However, if the total is relatively small, the IRS may accept the cost of repairs necessary to restore the property to its condition before the tornado as an acceptable measure of the decrease in value.
When you claim the casualty loss on your tax return, remember that you must reduce the amount by any insurance payment. The net loss must then be further reduced by the IRS deductible of $100 for each separate loss event.