The IRS issued a notice to clarify the tax treatment of the premium paid on TIPS issued at a negative yield.
Because the Treasury used to set the TIPS coupon rate at the nearest 0.125% below the auction result, and the auctions usually result in a positive real yield, TIPS are usually issued at a discount. In other words, you pay slightly less than $1,000 for each $1,000 TIPS. For a reopened bond, even if you pay a premium, the yield used to be still positive.
Now the Treasury sets a floor rate at 0.125% and the real yield on short-term TIPS are negative, TIPS will be issued at a premium. You will pay more than $1,000 for each $1,000 TIPS and you get a negative real yield. The IRS issued Notice 2011-21 to clarify the tax treatment of the premium paid.
The premium is amortized using the same method when the yield is positive. The amortized amount first offsets the interest. If it exceeds the actual interest received, the remainder is used to offset the inflation adjustment (OID). The IRS notice includes specific examples for the calculation.
If you hold individual TIPS in a taxable account and you will buy TIPS with a negative real yield, be sure the study the IRS notice and understand how to amortize the premium you pay.
To avoid math headaches, buy individual TIPS in a tax deferred account or buy TIPS fund or ETF in a taxable account.
IRS Notice 2011-21: Treasury Inflation-Protected Securities Issued at a Premium