Original Issue Discount (OID) comes into play if you own individual TIPS in a taxable account. It's not an issue if you own individual TIPS in a tax deferred or tax free account. It's also not an issue if you own TIPS mutual funds or ETFs in a taxable account.

Because our tax system operates on nominal dollars while TIPS work on real dollars, the IRS requires that TIPS investors pay taxes on inflation adjustment to principal every year. The inflation adjustment is treated as an Original Issue Discount (OID).

The IRS publishes rules on OID in Publication 1212 Guide to Original Issue Discount (OID) Instruments. You can certainly read the publication for more information, but I think it's best illustrated with a real world example.

Facts

Suppose you purchased one 10-year TIPS (CUSIP 912828GD6) at auction on Jan. 11, 2007. The interest rate was set to 2.375%. The yield was 2.449%. You paid $993.4228 as the adjusted price plus $0.06561 as accrued interest on Jan. 16, 2007 (the issue date). The index ratio for this TIPS note was 0.99995 on the issue date. These numbers are on the auction result announcement.

On July 15, 2007, the index ratio for this TIPS note was 1.02773. It paid interest of

$1,000 * 1.02773 * 2.375% / 2 = $12.2043

On Jan. 1, 2008, the index ratio for this TIPS note was 1.03606. You continue to hold the bond through 2008. On Jan. 1, 2009, the index ratio for this TIPS note was 1.07393.

Calculation

You received $12.2043 in interest from this TIPS note. You also paid $0.06561 as accrued interest at the time of purchase. You enter the accrued interest as a negative adjustment on Schedule B Interest and Ordinary Dividends, line 1. The net interest income in 2007 was:

$12.2043 - $0.06561 = $12.1387

You paid $993.4228 for a $1,000 note. The de minimis rule allows you to treat OID as zero if it's less than 0.25% of the face value times the number of full years until maturity. For this 10-year note, 0.25% times 10 is 2.5%. A 2.5% discount from $1,000 is $25. Because your discount is only $1,000 - $993.4228 = $6.58, you can disregard this small discount in the OID calculation.

The inflation adjustment must be treated as OID. The OID due to inflation adjustment between Jan. 16 and Dec. 31, 2007 was:

$1,000 * (1.03606 - 0.99995) = $36.11

This is calculated by subtracting the index ratio on the issue date from the index ratio on January 1 of the following year and then multiplying by $1,000 per bond.

The total interest you report in 2007 was:

$36.11 + $12.1387= $48.2487

In 2008, the OID due to inflation adjustment was:

$1,000 * (1.07393 - 1.03606) = $37.87

You add $37.87 per note to the interest you received in 2008 and report it as the interest income.

If the inflation adjustment OID is negative due to deflation, it offsets against the interest payment in the same year.

Your brokerage company is supposed to help you do the math and put the correct OID amount on the 1099-OID form it sends to you. However, if you don't know how to calculate the OID yourself, there is no way for you to verify if they got it right.

If you hold individual TIPS in a taxable account, you have to trust your brokerage firm to do the right calculation and resign to the fact you may end up paying more taxes than you have to, or learn how to do the math yourself. Holding TIPS in a tax deferred account or a tax free account, or holding a TIPS mutual fund or ETF will make this math headache go away.