7650 / How is original issue discount (OID) on corporate and treasury obligations issued after July 1, 1982 included in income?

If a bond is issued for property (stock or securities, or to the extent provided for in regulations, for other property in tax years ending after July 18, 1984) and either the bond or the property is traded on an established market, the issue price of the bond is considered to be the fair market value of the property.²

The amount of original issue discount is included in income as it accrues over the life of the bond. For bonds issued after April 4, 1994, OID must generally be accrued using the constant yield method. The holder of a bond may use accrual periods of different lengths provided that no accrual period is longer than one year. Payments may occur either on the first day or final day of an accrual period.³

The amount of original issue discount accruing each period is ratably allocated to each day in the period. These “daily portions” must be included in gross income by each owner for each day the owner holds the bond during the tax year.⁴ (More often than not, the individual’s tax year will overlap two periods. If so, the owner simply totals the appropriate daily portions for the parts of each period that falls in his or her tax year.) Taxpayers who use the cash receipts and disbursement method of accounting and maintain a brokerage account that includes original issue discount debt instruments and stripped bonds must include in gross income for the taxable year the amount of accrued discount allocable to the portion of the taxable year in which they held the debt instruments. The taxpayers cannot defer the inclusion of original issue discount until it is actually received.⁵

Gain on the sale, exchange, or retirement of a bond is treated as ordinary income to the extent of unaccrued original issue discount if, at the time of original issue, there existed an intention to call the bond prior to maturity. According to regulations, an intention to call exists only if there is an agreement not provided for in the debt instrument that the issuer will redeem the instrument prior to maturity.⁶ This rule is not applicable to publicly offered bonds.⁷ The rules of this paragraph are effective for bonds issued on or after April 4, 1994, and may be relied upon by taxpayers with bonds issued after December 21, 1992.

If the holder purchased the debt instrument at a premium or an acquisition premium or made an election to treat all interest as original interest discount, the amount of original issue discount must be adjusted.⁸ Furthermore, for bonds held on or after March 2, 1998, a holder making an election to treat all interest on a bond as original issue discount is deemed to have elected to amortize any existing bond premium (see Q 7654).⁹

The owner’s basis is increased by the amount of discount included in income and decreased by the amount of any payment from the issuer to the holder under the debt instrument (other than a payment of qualified stated interest).¹⁰

The application of these rules to bonds acquired in a debt-for-debt exchange in a corporate reorganization is covered in Treasury Regulation Section 1.1272-2.

The Service has ruled that a taxpayer who acquired two debt instruments that were structured so that it was expected that the value of one would increase significantly at the same time that the value of the other debt instrument would decrease significantly was not allowed to claim a current loss on the sale of the debt instrument that decreased in value while not recognizing the gain on the other debt instrument. The loss deductions for each set of debt instruments were denied under IRC Section 165(a) and Treasury Regulation Sections 1.1275-6(c)(2) (the integration rule) and 1.1275-2(g) (the anti-abuse rule), respectively.¹¹

Special rules apply to determine the inclusion in income of original issue discount on debt instruments issued after 1986 that have a maturity that is initially fixed, but that is accelerated based on prepayments on other debt obligations securing the debt instrument.¹² For rules applying to variable rate debt instruments and debt instruments that provide for contingent payments, see Treasury Regulation Section 1.1272-1(b)(2). The sale of additional Treasury or corporate debt instruments that are issued after the original issue but that are treated as part of the original issue is referred to as a “qualified reopening.” For rules governing the treatment of original issue discount with respect to such sales, see Treasury Regulation Sections 1.163-7(e), 1.1275-1(f), 1.1275-2(d); 1.1275-2(k), 1.1275-7(g). See also Revenue Procedure 2001-21¹³ (providing an election that will facilitate the substitution of newly issued bonds for outstanding bonds).

These rules do not apply to tax-exempt bonds, to short-term government (federal or state) obligations (such as T-bills), to savings bonds (e.g., EE bonds), or to short-term corporate obligations.¹⁴

The treatment of Treasury bills is discussed in Q 7625 and Q 7626, and short-term corporate obligations in Q 7627 and Q 7628.