4.21 Discount on Short-Term Obligations

Short-term obligations (maturity of a year or less from date of issue) may be purchased at a discount from face value. If you are on the cash basis, the discount on short-term obligations other than tax-exempt obligations must be reported as interest income in the year the obligations are sold or redeemed unless you elect to include the accrued discount in income currently.

Discount must be currently reported by dealers and accrual-basis taxpayers.

Discount allocable to the current year must be reported as income by accrual-basis taxpayers, dealers who sell short-term obligations in the course of business, banks, regulated investment companies, common trust funds, certain pass-through entities, and for obligations identified as part of a hedging transaction. Current reporting also applies to persons who separate or strip interest coupons from a bond and then retain the stripped bond or stripped coupon; the accrual rule applies to the retained obligation.

Caution

Reporting Zero Coupon Bond Discount

Zero coupon bond discount is reported annually as interest over the life of the bond, even though interest is not received. This tax cost tends to make zero coupon bonds unattractive to investors, unless the bonds can be bought for IRA and other retirement plans that defer tax on income until distributions are made.

Zero coupon bonds also may be a means of financing a child’s education. A parent buys the bond for the child. The child must report the income annually, and if the income is not subject to the parent’s marginal tax bracket under the “kiddie tax” (Chapter 24), the income subject to tax may be minimal.

The value of zero coupon bonds fluctuates sharply with interest rate changes. This fact should be considered before investing in long-term zero coupon bonds. If you sell zero coupon bonds before the maturity term at a time when interest rates rise, you may lose part of your investment.

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For short-term nongovernmental obligations, OID is generally taken into account instead of acquisition discount, but an election may be made to report the accrued acquisition discount. See IRS Publication 550 for details.

Basis in the obligation is increased by the amount of acquisition discount (or OID for nongovernmental obligations) that is currently reported as income.

Interest deduction limitation for cash-basis investors.

A cash-basis investor who borrows funds to buy a short-term discount obligation may not fully deduct interest on the loan unless an election is made to report the accrued acquisition discount as income. If the election is not made, the interest you paid during the year is deductible only to the extent it exceeds (1) the portion of the discount allocated to the days you held the bond during the year, plus (2) the portion of interest not taxable for the year under your method of accounting. Any interest expense disallowed under this limitation is deductible in the year in which the obligation is disposed.

The interest deduction limitation does not apply if you elect to include in income the accruable discount under the ratable accrual method or constant yield method (4.20). The election applies to all short-term obligations acquired during the year and also in all later years.

Filing Tip

Discount on Short-Term Government Obligations

For short-term governmental obligations (other than tax-exempts), the acquisition discount is accrued in daily installments under the ratable method, unless an election is made to use the constant yield method.

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Gain or loss on disposition of short-term obligations for cash-basis investors.

If you have a gain on the sale or exchange of a discounted short-term governmental obligation (other than tax-exempt local obligations), the gain is ordinary income to the extent of the ratable share of the acquisition discount received when you bought the obligation. Follow the computation shown in the discussion of Treasury bills (4.27) to figure this ordinary income portion. Any gain over this ordinary income portion is short-term capital gain; a loss would be a short-term capital loss.

Gain on short-term nongovernmental obligations is treated as ordinary income up to the ratable share of OID. The formula for figuring this ordinary income portion is similar to the formula for short-term governmental obligations (4.27), except that the denominator of the fraction is days from original issue to maturity, rather than days from acquisition. A constant yield method may also be elected to figure the ordinary income portion. Gain above the computed ordinary income amount is short-term capital gain (Chapter 5). For more information, see IRS Publication 550.