Accrued market discount is a concept that can significantly impact the taxation of bonds and other debt instruments. It arises when an investor purchases a bond at a price lower than its face value in the secondary market, potentially leading to additional taxable income upon sale or maturity. Understanding how it affects taxes is crucial for investors aiming to optimize their tax liabilities.
Conditions That Trigger the Discount
Accrued market discount applies when an investor buys a bond in the secondary market for less than its redemption value. This typically occurs due to shifts in interest rates, changes in the issuer’s credit quality, or fluctuations in market demand. For example, rising interest rates can reduce the value of existing bonds with lower coupon rates, creating a market discount. Under Internal Revenue Code Section 1278, market discount is generally the excess of the bond’s stated redemption price at maturity over the investor’s basis immediately after purchase, and a “de minimis” amount (less than 0.25% of face value times the number of full years to maturity) is treated as zero. The market discount rules generally apply to most taxable bonds; notable exceptions include short‑term obligations (maturity of one year or less), U.S. savings bonds, certain installment obligations, and tax‑exempt obligations purchased before May 1, 1993. Market discount on tax‑exempt bonds is not tax‑exempt; if you don’t elect to include it currently, the gain up to accrued market discount is taxable when you dispose of the bond.
Calculation Methods
Investors can calculate accrued market discount using either the ratable accrual method or the constant yield method. The ratable accrual method spreads the discount evenly over the bond’s remaining life. For instance, a $100 discount on a bond with 10 years to maturity would result in $10 of discount recognized annually. The constant yield method, while more complex, calculates the yield to maturity based on the purchase price and adjusts the accrual annually to reflect changes in the bond’s yield curve. The choice of method impacts both the timing and amount of taxable income, making it important to consult IRS guidelines or a tax professional.
Timing of Recognition
Investors must decide whether to defer recognition of accrued market discount until the bond is sold or matures, or to recognize it annually. Deferring recognition postpones tax liability but may lead to a larger tax bill later when the amount up to accrued market discount is treated as ordinary interest income. Recognizing the discount annually spreads the tax burden over the bond’s life, aligning with economic accrual. This election is made in the year the bond is acquired, applies to all market discount bonds you acquire in that year and later years, and generally cannot be revoked without IRS consent.
Recording on Tax Documents
Accurate reporting of accrued market discount is essential for compliance. If you did not elect to include market discount currently, report the sale on Form 8949 and treat the portion of gain up to the accrued market discount as interest income on Schedule B (label it “Accrued Market Discount”).1Internal Revenue Service. Publication 550 (2024), Investment Income and Expenses
If you elected to include market discount currently and the bond is a taxable covered security, your broker may report the amount that accrued for the year in Box 5 of Form 1099‑OID (you must have notified the broker of your election). Keep these forms with your records to reconcile what you report.2Internal Revenue Service. Publication 1212 (01/2025), Guide to Original Issue Discount (OID) Instruments
Adjusting the Basis
Adjusting the bond’s basis prevents double taxation. When you include market discount in income currently, increase your basis each year by the amount you reported. For example, a $50 market discount recognized over five years increases the basis by $10 annually. If you defer recognition, you do not increase basis for the accrued discount; instead, at sale or redemption the portion of gain up to the accrued discount is taxed as ordinary interest income, and only any remaining gain (if any) is capital. This approach ensures the market discount isn’t taxed again as capital gain and helps investors implement straightforward tax planning.