Original Issue Discount (OID)

Original issue discount, abbreviated OID by the IRS itself, is defined in IRC 1273(a)(1): "The term "original issue discount" means the excess (if any) of— (A) the stated redemption price at maturity, over (B) the issue price." For a publicly offered bond the issue price is, under 1273(b)(1), "the initial offering price to the public (excluding bond houses and brokers) at which price a substantial amount of such debt instruments was sold." The stated redemption price at maturity is the amount due at the end, including any interest that is not paid at fixed periodic intervals of a year or less along the way. Publication 1212, the IRS's guide to OID instruments, puts the whole idea in one line: "OID is a form of interest."

The word "original" is doing work. OID arises only from the terms at which the instrument was first sold. A bond that was issued at face value and later falls in price has no OID; a later buyer's discount is market discount, and the two are taxed under different rules. A zero-coupon bond is the pure case of OID, since all of its return is the gap between issue price and face value, but any bond issued below its redemption price carries some, and Publication 550 notes that "All debt instruments that pay no interest before maturity are presumed to be issued at a discount."

Current inclusion by constant yield. IRC 1272(a)(1) requires the holder of a debt instrument with OID to include in gross income "an amount equal to the sum of the daily portions of the original issue discount for each day during the taxable year on which such holder held such debt instrument." Those daily portions come from 1272(a)(3): for each accrual period, the OID is the adjusted issue price at the start of the period multiplied by the yield to maturity, less the stated interest payable during the period, and that amount is spread evenly over the period's days. The adjusted issue price is the issue price plus all OID previously accrued, per 1272(a)(4), and an accrual period is, by default under 1272(a)(5), a six-month period ending on the maturity date's anniversary or the date six months before it. Because the yield is applied to a growing base, the dollar accrual rises each period. IRC 1272(c)(2) then provides that the holder's basis "shall be increased by the amount included in his gross income pursuant to this section," which is what prevents the same dollars being taxed again at maturity or sale.

The four exceptions. IRC 1272(a)(2) lists the instruments the current-inclusion rule does not reach: "(A) Tax-exempt obligations", "(B) United States savings bonds", "(C) Short-term obligations", defined as "Any debt instrument which has a fixed maturity date not more than 1 year from the date of issue", and "(D) Loans between natural persons" made outside the lender's trade or business where the loan, added to prior loans between the same two people, "does not exceed $10,000." That last exception disappears if tax avoidance is a principal purpose of the loan, and a married couple counts as one person. Separately, 1272(b)(1) exempts any holder "who has purchased the debt instrument at a premium," since someone who paid more than the redemption price has no discount to accrue.

Tax-exempt OID accrues but is not taxed. Exception (A) removes municipal OID from income, but IRC 1288 still requires it to accrue for the purpose of determining the holder's basis, so a municipal zero's basis rises along the same curve and its eventual repayment at face value is not a gain. Brokers report tax-exempt OID on Form 1099-OID in box 11.

Acquisition premium is not bond premium. A buyer in the secondary market who pays more than the adjusted issue price but less than the redemption price has, in the words of Publication 1212, an acquisition premium: "the excess of a debt instrument's adjusted basis immediately after purchase, including purchase at original issue, over the debt instrument's adjusted issue price at that time." Under IRC 1272(a)(7) the daily OID accruals are reduced by a fraction that spreads the acquisition premium over the remaining life, so the holder reports less OID than the original buyer would have. If the buyer pays more than the redemption price itself, there is no OID to reduce and the excess is bond premium under IRC 171, a different regime covered on its own page.

Stripped bonds create OID by purchase. Treasury STRIPS and other stripped securities were not issued at a discount by anyone, so IRC 1286(a) supplies the OID synthetically: a purchased stripped bond or coupon "shall be treated for purposes of this part as a bond originally issued on the purchase date and having an original issue discount equal to the excess (if any) of— (1) the stated redemption price at maturity (or, in the case of coupon, the amount payable on the due date of such coupon), over (2) such bond's or coupon's ratable share of the purchase price." Each STRIPS holder therefore has their own OID measured from their own purchase, which is why Publication 550 warns that the OID shown on a Form 1099-OID for a stripped bond must be refigured by the holder.

Short-term paper is handed to a different section. Exception (C) takes instruments maturing within a year out of the yearly accrual rule, and IRC 1271(a)(3) and (a)(4) then catch the discount at sale or maturity instead. For a short-term government obligation, "any gain realized which does not exceed an amount equal to the ratable share of the acquisition discount shall be treated as ordinary income," and the same rule applies to a short-term nongovernment obligation up to the ratable share of its OID. The ratable share is the discount multiplied by the days held over the days to maturity, counted from the holder's acquisition for a government obligation and from the original issue date for a nongovernment one. Publication 550 adds that a holder may instead choose to include the discount in income currently. This is the rule that governs a Treasury bill bought at a discount.

Two neighboring rules, covered elsewhere. A discount smaller than one quarter of one percent of the redemption price for each complete year to maturity is treated as zero under the de minimis rule, which has its own page. And the annual increase in a TIPS holder's inflation-adjusted principal is reported as OID under the rules for inflation-indexed instruments, a consequence covered on the Treasury Inflation-Protected Securities page. The reporting form for all of it is Form 1099-OID, whose box 1 carries taxable OID, box 2 other periodic interest, box 5 market discount, box 6 acquisition premium, box 8 OID on Treasury obligations, box 10 bond premium and box 11 tax-exempt OID, under the IRS instructions revised January 2024.

When a debt instrument is issued below its redemption price, the issuer or the broker holding it computes the yield to maturity from the issue price, divides the term into accrual periods, and each year reports to the holder the OID that accrued during the days the holder owned it. The holder includes that amount as interest income and adds it to basis. At maturity the redemption price equals the adjusted basis and no further income results.

A hypothetical example. Rafael buys at original issue a zero-coupon bond with a stated redemption price of $10,000 due in 10 years. The issue price is $6,729.71, which corresponds to a yield of 4 percent compounded semiannually, that is, 2 percent per six-month accrual period. Because the bond pays no stated interest, the OID is $10,000 − $6,729.71 = $3,270.29, and the de minimis threshold of 0.25% × $10,000 × 10 = $250 is far exceeded, so the full amount accrues.

First accrual period: adjusted issue price $6,729.71 × 2% = $134.59 of OID. The adjusted issue price becomes $6,729.71 + $134.59 = $6,864.30.

Second accrual period: $6,864.30 × 2% = $137.29 of OID. The adjusted issue price becomes $7,001.59.

For the first year Rafael reports $134.59 + $137.29 = $271.88 of interest income, receives no cash, and his basis in the bond rises from $6,729.71 to $7,001.59. Each later year's figure is a little larger, because 2 percent is applied to a bigger base.

If Rafael sells the bond at the end of that first year for $7,100, his gain is $7,100 − $7,001.59 = $98.41, a capital gain, because the interest component of his return has already been taxed as OID and captured in basis. If he holds to maturity he receives $10,000 against a basis that has accreted to $10,000, and nothing further is taxed.

Pros

• The rule taxes the economic interest a discounted bond earns, so a zero-coupon holder and a coupon-bond holder with the same yield end up taxed on the same income over the same years.
• Basis rises with every dollar reported, so the discount is never taxed twice and a repayment at face value produces no gain.
• The constant-yield method is mechanical and the broker computes it, reporting the year's figure on Form 1099-OID.
• Four clear exceptions keep tax-exempt bonds, savings bonds, one-year paper and small personal loans out of the yearly accrual.

Cons

• The holder owes tax on income the instrument has not paid, which can create a cash-flow problem in a taxable account, especially with a large zero-coupon position.
• A stripped bond's Form 1099-OID may not match the holder's own OID, which is measured from the holder's purchase price, so the figure has to be refigured using Publication 1212.
• Acquisition premium, market discount and bond premium each interact with OID under different rules, and a bond bought in the secondary market can carry more than one of them at once.
• Short-term discount paper follows a separate recharacterization rule at sale, so a Treasury bill and a ten-year zero produce the same kind of income under two different sections.