What Are The Market Discount Rules?
The market discount rules are designed to prevent taxpayers from receiving capital gain treatment on what is actually interest income. When the value of a debt instrument (e.g., a bond) decreases after its issue date because of an increase in interest rates, and then the bond is purchased at a discount on the secondary market, the bond is called a "market discount bond." The market discount rules treat a portion of the gain from a market discount bond as ordinary income, rather than as capital gain.
What Is A Market Discount Bond?
A market discount bond is one that is purchased in the secondary market for less than its face value. To determine the market discount, you need to know only two things: (1) what you paid for the bond and (2) what you will get for it when you redeem it at maturity. Market discount is the face or redemption price minus the purchase price.
Example(s): Assume you purchased a $1,000 face value bond for $900. The market discount is $100 ($1,000 - $900 = $100).
Why do you get a discount? Bond prices, like the prices of other securities, may fluctuate. The two most important factors are changes in market risk and changes in the interest rate. Changes in value related to risk are generally taxed at the favorable capital gains rates, but interest income is generally subject to higher ordinary tax rates. (Congress believes that if a portion of the difference between the face and purchase price represents interest, then ordinary rates should apply.)
Technical Note: Market discount is different from original issue discount (OID), which applies when a bond is originally issued at a price below its par value; in such a case, the difference between the issue price and the redemption price takes the place of periodic interest payments on the bond. The difference is important because income derived from market discount is treated differently from original issue discount by the tax code. However, it's possible for a single bond to have both types.
What Portion Is Taxed As Ordinary Income Rates?
You can elect to either: (1) Include the market discount in income currently as interest income (which increases your basis in the bond), or (2) On disposition of the bond, treat any gain up to the amount of the accrued market discount as ordinary interest income. Any excess is taxed as capital gain.
Example(s): Assume Ken buys a bond with a $1,000 redemption price for $800; the market discount on the bond is $200. If Ken later redeems the bond at maturity for $1,000, then: (1) $200 is reported on Schedule B as accrued market discount; and (2)(a) redemption (sale) of the bond is reported on Schedule D, showing a gain of $200 ($1,000 - $800), and (b) on the next line of Schedule D, Ken enters "Accrued Market Discount" as a $200 loss in column (f). If Ken sells the bond for more than $1,000, any excess gain is taxed as capital gain.
How Do You Calculate Amounts Subject To Ordinary Rates?
How do you calculate the amount that is subject to the market discount rule? The accrued market discount is determined by using either the (1) ratable accrual method or (2) the constant interest method. Both methods start with the market discount—redemption minus purchase price.
The Ratable Accrual Method
The amount of market discount that has accrued is calculated by the ratable accrual method, unless you elect the constant interest method. To compute the accrued market discount under the ratable accrual method, you take the total market discount and multiply it by a ratio. The ratio is simple--it's the number of days you have owned the bond over the number of days to maturity after you bought it. If you bought the bond when issued, the ratio is one.
Example(s): You buy a $1,000 X bond at $900 (a market discount of $100) and sell it 100 days later for $915--for a gain of $15. When you purchased the bond, there were 1,000 days until maturity. What's the accrued market discount (i.e., the amount of the gain taxed as ordinary income)? It's $100 x 100/1000 (10 percent) = $10. Ten dollars of the gain is ordinary income, and $5 is short-term capital gain.
The Constant Interest Method
To use this method, you must make an irrevocable election. This allows you to treat the built-in interest as Original Issue Discount. This effectively accelerates interest recognition, but not for an accrual taxpayer. Since (as an individual) you are probably not on the accrual method, you probably don't need to consider this method.
Recognize Ordinary Income First
Any partial payment of principal on a market discount bond is ordinary income to the extent of accrued market discount. In other words, you pay ordinary tax first.
Exceptions to the Rule
The market discount rule does not apply to debt instruments that mature within one year of issuance, U.S. savings bonds, installment bonds, or tax-exempt bonds issued before May 1, 1993.
Generally, interest expense incurred to purchase a market discount bond may be deducted currently only to the extent it exceeds the market discount allocable to the number of days the bond is held. Any interest deductions deferred under this rule are allowed in the year of disposition of the bond.
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