Taxation of CDS in US

J

JoeyDVivre

New member
Joined
Jun 18, 2026
Messages
0
Reaction score
0
Does anybody have any idea how this works? I can’t make heads or tails of this.
 
Um, you pay ordinary income taxes on interest earned. Whether or not it is received, you still pay tax on it.
Example: You have a CD that matures in 5 years. All interest is paid upon maturity. You will still pay taxes the other 4 years it is accuring interest. Your institution will give you a 1099 form with the amount of interest you need to declare on your 1040.
 
KJH Wrote:
——————————————————-
> Um, you pay ordinary income taxes on interest
> earned. Whether or not it is received, you still
> pay tax on it.
>
> Example: You have a CD that matures in 5 years.
> All interest is paid upon maturity. You will
> still pay taxes the other 4 years it is accuring
> interest. Your institution will give you a 1099
> form with the amount of interest you need to
> declare on your 1040.
Thanks; next time I have a question on my checking account I will make sure I ask here.
 
We’ve had a discussion about this with a few of our managers. Unfortunelately, I stepped out of the implementation team before it was completely finalised. Don’t think I can help you a whole lot.
All in all, at the time we came to conclude that the effects of taxation would be small because the market is limited to large institutions rather than individuals and that for most of these institutions cash flows and mark-to-market gains and losses from swaps are taxed as ordinary income. The tax treatment of both legs of the swap is the same; there is no tax asymmetry driving a wedge between the values of the premium and protection legs of the swap.
Don’t know what the really outcome was, we sent some fiscal experts out to investigate.
 
Ok, so this is a great chance for me to ask a releated CDS question that is totally stupid. It’s also sad that I really don’t know the answer at all, considering my shops trades CDS pretty heavily. But I’m in research and have zero contact with performance measurement / accounting.
How to you calculate returns on a CDS trade? I know how to calculate the mark-to-market, but what do you compare that to if you want to calcualte something like a holding period return in % form?
 
You don’t. Calculating the holding period gain or loss on derivatives just doesn’t work.
 
The IRS views CDS as financial assets even though they’re just insurance premiums on high yield debt. If you trade CDS derivatives, when you sell it, you recognize the capital gains/loss relative to your initial tax basis in acquiring that derivative, and you are taxed on realized capital gains. Your initial tax basis is the value of the derivative (the premium) + transaction costs. If you held the CDS for more than 1 year you may qualify for the 15% lower rate, other wise you get axed at 35% short term rate.
Now, if you are an underwriter, you are taxed only on the profit at the end of the policy, at your marginal corporate tax rate, just like ordinary income.
Profit = earned premium + investment income - incurred loss - underwriting expenses
Hope that helps.
 
OK so I’m still having trouble with this. Suppose that Ford bonds are selling at 40 with 8 yrs to maturity. I buy a bond and two years later it is selling at 80. You buy a risk-free bond and sell CDS protection on the Ford bond for two years. Leaving aside liquidity and similar, we both have the same position at the beginning and are taking on the same risk. But it seems that the IRS is going to hit me up for lots more taxes than you. Is it so?
 
^
I don’t think I understand your question, so forgive me if I’ve gone off track.
CDS protection, calls, puts, and other derivatives, are just financial assets like stocks and bonds.
The IRS doesn’t care what kind of asset/derivative/hedging instrument you have. All uncle sam cares about are the kinds of income you receive from your assets.
Ordinary income- bond coupon payments, stock dividends, net profits, are taxed as ordinary income at your marginal individual or corp tax rate. If you bought CDS protection, you’re not earning anything, so no tax here.
Capital gains= Amt realized on sale - Initial tax/cost basis. Depending on how long you have held on to the asset/derivative, the IRS will classify capital gains as short or long-term capital gains. Short term gains are taxed at 35%, and long-term gains are taxed at 15%, based on the Bush Tax Recon Act, which is still valid until 2010 .
So let’s say you purchase CDS protection for your Ford bond for $10, and 2 years later you find a buyer willing to buy it for $20. When selling it, you recognize the capital gain/loss, and since you’ve held it for more than a year, you qualify for the 15% long-term cap gains rate. Your tax is =(20-10)*0.15=$1.50.
If you sold it before 1 year you’re taxed at the short-term 35% cap gains tax rate.
Also, when your CDS buyer receives the CDS, his initial tax basis is $20+other transaction fees, and his holding period restarts from 0. In taxation it’s called a no “carry over basis” in the asset basis and holding period.
Note that credit default swaps can be very illiquid sometimes because there isn’t a ready market for them. They are typically traded b/w banks and HF’s, so, you can expect much price volatility in these instruments. So, if you sell your Ford bond, you no longer need the CDS, so getting rid of it *may* not be too easy unless you have a willing buyer at a bank or HF.
But if you’re trading in and out of junk paper, why do you care for CDS protection? IMHO it’ll just lower returns, but that’s your call.
 
Forget about liquidity issues and whether or not it’s a good idea to be trading CDS on trashy bonds.
So my Ford bond with 8 yrs to maturity trading at 40 is a really trashy credit. If I sell CDS protection on that bond say that lasts until maturity of the bond, I’m getting 400 bp (or whatever my Hull and White model tells me I should get). Presumably, the 400 bp I’m getting are just taxed as ordinary income (if that’s not true it rocks my world). Now after two years, the Ford bond is trading at 80 and now my Hull and White model says I should be getting 150 bp (or whatever). My contract to be getting 400 bp is now quite valuable because I’m getting an extra 250 bp over 6 years. Since I have expenses, I decide to sell the contract.
Here’s what I think the tax situation ought to be. The contract originally had zero value so my basis in it is 0. Now I sell it for whatever the PV is of those payments - say 10. All of that gain is taxed at long-term capital gains rates. Yes?
If so, all the gains in credit quality of that bond are taxed to the CDS seller as long-term capital gains.
But, if I had purchased the Ford bond originally I would be subject to market discount taxation. So when I bought my bond at 40 with 8 years left to maturity, the first 60/8 = 7.5 pts of credit improvement per year is taxed as ordinary income. So when my bond goes to 80 and I sell after 2 years, I am taxed on the first 15 pts of that increase as ordinary income and the 25 pts as capital gains.
So the numbers aren’t right here obviously and I don’t feel like pricing CDS before my first cup of coffee, but the point is that if you expect credit improvement on a bond that is selling at a discount your tax situation is much better if you sell CDS protection on that bond rather than buying the bond (forgetting about liquidity issues, etc). That just can’t be right.
 
I found this Joey, but honestly I don’t have time to see if it is even helpful. Seems to be mostly about cross-border transactions and not the basics.
http://www.nysba.org/Content/ContentGroups/Section_Information1/Tax_Sect...
The problem I guess is it seems the annual mark-to-market gains on your long risk CDS position are not taxed as they are unrealized, but on the cash bond you would be taxed to the extent that your discount is accreting towards par.
I don’t know but it’s an interesting question. I’m sure there is someone at my firm who knows this, but I don’t even know where to find them. I guess one differene is, assuming the par amount of the bond trade and the notional of the CDS are the same, you have more $ at risk in the CDS trade. Whatever you assume the recovery rate to be, in the event of a default you are out 100 - recovery rate while with the bond it’s 40 - rr. Then again for bonds trading at 40 CDS would probably be trading with points up front and running. ResCap was recently trading like this with the bonds in the high 70s. Not the point obviously but god knows what that does to the tax implications.
 
Here’s an interesting paragraph frmo that report.
“Alternatively, a CDS can be viewed as a “slice” of a debt obligation consisting of
the credit spread and the credit risk, without funding cost and interest rate risk. This
characterization can readily be understood by comparing the different forms of actual and
synthetic CLN described in Section II.B.3(e), above. A tax regime that minimizes the potential
for both taxpayer arbitrage and inadvertent whipsaws would seek to minimize the differences in
the way that those structures are taxed by harmonizing the results for synthetic investments with
those resulting from an actual investment in the underlying obligation.”
I don’t think the IRS has this worked out yet.
 
You know what else seems clear from that article…
Suppose that you own a bunch of bonds secured by an oil pipeline and whose coupon payments are somehow coming from the revenue from that pipeline. If you want to protect yourself, from a tax perspective you might be better off buying an insurance policy on the pipeline than buying CDS protection on the bonds even though those are economically the same thing.
 
I’m coming to the realization that there is a lot of tax arb that can be done with CDS…
 
There were definitely some interesting points raised here: I will talk to a few people who know a lot more about the intricacies of CDS than I do, and see what I can find out..
 
Bump
Does anyone have experience with CDS tax? Or any good papers/books on taxation of derivates / taxation of CDS vs bonds vs physical insurance?
there are some good explanations up top but I would love to find out more about this.
 
You must log in or register to reply here.
Back
Top