Interest income earned on an inflation-adjusted bond is taxed as ordinary income by the IRS. There is no distinction between inflation-adjusted income and nominal income. The appreciation of principal and the semi-annual fixed interest on these bonds are taxed in the year they are accrued (earned), even though an investor will not actually receive the principal increases until the bond matures. These increases are sometimes referred to as "phantom income." This means that when inflation increases, so do the taxes on inflation-adjusted bonds. There is a risk that in years of high inflation, tax liability could exceed your coupon interest income, wiping out your yield.
If the economy experiences deflation, the deflation offsets interest earned on the bond. If deflation is greater than the interest earned, the unused portion of interest can be carried forward to offset future income. If the deflation amount is not used by the bond's maturity, the bondholder may claim it as a capital loss.
Like other Treasury bonds, Treasury inflation-adjusted bonds are exempt from state income taxes.
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