4.18 Discount on Bonds

There are two types of bond discounts: original issue discount and market discount.

Market discount.

Market discount arises when the price of a bond declines because its interest rate is less than the current interest rate. For example, a bond originally issued at its face amount of $1,000 declines in value to $900 because the interest payable on the bond is less than the current interest rate. The difference of $100 is called market discount. The tax treatment of market discount is explained in 4.20.

Original issue discount (OID).

OID arises when a bond is issued for a price less than its face or principal amount. OID is the difference between the principal amount (redemption price at maturity) and the issue price. For publicly offered obligations, the issue price is the initial offering price to the public at which a substantial amount of such obligations were sold. All obligations that pay no interest before maturity, such as zero coupon bonds, are considered to be issued at a discount. For example, a bond with a face amount of $1,000 is issued at an offering price of $900. The $100 difference is OID.

Generally, part of the OID must be reported as interest income each year you hold the bond, whether or not you receive any payment from the bond issuer. This is also true for certificates of deposit (CDs), time deposits, and similar savings arrangements with a term of more than one year, provided payment of interest is deferred until maturity. OID is reported to you by the issuer (or by your broker if you bought the obligation on a secondary market) on Form 1099-OID (4.19).

Filing Tip

When OID May Be Ignored

You may disregard OID that is less than one-fourth of one percent (.0025) of the principal amount multiplied by the number of full years from the date of original issue to maturity. On most long-term bonds, the OID will exceed this amount and must be reported.

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Exceptions to OID.

OID rules do not apply to: (1) obligations with a term of one year or less held by cash-basis taxpayers(4.21); (2) tax-exempt obligations, except for certain stripped tax-exempts (4.26); (3) U.S. Savings Bonds; (4) an obligation issued by an individual before March 2, 1984; and (5) loans of $10,000 or less from individuals who are not professional money lenders, provided the loans do not have a tax avoidance motivation.

Bond bought at premium or acquisition premium.

You do not report OID as ordinary income if you buy a bond at a premium. You buy at a premium where you pay more than the total amount payable on the bond after your purchase, not including qualified stated interest. When you dispose of a bond bought at a premium, the difference between the sale or redemption price and your basis is a capital gain or loss (4.17).

If you do not pay more than the total due at maturity, you do not have a premium, but there is “acquisition premium” if you pay more than the adjusted issue price. This is the issue price plus previously accrued OID but minus previous payments on the bond other than qualified stated interest. The acquisition premium reduces the amount of OID you must report as income. The rules for computing the reduction to OID are in IRS Publication 1212.