Taxation plays a key role in what you actually earn by investing in bonds. Read on to understand how interest income and capital gains on bonds are taxed in India.
On a weekend, Mr. Financewala met with his close friend, Mr. Budgetbhai, again to check on his new job. However, their conversations quickly turned into discussions around the bond market.
Mr. Financewala walked his friend through concepts like yield, pricing, and risk. Mr. Budgetbhai nodded and then added a remark saying, “I have been investing in bonds for a while too”.
“But there’s one aspect that really shapes how these returns play out”, he added. “Yes, yes, I know all about risks of bond investing, replied Mr. Financewala. “No,” said Budgetbhai, “it’s taxation”.
He explained that since he fell in a higher tax bracket, his interest income had been taxed accordingly, something he now factors into his investment decisions from the start.
Taxation doesn’t change the value of bonds as an investment, but it does change how you evaluate them, especially when you want to know your exact returns in hand. In chapter 6 of this series, we break down how bonds are taxed in India, so you can evaluate your investments with a clearer, more complete perspective.
How Bond Interest is Taxed
Every time you receive interest (coupon) from a bond, it gets categorized as “Income from Other Sources” and is added to your total annual income for the year. This interest income is then taxed at your applicable income tax slab rate. For example, if you fall under the 30% tax slab and your bond pays you ₹1,00,000 in interest, you will be paying ₹30,000 of that in tax at the end of the financial year.
In case of a cumulative bond (where interest is paid one-time at maturity), you will be taxed as per accrual basis taxation.
TDS on Bond Interest
Tax Deducted at Source (TDS) on bond interest refers to the process where the issuer or intermediary deducts tax before the interest is credited to your account.
As per Section 193 of the Income Tax Act, TDS at 10% may apply on interest earned from certain bonds and debentures, depending on the nature and structure of the instrument.
- TDS at 10% may apply on interest from both listed and unlisted bonds under Section 193, subject to specified thresholds and conditions.
- TDS may apply in case of unlisted bonds or certain privately issued instruments, subject to specified conditions
If TDS is applicable and you do not provide a valid PAN, the deduction rate may increase to 20%.
If your total income is below the taxable limit, you may submit Form 121, a unified self-declaration form introduced from April 2026, to avoid TDS deduction at source, subject to eligibility.
Form 121 replaces the earlier Form 15G and Form 15H and can be submitted by eligible resident taxpayers declaring that their total income is below the taxable threshold
The TDS deducted is reflected in your Form 26AS and can be adjusted against your final tax liability when you file your income tax return
So far, we’ve looked at how the income you receive is taxed. But taxation also applies when you sell a bond and make a profit.
Taxable Bonds
Most bonds in India are taxable. Within this category, these bonds are taxed depending on whether the bond is listed or unlisted.
Listed Bonds
A listed bond is one traded on a recognized stock exchange, such as the BSE or NSE. When you sell a listed/unlisted bond before maturity and make a profit, that profit is called a capital gain. How it is taxed depends on how long you held the bond.
- Short-Term Capital Gains (STCG):
If you sell a listed bond within 12 months of buying it, the gain is treated as short-term and added to your overall income for the year. It is taxed at your applicable slab rate.
- Long-Term Capital Gains (LTCG):
If you hold the bond for more than 12 months before selling, the gain qualifies as long-term. Here, the tax rate is a flat 12.5%, without indexation. This means you cannot adjust the purchase price for inflation before calculating the gain and are required to pay 12.5% on the full profit.
Unlisted Bonds
Unlisted bonds are the ones that are not traded on stock exchanges. These bonds follow a different tax treatment.
As per Section 50AA of the Income Tax Act, gains from unlisted bonds are always treated as Short-Term Capital Gains (STCG) regardless of how long you hold them. Meaning, whether you hold the bond for 6 months or 6 years, the profit will added to your total income and taxed at your applicable slab rate.
While most bonds fall under taxable categories, there are certain instruments where taxation works differently.
Tax-free Bonds
Tax-free bonds are bonds issued by the government or government-owned entities under Section 10(15) of the Income Tax Act.
Some of the approved issuers of tax-free bonds include the National Highways Authority of India (NHAI), Rural Electrification Corporation (REC), Power Finance Corporation (PFC), and Indian Railway Finance Corporation (IRFC).
While major tax-free bond issuances occurred between 2011 and 2016, no new tax-free bond issuances have occurred since 2016. If you want to invest in them today, you can do so through the secondary market or through online bond platform providers.
Another thing to note is that the “tax-free” label applies only to the interest income earned on these bonds. If you sell these bonds before maturity and realize a capital gain, that gain will be liable to taxation; LTCG at 12.5%, if held for more than 12 months, or at your slab rate if held for less than 12 months. Additionally, no TDS is deducted on the interest from tax-free bonds. You receive the full coupon directly.
Generally, investors in high-income tax brackets prefer tax-free bonds, since a tax-free bond offering 5.5% interest can be more valuable than a taxable bond offering 7%.
Apart from bonds that reduce your tax on interest, there are also instruments designed to help you manage taxes on capital gains.
Tax-saving Bonds
Tax-saving bonds differ from tax-free bonds. While tax-free bonds exempt your interest income, tax-saving bonds help you manage tax on capital gains arising from the sale of specified assets.
Earlier known as Section 54 EC bonds, these bonds are rebranded as Section 85 bonds in the Income Tax Act 2025.
Here is how they work. If you sell a long-term immovable asset (land or building) and realize a capital gain, you are normally liable to pay LTCG tax on that gain. However, if you invest that capital gain into Section 85 bonds within 6 months of the sale, the amount invested becomes eligible for tax exemption, subject to limits.
These bonds come with a mandatory lock-in period of 5 years, during which they cannot be transferred or pledged. You are allowed to invest a maximum of ₹50 lakh, and the exemption is available only to the extent of the amount invested, not the entire gain, unless fully reinvested.
Note: It is important to note that this exemption applies only to long-term capital gains arising from land or building, and not from other asset classes
There’s also a category of bonds where returns don’t come in periodic payouts, changing how taxation applies altogether.
Zero-coupon Bonds
Zero-coupon securities are bonds that do not pay periodic interest. Instead, they are issued at a discount and are realized at full face value at maturity. A common example of a zero-coupon bond is a treasury bill. Suppose you purchase a T-bill with a face value of ₹1,000 at ₹800 today. At maturity, it is redeemed at ₹1,000, resulting in a gain of ₹200.
This income from the transfer or maturity of a treasury bill will be treated as “Income from Other Sources”.
The holding period rules remains the same as for listed bonds:
- STCG (held for 12 months or less): Taxed at your applicable slab rate
- LTCG (held for more than 12 months): Taxed at a flat 12.5%, without indexation
So, while zero-coupon bonds simplify returns structurally, their taxation still follows the broader rules applicable to debt instruments.
Conclusion
Understanding taxation helps you make more informed bond investment decisions by giving you a clearer perspective.
Once you know how different bonds are taxed, you can compare them fairly, not just on what they promise, but on what they actually deliver to your account.
Now that Mr. Financewala understands the concepts, the risks, etc., it is time to invest in bonds.
In Chapter 7, we move from understanding bonds to owning them, with a simple step-by-step guide to buying and selling bonds in India.
