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

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

For taxable bonds issued on or before July 18, 1984, and acquired on the market after that date but before May 1, 1993, and for tax-exempt bonds purchased on the market before May 1, 1993, recovery of market discount on sale or disposition is generally treated as capital gain, rather than as interest income. However, gain on such taxable bonds acquired with borrowing (or the proceeds of a short sale) must be recognized as ordinary income to the extent of any deferred disallowed interest (or short sale) expense (discussed in Q 8046) that is deductible in the year of disposition.⁵

Loss on sale or disposition of a market discount bond is a capital loss (see Q 702).⁶ For the rules governing the treatment of market discount when there is a substitution of newly issued bonds for outstanding bonds, see Revenue Procedure 2001-21.⁷

The installment method for reporting gain is not available for securities traded on an established securities market (see Q 667). As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in a subsequent tax year.⁸

If the disposition is by gift, see Q 7646; by conversion of a convertible bond into stock, see Q 7637 and Q 7648.If the bond sold was acquired by gift, see Q 7647.

If a market discount bond was held as part of a tax straddle, the additional rules and qualifications explained in Q 7593 to Q 7614 apply. If a market discount bond was held as part of a conversion transaction, the additional rules discussed in Q 7615 and Q 7616 apply.

Generally, neither gain nor loss is recognized on a transfer between spouses, or between former spouses if incident to divorce (see Q 789).⁹