7643 / What is market discount? What is a “market discount bond”?

Bond prices on the market fluctuate as interest rates change and as the borrower’s credit rating changes. Therefore, bonds may be bought at a discount because of a decline in value of the obligation after issue. A bond acquired at a discount on the market is called a “market discount bond.” For tax purposes the term “market discount bond” does not include tax-exempt municipal obligations purchased before May 1, 1993, short-term obligations, and U.S. Savings Bonds.¹ With certain exceptions (e.g., bonds acquired at issue for less than issue price–usually by large institutional investors), bonds acquired at the time of original issue are not “market discount” bonds.²

Market discount is the amount by which the stated redemption price exceeds the taxpayer’s basis in the bond immediately after its acquisition, if the bond was originally issued at par.³ If the bond was originally issued at a discount and purchased on the market for less than the original issue price increased by the amount of original issue discount accruing since issue up to the date of purchase, the difference is market discount.⁴ If the total market discount is less than ¼ of 1 percent (.0025) of the stated redemption price at maturity (or if the bond was issued at a discount of the issue price increased by original issue discount accruing since issue to the date of purchase) multiplied by the number of complete years until maturity, it is treated as if there were no market discount.⁵

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1. IRC § 1278(a)(1).

2. IRC § 1278(a)(1)(D).

3. IRC § 1278(a)(2).