The amount of discount treated as ordinary income is determined in the following manner. Any individual holding the bill at maturity includes as ordinary income the difference between the tax basis and the bill’s face value. (The difference between an individual’s basis and the bill’s face value is called “acquisition discount.”) Any individual who sells the bill prior to maturity includes as ordinary income only a portion of the acquisition discount based on the total time he or she held the bill; the amount included is the acquisition discount multiplied by a fraction having as numerator the number of days the individual held the obligation and as denominator the number of days after he or she acquired the bill up to and including the maturity date.4 This formula enables each holder to determine the portion of any gain to be treated as interest income without reference to the original discount or the treatment applicable to any other holder.
An owner may elect irrevocably on a bill-by-bill basis to compute the amount of discount on a daily compounding basis instead of in equal daily portions.5
If the investor has elected to include discount in income as it accrues prior to sale, the tax basis is increased by the amount included, and the entire gain is capital gain (see Q 7625).6