7644 / Is market discount on a taxable bond included annually in gross income as it accrues?

As a rule, market discount is not includable in income by a cash basis investor before sale or disposition of the bond or note. However, an election may be made to include market discount as it accrues on bonds and notes other than tax-exempt obligations purchased before May 1, 1993, short-term obligations, U.S. Savings Bonds, and certain obligations arising from installment sales of property.¹ (Such an election may be necessary to permit current deduction of interest paid on amounts borrowed to acquire bonds issued after July 18, 1984, or issued on or before July 18, 1984, and purchased on the market after April 30, 1993 (see Q 8046).) Once the election is made, it applies to all obligations having market discount (other than tax-exempt obligations purchased before May 1, 1993, short-term obligations, certain obligations arising from installment sales of property, and U.S. Savings Bonds) acquired by the taxpayer in the tax year of the election and any future years (whether or not using borrowed funds) unless the taxpayer receives permission from the IRS to revoke the election.² Amounts includable under the election are treated as interest (except for purposes of the tax on non-business income of nonresident aliens and foreign corporations and, apparently, for withholding generally). Thus, for example, includable market discount is counted as investment income for purposes of determining the limit on deductible interest expense (see Q 8040).

Any partial payment of principal on a market discount bond acquired after October 22, 1986, is includable as ordinary income to the extent it does not exceed the market discount on the bond that has accrued up to that time. The amount of accrued market discount is reduced accordingly (see Q 7645).³ If the principal of a bond acquired after October 22, 1986, is to be paid in two or more payments, the amount of accrued market discount is to be determined under regulations.⁴

Under the election to include market discount in income as it accrues, market discount is accrued on a ratable basis, but the taxpayer may instead elect to use a constant interest rate with respect to particular bonds and notes. Under the ratable accrual method, the amount of market discount is determined by dividing the total market discount on the bond by the number of days after the date of acquisition (up to and including the date of maturity). This method will accrue market discount in equal daily installments during the period between acquisition and maturity. Alternatively, the taxpayer may elect to accrue market discount on a constant interest rate method (the method used in determining daily portions of original issue discount on bonds issued after July 1, 1982 (see Q 7650). The constant interest rate election is irrevocable as to the bond for which the election is made, but the ratable method will apply to other obligations for which the constant interest rate election was not made.⁵

The Service has established procedures for taxpayers to use in making the elections described above. Specific procedures are required to be followed under the following circumstances: (1) the taxpayer wishes to make an election under IRC Section 1278(b) for a taxable year ending after July 18, 1984, and his or her income tax return is filed (on time) on or after September 23, 1992; (2) the taxpayer wishes to make an election under IRC Section 1276(b) to apply a constant interest rate to a market discount bond acquired in a taxable year ending after July 18, 1984, and his or her income tax return is filed (on time) on or after September 23, 1992; or (3) the taxpayer wishes to request consent to revoke an election under IRC Section 1278(b). If the procedures detailed by the Service are followed with respect to elections made under IRC Sections 1278(b) and 1276(b), the Service’s consent to such elections will be automatic.⁶