Interest Is Income, Regardless of Rate Type
Bonds, promissory notes, and similar debt instruments are common trust investments. They generate two types of cash flow: periodic interest payments and the return of principal at maturity or sale. This statute draws a clear line between the two. An income beneficiary receives the interest payments. The trust document may provide additional guidance on how these amounts are handled.
An amount received as interest, whether determined at a fixed, variable or floating rate, on an obligation to pay money to the trustee, including an amount received as consideration for prepaying principal, must be allocated to income without any provision for amortization of premium.
A.R.S. § 14-7415(A)All interest goes to income. It does not matter whether the rate is fixed, variable, or floating. Even prepayment consideration goes to income. The statute also eliminates premium amortization. If the trust purchased a bond at a premium, the trustee does not need to reduce income to account for the premium declining as the bond approaches maturity. An instrument that accrues interest follows the same rule.
Sale Proceeds and the One-Year Rule
When the trustee sells, redeems, or otherwise disposes of a debt obligation held for more than one year, the proceeds go to principal. This applies even when the bond was purchased at a discount. Capital gains from these sales stay in the trust's principal, not distributed as income.
A trustee shall allocate to principal an amount received from the sale, redemption or other disposition of an obligation to pay money to the trustee more than one year after it is purchased or acquired by the trustee, including an obligation whose purchase price or value when it is acquired is less than its value at maturity.
A.R.S. § 14-7415(B)There is one exception for short-term obligations. If the obligation matures within one year of purchase, any amount received above the purchase price goes to income rather than principal. This distinction recognizes that short-term instruments function more like cash equivalents than long-term investments.
For trustees managing a bond portfolio or holding notes receivable, these rules determine how much flows to current beneficiaries versus how much stays in capital. Income tax and federal tax treatment of these amounts may differ from the trust accounting classification. The trustee should track both to meet legal requirements and keep all beneficiaries properly informed.
Understanding how real estate notes, corporate bonds, and other debt instruments are classified helps families plan ahead. When a trust holds diverse fixed-income investments, proper classification protects both the income beneficiary and the remainder beneficiaries.