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How does one account for the 'premium" or 'discount' on a treasury note held to maturity for tax purposes?


Try this:
Assume you bought a Treasury Note maturing in 6 months for $24800 (face value=25,000) and held it untill it matured. Do you account for the $200 as a short term capital gain (where it seems to be reported on the 1099) or as treasury interest? Is it still taxable as a gain by my state (CA)?

The discount is taxed as ordinary income on line 21 of your 1040. This income increases you cost basis to face value so you have no short term gain - but you still report it on Schedule D with no gain. This is taxable on your state return since the income is not a US Treasury obligation - the discount is a bond market discount under IRC Section 1276. See IRS publication on investment income.
Based on my fading memory of accounting class and my reading of IRS Publication 550, I believe the premium or discount is used to adjust the amount of interest recognized.
http://www.irs.gov/publications/p550/ch0...
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