Tax Treatment of Market Discount Bonds

By Timothy S. Oberst, CPA, Bennett Thrasher PC, Atlanta, GA

Editor: Joel E. Ackerman, CPA, MST

Generally, gain or loss on the sale of a note will be capital gain or loss if the note is a capital asset in the holder’s hands. Other than a note or trade receivable arising from the provision of a service or the selling of inventory or stock in trade, gain or loss recognized from the disposition of a note or account receivable will be capital gain or loss, unless the taxpayer is a dealer with respect to the note or account receivable (Sec. 1221(a)(4)). A taxpayer who purchases a note at a discount as an investment might therefore assume that any gain realized will qualify for capital gain treatment if the note is held until maturity and paid off or sold for a profit. Prior to 1984, this assumption would have been correct. However, Congress reasoned that, from a holder’s standpoint, there is no valid distinction between original issue discount (OID) and market discount and that the holder of a debt instrument should take into account any gain realized from its sale attributable to such discount as interest income. Congress therefore enacted Secs. 1276 and 1278 in 1984, which require gain on the disposition of notes purchased at a discount to be reported as ordinary income to the extent of accrued market discount.

Market Discount Bonds

Relevant definitions are found in Sec. 1278(a). The term “bond” refers to any bond, debenture, note, certificate, or other evidence of indebtedness. “Market discount” is the excess of the stated redemption price of the bond at maturity over the basis of the bond immediately after its acquisition by the taxpayer. The term “market discount bond” refers to any bond having market discount. Market discount bonds generally do not include any bonds acquired at their original issue. Also, they do not include (1) short-term obligations that mature within one year of issuance; (2) installment obligations subject to Sec. 453B; (3) U.S. savings bonds; and (4) tax-exempt bonds purchased before May 1, 1993 (Sec. 1278(a)(1)).
When a taxpayer purchases a note at a discount, the gain to the purchaser on repayment of the note in full is interest income because the transaction does not involve a sale or exchange. The rules regarding dispositions of market discount bonds are outlined in Sec. 1276. Gain realized on the disposition of a market discount bond must be recognized as interest income to the extent of the accrued market discount, and any remaining gain will be capital if the bond is a capital asset in the hands of the holder. This ordinary income treatment applies to obligations issued after July 18, 1984, and to obligations issued on or before that date that were purchased after April 30, 1993. Under the general rule, market discount is accrued ratably (Sec. 1276(b)(1)). Instead of recognizing ordinary interest income on the disposition of a market discount bond, a taxpayer can make an election under Sec. 1278(b) to include market discount in income currently.

To determine the amount of discount accrued ratably, the total amount of discount is multiplied by a fraction: the number of days the taxpayer has held the debt instrument at the time of disposition divided by the number of days after the date of acquisition to and including the maturity date. This is illustrated in the following example.

Example 1: A debt instrument with stated principal amount of $200,000, payable at maturity, is issued on January 1, 2003; it provides for interest at the rate of 10%, payable annually. The debt instrument matures on January 1, 2006. It is purchased from the original holder by taxpayer B on October 1, 2004. The debt instrument was issued at par and was sold to B for $184,000. B holds the debt instrument until March 12, 2005, on which date B sells the debt instrument at a gain. The market discount is $16,000, the excess of the debt instrument’s $200,000 stated redemption price at maturity over B’s basis immediately after acquisition. When B acquired the debt instrument, there remained 456 days to maturity. B held the debt instrument 162 days before selling it. Market discount accrued on a ratable basis to the date of sale is $5,684.21 ($16,000 3 162 ÷ 456). A gain realized not in excess of $5,684.21 will be recognized as interest income.

For a debt instrument without OID, the accrued market discount for a period is the total remaining discount multiplied by a fraction: stated interest paid during the accrual period divided by the total stated interest remaining to be paid as of the beginning of the period. Alternatively, a taxpayer may elect to determine the accrued market discount under a constant interest method (Sec. 1276(b)(2)). This election does not require prior consent, is irrevocable, is available for each debt instrument, and is made according to the rules of Rev. Proc. 92-67.
If a note calls for interest-only payments, the entire purchase discount will not be recognized as interest income until the entire principal is paid at maturity. However, if a note’s principal is paid according to an amortization schedule, partial principal payments before maturity are treated as partial dispositions of the debt instrument for purposes of Sec. 1276. Under Sec. 1276(a)(3), a partial principal payment on a market discount bond is includible in ordinary income, to the extent the payment does not exceed the accrued market discount on the bond. This treatment applies to market discount on debt instruments whose principal is paid in two or more payments. The calculation of accrued market discount in the case of such debt instruments is to be provided by regulations that have not yet been issued or proposed (Sec. 1276(b)(3)). Until the Treasury issues those regulations, the 1986 Conference Report (H.R. Conf. Rep’t No. 99-841, 99th Cong., 2d Sess. (1986)) provides temporary rules under which the taxpayer may elect to accrue market discount on a constant interest basis. To avoid double counting, the amount of any partial principal payment included in income will reduce the amount of accrued market discount for purposes of the rule that gain on the disposition of a market discount bond is ordinary income to the extent of accrued market discount (Sec. 1276(a)(3)(B)).

Dealers in Securities

Any gain on the disposition of a market discount bond in excess of the accrued market discount will be capital in nature unless the taxpayer is a dealer with respect to the note. If the taxpayer is a dealer, the entire gain will be ordinary income. Therefore, it may be necessary to determine whether a taxpayer is a dealer with respect to a purchased note.
Under Sec. 1236(c) and Regs. Sec. 1.1236-1(c)(1), a security is defined as any share of stock in any corporation, certificate of stock, or interest in any corporation, note, bond, debenture, or evidence of indebtedness, and, under Sec. 1236(a) and Regs. Sec. 1.1236-1(a), a gain by a dealer in securities from the sale or exchange of a security is generally not a capital gain. For the definition of a “dealer in securities,” Regs. Sec. 1.1236-1(c) refers to the regulations under Sec. 471, which define a dealer in securities as “a merchant of securities, whether an individual, partnership, or corporation, with an established place of business, regularly engaged in the purchase of securities and their resale to customers” (Regs. Sec. 1.471-5(c)). In addition, Sec. 475, which addresses the mark-to-market accounting method rules, defines a dealer in securities as a taxpayer who “regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business.”

Note Modifications

When a taxpayer purchases a note at a discount, the terms of the note may be modified, in which case it is necessary to determine whether the modification constitutes a taxable event. If the terms of a debt instrument are significantly modified, for federal income tax purposes there is a deemed exchange of the old debt for a new (modified) debt instrument. On the deemed exchange, the debtor realizes debt-discharge income to the extent the principal amount of the old debt exceeds the issue price of the new debt. The holder realizes gain or loss on its deemed disposition of the old debt measured by the difference between the issue price of the new debt and the holder’s adjusted tax basis in the old debt (Regs. Secs. 1.1001-1(a) and 1.1274-2(a); Rev. Rul. 89-122). If the new instrument provides for adequate stated interest, the issue price equals the stated principal amount.
Regs. Sec. 1.1001-3 addresses the issue of when a modification of a debt instrument will be deemed to trigger an exchange; this regulation is effective for alterations of the terms of a debt instrument on or after September 24, 1996. A “modification” is any alteration of a legal right or obligation of the holder or the issuer, including the addition or deletion of a right or obligation (Regs. Sec. 1.1001-3(c)(1)). The regulation provides three exceptions to the definition of a modification: (1) an alteration that occurs by operation of the terms of the debt instrument; (2) the failure of the issuer to perform its obligations under the debt instrument; and (3) the failure of a party to a debt with an option to change a term of the instrument to do so.
When a modification has taken place, it is necessary to determine based on the facts and circumstances whether the modification is significant. Generally a modification is significant if the legal rights or obligations being changed and the degree to which they are being changed are economically significant (Regs. Sec. 1.1001-3(e)(1)), and the regulations do provide some specific guidance. For example, the substitution of a new obligor is generally a significant modification, while a change in payment mechanics is not. If a modification results in a change in a debt instrument’s yield, it is significant only if the modified yield varies from the unmodified yield by more than the greater of 25 basis points (0.25 percentage point) or 5% of the yield of the unmodified debt (Regs. Sec. 1.1001-3(e)(2)(ii)). The following example is from the regulations.

Example 2: A debt instrument with a 10-year term provides for 10% interest, payable annually, and a $100,000 payment at maturity. At the end of the fifth year, the parties reduce the amount payable at maturity to $80,000. This is a significant modification under the regulations because the yield on the instrument has been reduced to 4.332%. Thus, there is a deemed exchange (Regs. Sec. 1.1001-3(g), Example (3)).

A change in the timing and/or amounts of payments is significant if it materially defers payments due under the debt.  Materiality is determined on the basis of all the facts and circumstances, including the following: (1) length of the deferral, (2) original term of the debt instrument, (3) amounts of payments deferred, and (4) time period between the modification and the actual deferral of payments (Regs. Sec. 1.1001-3(e)(3)(i)). The regulations provide a safe-harbor period. Deferral of one or more scheduled payments within that period is not a material deferral if the deferred payments are unconditionally payable no later than the end of the period. The safe-harbor period begins on the due date of the first deferred scheduled payment and lasts for the lesser of five years or 50% of the principal term of the debt instrument. The following is another example from the regulations.

Example 3: A 20-year debt instrument with stated principal of $100,000 payable at maturity bears a 10% coupon payable annually. At the beginning of the 11th year, issuer and holder agree to defer all remaining interest payments until maturity with compounding (thus the yield is unchanged). The safe-harbor period begins at the end of the 11th year, the date the payment is due, and ends at the end of the 16th year. Because the deferred payments are not unconditionally payable on or before the end of the safe-harbor period, the deferral is not within the safe harbor. There is clearly a material deferral, and the modification is significant (Regs. Sec. 1.1001-3(g), Example (4)).


If a taxpayer purchases a note at a discount and holds it until maturity, at which time the note is paid in full, the entire purchase discount will be recognized in income as interest income at the time of repayment. If the taxpayer sells the note prior to maturity, gain on the disposition is reported as interest income to the extent of accrued market discount. Market discount is accrued ratably or under the constant interest method. Any gain realized in excess of accrued market discount is capital gain if the taxpayer holding the note is not considered a dealer with respect to the note. A taxpayer also recognizes interest income as principal payments are received. Finally, if the terms of a note are modified on acquisition, the modification(s) must be analyzed to determine if a taxable event has occurred.


Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or

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