How does Massachusetts tax selling US Treasury Bills before maturity?

Question

If I buy a 4-week US Treasury Bill at auction and hold it to maturity, the interest I earn is state-tax-free. Just to put a number on it (even though I know rates aren't actually that high right now), suppose the discount rate makes it that I buy it for $998 and it matures at $1000. My understanding is that the $2 of interest I then earned is reported to me on 1099-INT. It shows up with the rest of my interest on my federal 1040 and on my MA Form 1 Schedule B, but I subtract it out on Form 1 Schedule B Line 6 as "interest to be excluded" since states aren't allowed to tax federal interest.

But now, what if two weeks in to holding the bill I had bought at auction, I decide I need the money and sell it on the secondary market. To keep with the example, say I bought it at auction for $998 and sell it two weeks later for $999. How does that $1 I earned get reported to me, and where would I put it on my Massachusetts Income Tax return? Does it show up as federal interest and thereby get excluded in the same way, or does it count as a capital gain since the $1 I got didn't come "directly" from the government? As Massachusetts taxes short-term capital gains at 12%, it makes a big difference. (Obviously not that big a difference for just the one bond in my example, but I'm trying to understand how it would work for larger amounts.)

I tried asking Fidelity about how it would be reported to me (as I was hoping I wouldn't get a generic "we don't give tax advice" message), and got this response:

You are correct in that holding a T-Bill to maturity would result in earned interest that would only be taxable at the Federal level. If you were to sell a T-Bill prior to maturity, you could be subject to capital gains on the sale. However, there are some special rules for securities purchased at a market discount, where as the accrued interest may limit the capital gains owed because it is an Original Issue Discount (OID). We would automatically make these calculations for you on your Consolidated 1099 tax form if this were to occur.

I've tried looking into more about "OID", but a lot of what I'm finding seems to be related to longer-term bonds. I find a reference in IRS Publication 1212 that "Short-Term U.S. Treasury Bills" are in "Section III-A" of "the OID list", but I still can't find specifics about how I would report it at the federal level (though I'm less worried about that, since I'm pretty sure regardless it would be at my ordinary income tax rate). And really what I'm looking for here is how it would be taxed at the state level, since it seems it might be taxed at 0%, 5-ish%, or 12% depending on how exactly it's reported.

Answer 1

I think I've figured out how this works, though I haven't yet tried it.

When the Treasury Bill is sold, the sale is reported (like any security sale) on 1099-B. It will list the amount I paid for it, the amount I sold it for, and (here's what I hadn't realized) in Box 1f the "Accrued market discount" lists how much of the gain is due to interest rather than being due to a capital gain. From the Schedule D instructions, under "Market Discount Bonds",

In general, a capital gain from the disposition of a market discount bond is treated as interest income to the extent of accrued market discount as of the date of disposition.

For instance, in the example that it was bought for $998 and then halfway through sold for $999, assuming that interest rates haven't changed, then it would list a basis of $998, proceeds of $999, and accrued market discount of $1. The $1 gets put in interest (on both the Federal and State form), not as a capital gain, and since it counts as interest (since it is) as best I can tell it still counts as being excluded from state taxes. (One does need to fill out federal Schedule D and Form 8949 which shows the $1 difference, and subtract out the accrued interest as an adjustment with code D so that it shows $0 in capital gains. The state Form 1 Schedule B & D get their totals from the federal forms.)

Where it gets slightly tricky is that since interest rates aren't static there probably will be a small capital gain or loss associated with the sale, for the portion of the proceeds that isn't just attributed to interest. So for instance, if rates are dropping that bill purchased for $998 might get sold for $999.50, with $1 as accrued market discount (that is, counts as interest) and the other $0.50 counting as a short term capital gain. Or if rates are going up, then selling for $998.50 would still be $1 of interest income, but $0.50 as a short-term capital loss.

Certainly for 4-week bills the rates aren't likely to fluctuate as drastically as my example, but there certainly may be a little change, and the principle works the same for longer-term bills too.