7635 / How are proceeds on the sale or retirement of a corporate bond taxed?

(2) Proceeds in excess of item (1), above, are recovered tax-free to the extent of the investor’s adjusted basis in the bond.² As a general rule, the investor’s adjusted basis is the cost of acquisition adjusted by (a) adding any original issue discount (OID) included in income as it accrued (see Q 7650, Q 7652) and market discount included in income prior to the sale (see Q 7644, Q 7646, Q 7647), or (b) subtracting amounts of premium deductible or applied to reduce interest payments if an election was made to amortize bond premium (see Q 7654).

(3) Ordinarily, amounts in excess of interest and basis are treated as capital gain (long-term or short-term, depending on the investor’s holding period). See Q 699 regarding holding periods and Q 702 for the treatment of capital gains and losses. However, if the bond was originally issued at a discount or was purchased on the market at a discount, part or all of the gain must be treated as interest instead of capital gain, if the discount was not included in income as it accrued. (Discount that is less than ¼ of 1 percent (.0025) of face value multiplied by the number of complete years to maturity is considered no discount.)

(a) If the bond was issued after July 18, 1984, or if the bond was issued on or before July 18, 1984, and purchased on the market after April 30, 1993, gain to the extent it does not exceed market discount must be treated as interest income, not capital gain (see Q 7643, Q 7645, Q 7647). If a bond issued on or before July 18, 1984 was acquired after July 18, 1984, but before May 1, 1993, at a market discount using borrowed funds, a part of the gain must be treated as ordinary income if a deferred interest expense deduction is taken (see Q 8046).