4.20 Reporting Income on Market Discount Bonds
Market discount arises where the price of a bond declines below its face amount because it carries an interest rate that is below the current rate of interest.
When you realize a profit on the sale of a market discount bond, the portion of the profit equal to the accrued discount must be reported as ordinary interest income rather than as capital gain. Alternatively, an election may be made to report the accrued market discount annually instead of in the year of disposition.
These rules apply to taxable as well as tax-exempt bonds bought after April 30, 1993. However, there are these exceptions: (1) bonds with a maturity date of up to one year from date of issuance; (2) certain installment obligations; and (3) U.S. Savings Bonds. Furthermore, you may treat as zero any market discount that is less than one-fourth of one percent (.0025) of the redemption price multiplied by the number of full years after you acquire the bond to maturity. Such minimal discount will not affect capital gain on a sale.
Planning Reminder
Deferral of interest deduction and ordinary income at disposition if you borrow to buy or carry market discount bonds.
If you do not elect to report the accrued market discount annually as interest income (see below for “How to figure accrued market discount”), and you took a loan to buy or carry a market discount bond, your interest deductions may be limited. If your interest expense exceeds the income earned on the bond (including OID income, if any), the excess may not be currently deducted to the extent of the market discount allocated to the days you held the bond during the year. The allocation of market discount is based on either the ratable accrual method or constant yield method; see below.
In the year you dispose of the bond, you may deduct the interest expenses that were disallowed in prior years because of the above limitations.
You may choose to deduct disallowed interest in a year before the year of disposition if you have net interest income from the bond. Net interest income is interest income for the year (including OID) less the interest expense incurred during the year to purchase or carry the bond. This election lets you deduct any disallowed interest expense to the extent it does not exceed the net interest income of that year. The balance of the disallowed interest expense is deductible in the year of disposition.
How to figure accrued market discount.
Where the market discount rules apply, gain is taxed as ordinary interest income to the extent of the market discount accrued to the date of sale. There are two methods for figuring the accrued market discount. The basic method, called the ratable accrual method, is figured by dividing market discount by the number of days in the period from the date you bought the bond until the date of maturity. This daily amount is then multiplied by the number of days you held the bond to determine your accrued market discount; see Example 1 below.
Instead of using the ratable accrual method to compute accrual of market discount, you may elect to figure the accrued discount for any bond under an optional constant yield (economic accrual) method. If you make the election, you may not change it. The constant yield method initially provides a smaller accrual of market discount than the ratable method, but it is more complicated to figure. It is generally the same as the constant yield method used in IRS Publication 1212 to compute taxable OID (4.19). For accruing market discount, treat your acquisition date as the original issue date and your basis for the market discount bond (immediately after you acquire it) as the issue price when applying the formula in Publication 1212.
Reporting discount annually.
Rather than report market discount in the year you sell the bond, you may elect, in the year you acquire the bond, to report market discount currently as interest income. You may use either the ratable accrual method, as in Example 3 below, or the elective constant yield method discussed earlier. Attach to your timely filed return a statement that you are making the election and describe the method used to figure the accrued market discount. Your election to report annually applies to all market discount bonds that you later acquire. You may not revoke the election without IRS consent. If the election is made, the interest deduction deferral rule discussed earlier does not apply. Furthermore, the election could provide a tax advantage if you sell the bond at a profit and you can benefit from lower tax rates applied to net long-term capital gains.
Filing Instruction
Partial principal payments on bonds acquired after October 22, 1986.
If the issuer of a bond (acquired by you after October 22, 1986) makes a partial payment of the principal (face amount) and you did not elect to report the discount annually, you must include the payment as ordinary interest income to the extent it does not exceed the accrued market discount on the bond. See IRS Publication 550 for options on determining accrued market discount. A taxable partial principal payment reduces the amount of remaining accrued market discount when figuring your tax on a later sale or receipt of another partial principal payment.
Market discount on a bond originally issued at a discount.
A bond issued at original issue discount may later be acquired at a market discount because of an increase in interest rates. If you acquire at a market discount a bond with OID, the market discount is the excess of: (1) the issue price of the bond plus the total original issue discount includible in the gross income of all prior holders of the bond over (2) what you paid for the bond.
Exchanging a market discount bond in corporate mergers or reorganizations.
If you hold a market discount bond and exchange it for another bond as part of a merger or other reorganization, the new bond is subject to the market discount rules when you sell it. However, under an exception, market discount rules will not apply to the new bond if the old market discount bond was issued before July 19, 1984, and the terms and interest rates of both bonds are identical.