Market discount rules: In search of an escape route for distressed debt

By Lisa M. Loychik, CPA, Youngstown, Ohio

Editor: Anthony S. Bakale, CPA

Many times a taxpayer who has purchased distressed debt is unaware of the unfavorable results of the market discount rules. These rules are briefly explained below and have no exceptions for distressed debt, which is often purchased at a deep discount. Can a taxpayer make any arguments to escape the harsh treatment of the market discount rules? If not, can the taxpayer use cost recovery to alleviate some of the burden of these rules?

The market discount rules are codified at Secs. 1276 through 1278 and were enacted by Congress in 1984. These rules require holders of debt instruments to report gain on disposition or on payment at maturity as ordinary income to the extent the proceeds received by the taxpayer are attributable to a market discount under Sec. 1276(a). Market discount is defined in Sec. 1278(a)(2) as the excess of (1) the stated redemption price at maturity (usually the bond's principal amount) over (2) the holder's cost basis in the bond. Gain realized on the disposition of a market discount bond is considered attributable to market discount and thus taxed as ordinary income to the extent that the market discount has accrued during the holder's ownership. In this regard, market discount is treated as similar to original issue discount, except the recognition of the ordinary income occurs when the taxpayer receives payment on the bond or proceeds from a sale of the bond.

If the debtor makes a partial payment of principal on market discount debt, the taxpayer holding the debt first treats the payment as accrued market discount to the extent it was not previously recognized. This results in the first dollars received by the taxpayer being taxable as ordinary income. To the extent a partial payment on the bond exceeds the amount of accrued and previously unrecognized market discount, the excess is treated as a nontaxable recovery of principal (basis) under Sec. 1276(a)(3)(A).

Accrued market discount is generally determined on a straight-line (ratable) basis from the date of acquisition to the date of maturity. The calculation is based on the number of days and accrues daily. At the holder's election, the holder can use the constant-yield-to-maturity method over that period as provided in Sec. 1276(b)(1). The constant-yield-to-maturity method results in the accrual of a lower amount of market discount in the earlier portion of the holding period. Therefore, if the holder does not plan to hold the bond until maturity, electing the constant-yield-to-maturity method should be considered.

Sec. 1278(a)(1)(B) excludes certain debt instruments from the definition of a "market discount bond." Under this provision, (1) short-term obligations (maturing not more than one year from the date of issue), (2) U.S. savings bonds, and (3) installment obligations to which Sec. 453B applies are not market discount bonds even though the taxpayer may have acquired the debt instrument at a price that was less than the stated redemption price at maturity.

Sec. 1276(b)(1) requires a holder to accrue market discount from the acquisition date to its maturity date (the remaining term of the bond) or disposition date if earlier. What if the debt instrument has no remaining term when the holder acquires it? If the bond is distressed debt, it may very well be that the acquisition of the debt occurred after its maturity date had passed. Can the holder argue that the market discount rules do not apply because no remaining term exists? Would this argument hold up if the debt was acquired before maturity but it was in substantial default, whereby, under the terms of the note, the default provision causes the full amount due under the note to be payable currently and that provision is enforceable under applicable state law? In these circumstances, the debt instrument would be a demand loan when acquired. Therefore, there is no remaining term to accrue the market discount. It would appear based on these circumstances that the bond would be excludable from the definition of a market discount bond since it is now a short-term obligation.

However, Sec. 1278(a)(1)(B) limits short-term obligations to those with a maturity date that is one year or less from the date of issue. Therefore, if the bond cannot be treated as a newly issued debt at the time of the default (see Regs. Sec. 1.1001-3), it appears that the short-term obligation exclusion would not apply. In either case, since the debt instrument is due and payable at the time of acquisition, it appears the market discount rules cannot apply, by their own terms, since no accrual period exists with respect to the debt.

Assume a taxpayer acquires a deeply discounted debt instrument that is a performing loan and neither of the two previously noted circumstances applies. Is there any way to alleviate the tax detriment associated with the requirement that the taxpayer treat a portion of principal payments received on the note as payment of accrued market discount? Some cases that predate the enactment of the market discount rules may provide relief to the taxpayer. These cases, discussed below, have allowed for the use of the cost-recovery method. Under this method, a taxpayer can apply all payments of principal to basis first before recognizing income attributable to the market discount.

The legislative history to the enactment of the market discount rules does not indicate that Congress meant to overrule these cases. The issue in the cases cited below dealt with the timing of the recognition of the market discount income under Sec. 1276(a)(3). They did not deal with the character of the market discount income under Sec. 1276(a)(1). To the extent addressed, character of the market discount as ordinary income was not challenged.

The courts have agreed cost recovery can apply to speculative debt, taking into account several factors to determine if debt is speculative. In Underhill, 45 T.C. 489 (1966), the taxpayer acquired debt instruments at sizable discounts and usually secured the obligations by second deeds of trust. The Tax Court took into account the following elements (from decided cases) in determining whether the obligation was speculative:

  • Whether the debtors and/or guarantors had personal liability, their credit standing, and resources available to make payment (Phillips v. Frank, 295 F.2d 629 (9th Cir. 1961), rev'g 185 F. Supp. 349 (W.D. Wash. 1960); Liftin, 36 T.C. 909 (1961), aff'd, 317 F.2d 234 (4th Cir. 1963));
  • The marketability of the debt instrument (Phillips v. Frank, 295 F.2d 629 (9th Cir. 1961); Darby Investment Corp., 315 F.2d 551 (6th Cir. 1963), aff'g 37 T.C. 839 (1962));
  • Consideration as to whether the obligor was in substantial default on payments due at the time of acquisition (Phillips v. Frank, 295 F.2d 629 (9th Cir. 1961); Willhoit, T.C. Memo. 1958-207, rev'd, 308 F.2d 259 (9th Cir. 1962));
  • Whether a first, second, or other priority lien existed at the time of the acquisition, and the condition and market value of the underlying property (Darby Investment Corp.,315 F.2d 551 (6th Cir. 1963)); and
  • The size of the discount (Liftin, 36 T.C. 909 (1961)).

In Underhill, the Tax Court held:

[T]he ultimate test is whether, at the time of acquisition, the person acquiring the obligation . . . cannot be reasonably certain that he will recover his cost and a major portion of the discount.[emphasis added]

The court stated:

We believe it is not essential to the ultimate test that the major portion of the discount, which may be reasonably certain to be recovered, be determined precisely. It should be sufficient to make a broad finding in this regard.

Where certain debt obligations were determined to be speculative, the Tax Court allowed the taxpayer to use the cost-recovery method, and in cases where it found the debt instruments were not speculative, it required the taxpayer to report the payments for principal pro rata, based on the total discount.

If at the time of the acquisition there is no evidence to support a finding that the notes are short-term, and there is no evidence to support a finding that the taxpayer would not recover its basis in the notes, then market discount rules certainly apply, and the taxpayer cannot use the cost-recovery method. If factors exist that would lead an informed person to conclude the likelihood that the cost of the notes and a substantial portion of the discount would not be collected after pursuing all legal options and remedies as provided by the terms of the note (foreclosure, guarantees, etc.), then based on the cited case history, the notes would be considered speculative, and the cost-recovery method may be appropriate.


Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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