Market Discount

Market discount is the discount a holder gets by buying a bond after its original issue for less than the amount it will repay. IRC 1278(a)(2)(A) is precise: "The term "market discount" means the excess (if any) of— (i) the stated redemption price of the bond at maturity, over (ii) the basis of such bond immediately after its acquisition by the taxpayer." A bond carrying such a discount is a market discount bond, and IRC 1278(a)(1)(D)(i) makes the timing explicit: the term "shall not include any bond acquired by the taxpayer at its original issue." A discount built into the terms at issue is original issue discount, taxed under different sections and covered on its own page. Where a bond has both, 1278(a)(2)(B) measures the market discount not from face value but from the revised issue price, the issue price plus the OID that accrued before the holder bought.

The reason the tax law singles this discount out is that it is really interest. A bond bought at 94 and repaid at 100 pays its holder six points of return on top of the coupons, and that six points is compensation for lending at a below-market coupon, not appreciation of a capital asset. Sections 1276 through 1278 exist to tax it that way. The general fact that bond prices fall below face value when rates rise belongs to the bond and coupon rate pages; this page is about the tax consequence of buying one that has.

The default: ordinary income at disposition, up to the accrued discount. IRC 1276(a)(1) provides that "gain on the disposition of any market discount bond shall be treated as ordinary income to the extent it does not exceed the accrued market discount on such bond. Such gain shall be recognized notwithstanding any other provision of this subtitle." Any gain above the accrued discount remains capital gain, and a loss is a capital loss. The same recharacterization reaches a partial repayment of principal: under 1276(a)(3), a partial principal payment "shall be included in gross income as ordinary income to the extent such payment does not exceed the accrued market discount." Under 1276(a)(4) the recharacterized amount "shall be treated as interest for purposes of this title," with a short list of exceptions beginning with section 103. That exception does not extend the municipal exclusion to the discount; it withholds it. Publication 550 states the result directly: "Market discount on a tax-exempt bond is not tax exempt." The municipal bond page covers that case and its worked example.

How the discount accrues. IRC 1276(b)(1) accrues it ratably: the accrued market discount bears the same ratio to the total discount as "the number of days which the taxpayer held the bond" bears to "the number of days after the date the taxpayer acquired the bond and up to (and including) the date of its maturity." A holder may instead elect, bond by bond, a constant-yield accrual under 1276(b)(2), which treats the bond as if it had been issued on the purchase date at the purchase price and accrues the discount the way OID accrues; 1276(b)(2)(C) makes that election "irrevocable" for that bond. Ratable accrual front-loads the discount relative to constant yield, so a holder who sells early recognizes more ordinary income under the default method.

The election to include the discount currently. Instead of waiting for a sale, a holder may elect under IRC 1278(b) to include the accrued market discount in gross income each year as it accrues, in which case sections 1276 and 1277 do not apply and basis rises by the amounts included under 1278(b)(4). The scope is wide and prospective: under 1278(b)(2) the election "shall apply to all market discount bonds acquired by the taxpayer on or after the 1st day of the 1st taxable year to which such election applies," and under 1278(b)(3) it continues for all later years "unless the taxpayer secures the consent of the Secretary to the revocation." It reaches bonds acquired from the first year of the election onward, not bonds already held. Publication 550 adds a procedural point: the election is made by a statement attached to a timely filed return, and a holder who revoked a prior election within the last five calendar years cannot make a new one.

Borrowing to buy a market discount bond defers the interest deduction. IRC 1277(a) allows the net direct interest expense on debt incurred to buy or carry a market discount bond "only to the extent that such expense exceeds the portion of the market discount allocable to the days during the taxable year on which such bond was held," with the disallowed amount generally deducted in the year of disposition. This is the one part of the regime that does not reach tax-exempt bonds: IRC 1278(a)(1)(C) excludes tax-exempt obligations from the definition of market discount bond "For purposes of section 1277" only, leaving them fully inside section 1276. A holder who makes the 1278(b) election is also outside 1277, since the discount is already being taxed.

What is not a market discount bond. IRC 1278(a)(1)(B) excludes short-term obligations with "a fixed maturity date not exceeding 1 year from the date of issue," United States savings bonds, and installment obligations to which section 453B applies. And a small discount is not market discount at all: under 1278(a)(2)(C), if it "is less than ¼ of 1 percent of the stated redemption price of the bond at maturity multiplied by the number of complete years to maturity (after the taxpayer acquired the bond), then the market discount shall be considered to be zero," in which case the eventual gain is simply capital gain. The de minimis rule page covers that threshold and its OID counterpart. One historical boundary survives in Publication 550, which still lists "Tax-exempt obligations you bought before May 1, 1993" among the bonds that are not market discount bonds: tax-exempt bonds were outside these rules until a 1993 amendment brought them in, so for such a bond the ordinary-income recharacterization does not apply.

What the broker reports, and when. The Instructions for Form 1099-INT direct a payer to enter accrued market discount in box 10 for a covered security only "if the recipient notified you that a section 1278(b) election was made." For the default holder who has made no election, that box stays blank year after year, and the recharacterization appears only when the bond is sold, on the Form 1099-B for the sale, where the broker reports the accrued market discount in box 1f alongside the proceeds. A holder who has never read about market discount therefore meets it for the first time on a sale confirmation, as ordinary income on a bond they expected to produce a capital gain. On a bond that also carries OID, the accruals are reported on Form 1099-OID instead.

A bond is bought in the secondary market for less than its stated redemption price. The difference is the market discount, provided it clears the de minimis threshold. Unless the holder elects otherwise, nothing is reported while the bond is held. Each day a slice of the discount accrues, ratably by default. When the bond is sold, repaid or partly repaid, the gain is ordinary income up to the discount accrued to that point, and any remaining gain is capital.

A hypothetical example. Hana buys a taxable corporate bond with a stated redemption price of $10,000, issued at face value some years earlier, for $9,400 when it has exactly six years, about 2,190 days, left to maturity. Her market discount is $10,000 − $9,400 = $600. The de minimis threshold is 0.25% × $10,000 × 6 = $150; her discount exceeds it, so the rules apply in full.

She holds the bond for two years, about 730 days, then sells it for $9,800. Under the ratable method her accrued market discount is $600 × 730 ÷ 2,190 = $200, the same as $600 × 2 ÷ 6.

Her gain is $9,800 − $9,400 = $400. Of that, $200 is ordinary income, treated as interest, because it does not exceed the accrued market discount. The remaining $200 is capital gain, long-term because she held the bond for more than a year. Her broker's Form 1099-B for the sale reports the $200 of accrued market discount in box 1f, alongside the proceeds.

Had she instead made the IRC 1278(b) election in the year she bought the bond, she would have reported about $100 of ordinary income in each of the two years as the discount accrued, her basis would have risen to $9,600, and the sale would have produced a $200 capital gain and nothing more. Same total, different timing and character along the way. Had she held to maturity without electing, the full $600 of discount would have accrued and the entire $600 gain on repayment would have been ordinary income.

Pros

• The default regime defers all tax on the discount until sale or repayment, which is convenient for a holder who does not want yearly phantom income.
• The IRC 1278(b) election is available for anyone who prefers to report the discount as it accrues, and it raises basis as it goes.
• The de minimis threshold keeps small discounts out of the regime entirely, so a bond bought a fraction below face value produces capital gain in the ordinary way.
• The rules are mechanical: ratable accrual by days held needs no more than the purchase date, the maturity date and the discount.

Cons

• The gain a buyer expected to be capital gain comes back as ordinary income at the holder's top rate, up to the accrued discount, and a buyer may first learn this from the sale confirmation.
• On a tax-exempt bond the accrued discount is taxable even though the coupons are not, so a municipal bond bought at a discount can produce ordinary income.
• Ratable accrual front-loads the ordinary-income portion for a holder who sells early, and switching a bond to constant yield is irrevocable for that bond.
• The current-inclusion election is all-or-nothing for every market discount bond acquired from that year on and cannot be revoked without IRS consent.
• Interest on money borrowed to buy a market discount bond is only partly deductible while the bond is held, under IRC 1277.