Treasury bonds are not taxable by California at the state level when it comes to the interest they pay. Federal law blocks states from taxing interest on direct obligations of the U.S. government, so T-Bills, T-Notes, T-Bonds, TIPS, and U.S. savings bonds all produce interest income that California leaves alone. What California can tax is a capital gain if you sell a Treasury before maturity for more than you paid.
Where the Exemption Comes From
The rule is federal, not a California choice. Under 31 U.S.C. ยง 3124, stocks and obligations of the United States Government are exempt from taxation by any state or political subdivision, and the exemption covers every form of taxation that would require the obligation or its interest to be factored into a tax calculation.1Office of the Law Revision Counsel. 31 USC 3124 Exemption From Taxation California’s own regulations acknowledge the same thing: interest on bonds and other obligations of the United States is exempt from state taxation.2Legal Information Institute. California Code of Regulations Title 18 Section 24271(e) – Interest
What California Can Still Tax
The exemption applies only to interest. Federal law explicitly sends the tax treatment of gains and losses from selling these obligations back to the Internal Revenue Code.1Office of the Law Revision Counsel. 31 USC 3124 Exemption From Taxation If you sell a Treasury before maturity for more than you paid, the profit is a capital gain, and California taxes all capital gains as ordinary income with no preferential rate.3Franchise Tax Board. Capital Gains and Losses
That distinction is not academic. California’s top marginal rate reaches 13.3% once the 1% mental health services surcharge on taxable income above $1 million is layered on. A high-bracket investor who sells a Treasury note early can hand a chunk of that gain to Sacramento, while the same investor who holds to maturity keeps everything the note pays.
T-Bills, TIPS, and Savings Bonds
T-Bills don’t pay coupons. You buy them at a discount and receive face value at maturity, and that discount is treated as interest. California’s regulations confirm that when a bond is issued at a discount and later redeemed at face value, the original discount is interest.2Legal Information Institute. California Code of Regulations Title 18 Section 24271(e) – Interest Buy a $10,000 T-Bill for $9,800, hold it to maturity, and the $200 you earn is state-tax-free. Sell that same T-Bill early at a profit, and the profit is a taxable capital gain.
TIPS produce two streams: the semiannual coupon and the inflation adjustment to principal. Both are treated as interest on a U.S. government obligation, so both are exempt from California income tax.4Internal Revenue Service. Topic No. 403, Interest Received Federal law still requires you to report the inflation adjustment each year as income even though you don’t receive the cash until maturity, but California doesn’t add to that bill.
Series EE and Series I savings bonds are exempt the same way. If you redeem EE bonds issued after 1989 and use the proceeds for qualified higher education expenses, the interest may also be excluded federally under the Education Savings Bond Program. In that case there’s nothing to subtract on the California return because the interest never made it into your federal adjusted gross income to begin with.
Treasury Funds and ETFs Have an Extra Rule
Owning Treasuries through a mutual fund or ETF does not automatically turn all of your fund income into state-exempt interest. California requires the fund to hold at least 50% of its assets in U.S. government obligations or California state and municipal obligations before any exempt-interest passes through to shareholders at the state level.5Franchise Tax Board. 2024 Supplemental Guidelines to California Adjustments
Dedicated Treasury funds typically clear that bar. Broader bond funds that mix Treasuries with corporate or mortgage-backed debt may not. Each year the fund company publishes a tax supplement showing the percentage of ordinary dividends derived from U.S. government obligations, and you multiply your total ordinary dividends by that percentage to find the amount you can subtract on your California return. The percentage moves from fund to fund and year to year, so last year’s number isn’t a shortcut.
If the fund falls below 50%, none of its dividends qualify for the California exemption, even the portion genuinely attributable to Treasury interest. That is the single biggest trap for investors who assume anything with “Treasury” in the name is fully state-tax-free.
Claiming the Exemption on Your California Return
The exemption isn’t automatic on your state return. Your broker reports Treasury interest in Box 3 of Form 1099-INT, separate from other interest in Box 1.6Internal Revenue Service. Form 1099-INT It flows into your total taxable interest on Form 1040, line 2b. To pull it back out for California, you enter the Treasury interest amount on Schedule CA (540), Part I, Section A, Line 2, Column B (Subtractions).7Franchise Tax Board. 2025 Instructions for Schedule CA (540) California Adjustments
Column B on Line 2 should include interest from U.S. savings bonds, Treasury bills, notes, bonds, and any other direct obligations of the United States and its territories.7Franchise Tax Board. 2025 Instructions for Schedule CA (540) California Adjustments The subtraction reduces your California adjusted gross income on Form 540. Capital gains from selling Treasuries before maturity are reported separately and get no subtraction.
Miss the subtraction and you’ve overpaid. The Franchise Tax Board won’t flag the mistake or refund it. You’d file an amended return on Form 540X, and California generally gives you four years from the original filing deadline to claim a refund.
Federal Agency Bonds Are Not the Same as Treasuries
Not every bond issued by a federal entity qualifies. California does not treat Fannie Mae, Freddie Mac, or Ginnie Mae bonds as U.S. obligations, so their interest is fully taxable by the state.5Franchise Tax Board. 2024 Supplemental Guidelines to California Adjustments Interest from some other agencies, including Federal Home Loan Banks and Federal Farm Credit Banks, is exempt under their own enabling legislation. If you’re buying agency debt for the tax break, check the specific issuer rather than assuming all federal agency bonds work like Treasuries.