7642 / What is the discount bond method that holders and issuers of inflation-adjusted debt instruments can use to account for interest and original issue discount?

An inflation-indexed bond that does not qualify for the coupon bond method (e.g., it is issued at a discount) is subject to the more complex discount bond method. The discount bond method requires holders and issuers to make current adjustments to their original issue discount accruals for inflation and deflation. A taxpayer determines the amount of original issue discount allocable to an accrual period using steps similar to those for original issue discount bonds that are not inflation-indexed (see Q 7650).¹ First, the taxpayer determines the yield to maturity of the debt instrument as if there were no inflation or deflation over the term of the instrument. Second, the taxpayer determines the length of the accrual period, provided that accrual period is no longer than one month. Third, the percentage change in the reference index during the accrual period is determined by comparing the value at the beginning of the period to the value at the end of the period.² Fourth, the taxpayer determines the original issue discount allocable to the accrual period and, fifth, allocates a ratable portion of the original issue discount for the accrual period to each day in the period.³

Holders of stripped Treasury Inflation-Protection Securities must use the discount bond method to account for the original issue discount on the principal and coupon components of the bond.⁴

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1.   Treas. Reg. § 1.1272-1(b)(1).

2.   Treas. Reg. § 1.1275-7(e)(3)(iii).

3.   Treas. Reg. §§ 1.1275-7(e)(3)(iv) and 1.1275-7(e)(3)(v).