7645 / How is gain or loss treated when a market discount bond is sold?

When a cash basis taxpayer sells a market discount bond (as defined in Q 7643) issued after July 18, 1984, or issued on or before July 18, 1984, and purchased after April 30, 1993, or if the taxpayer sells a tax-exempt bond purchased on the market after April 30, 1993, at a discount, the gain is generally treated as interest income to the extent of market discount accrued up to the date of disposition.¹ Only gain in excess of the amount of accrued market discount may be treated as capital gain. (See Q 702 for the treatment of capital gains and losses.) However, if the taxpayer elected to include market discount in income annually as it accrued, and to increase the basis, the gain would not include previously included market discount.² The rule reflects recognition that market discount is a substitute for stated interest.

In determining how much market discount has accrued up to the time of sale, the discount is treated as accruing in equal amounts each day after the date of acquisition up to and including the date of maturity. But the taxpayer may elect (irrevocably) on a bond by bond basis to accrue using a constant rate of interest compounded at least annually as used in determining daily portions of original issue discount accruing on bonds issued after December 31, 1984 (see Q 7650).³ Under the constant rate method, the daily portions will accrue more slowly than under the ratable method in early years and more rapidly in later years, but the total amount accrued will always be less until maturity.

An adjustment must be made in determining the amount of accrued market discount on obligations issued after October 22, 1986, if a partial payment of principal was previously made, or if principal is paid in two or more payments (see Q 7644).

Gain treated as interest income will generally be treated as interest for all purposes of federal taxation. Thus, for example, it is investment income for purposes of the limitation on the deduction of interest expense (see Q 8040). However, accrued market discount will presumably not be treated as interest for withholding purposes.⁴