7647 / How is market discount treated on sale of a market discount bond received as a gift?

If gain is realized by a donee on disposition of a taxable bond issued after July 18, 1984, or a taxable bond issued on or before July 18, 1984, and purchased after April 30, 1993, or a tax-exempt bond purchased after April 30, 1993, any of which were previously received as a gift but acquired at a market discount by the donor, the gain is reported as interest up to the amount of market discount accrued prior to the time of sale and not previously included in income by the donor or donee (see Q 7645).¹ An adjustment to basis is made for any amount of accrued market discount recognized by the donor at the time of the gift and for any market discount included in the gross income of the donor and donee as it accrued.²

If the donor used borrowed funds (or the proceeds of a short sale) to acquire or carry a taxable bond described above, and as a result there was disallowed interest expense (or short sale expense) with respect to the bond at the time of the gift that was not entirely deductible by the donor at the time the donor made the gift, the donee may take the excess disallowed expense deduction as the donee’s own when he or she sells the bond (see Q 8046).³

Even if the taxable bond was issued on or before July 18, 1984, but acquired by the donor before May 1, 1993, the donee may deduct the disallowed expense.⁴ However, if there is a gain on the sale of such a bond, the donee must treat an amount equal to the interest (or short sale) expense deduction as ordinary income instead of capital gain (see Q 8046). ⁵

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1.   IRC § 1276(c).

2.   IRC §§ 1276(c), 1278(b).