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.