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Tax Considerations for CMO Investors

The interest portion of payments to CMO investors is subject to federal, state, and local income tax. When comparing Treasury yields to CMO yields, investors should remember that interest income from Treasury securities is exempt from state and local income tax.

Any portion of the CMO payment that represents return of principal or original cost is not taxable. However, if the securities were purchased at a discount from original issue or at a market discount, different rules apply. If an investor buys a mortgage security when originally issued for a price that represents an original discount from its face value, the investor may incur a tax liability on interest which accumulates on the security before it is paid out. If the security is purchased at a discount in the secondary market (market discount), the investor may be subject to a tax on the amount of principal received in excess of the purchase price as well as on the interest.

For CMO securities held in brokerage accounts, the Internal Revenue Service (IRS) requires the broker-dealer to report the investor’s aggregate amount of interest earned and original issue discount accrued during a given calendar year and allows reliance on an external source to supply such tax reporting information. If interest is earned in one calendar year, but not paid until the next, it still must be reported and may be taxable. Broker-dealers provide clients with copies of reports submitted to the IRS.

As required by federal income tax law, CMO issuers provide information to certain entities to calculate properly the taxable income attributable to CMOs. Those entities, in turn, are obligated to supply such information to individuals and other “beneficial owners” who are not exempt recipients. Investors should be aware, however, that such information need not be furnished before March 15 of any calendar year following a calendar year in which income accrues on a CMO.

Investors should consult their tax advisor for more specific information.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.