Market Discount

March 13, 2024

7648 / How is market discount treated on the sale of stock received on conversion of a market discount bond?

<div class="Section1">If, on conversion of a market discount bond issued after July 18, 1984, or issued on or before July 18, 1984, and purchased after April 30, 1993, a taxpayer receives stock in the issuer of the bond, the amount of market discount accrued to the date of exchange must be treated as ordinary interest income upon sale or disposition of the stock, unless the taxpayer had elected to include in income market discount on the bond as it accrued.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 1276(c), 1278(b). </div>

March 13, 2024

7643 / What is market discount? What is a “market discount bond”?

<div class="Section1">Bond prices on the market fluctuate as interest rates change and as the borrower’s credit rating changes. Therefore, bonds may be bought at a discount because of a decline in value of the obligation after issue. A bond acquired at a discount on the market is called a “market discount bond.” For tax purposes the term “market discount bond” does not include tax-exempt municipal obligations purchased before May 1, 1993, short-term obligations, and U.S. Savings Bonds.<a href="#_ftn1" name="_ftnref1">1</a> With certain exceptions (e.g., bonds acquired at issue for less than issue price–usually by large institutional investors), bonds acquired at the time of original issue are not “market discount” bonds.<a href="#_ftn2" name="_ftnref2">2</a></div> <div class="Section1"> Market discount is the amount by which the stated redemption price exceeds the taxpayer’s basis in the bond immediately after its acquisition, if the bond was originally issued at par.<a href="#_ftn3" name="_ftnref3">3</a> If the bond was originally issued at a discount and purchased on the market for less than the original issue price increased by the amount of original issue discount accruing since issue up to the date of purchase, the difference is market discount.<a href="#_ftn4" name="_ftnref4">4</a> If the total market discount is less than ¼ of 1 percent (.0025) of the stated redemption price at maturity (or if the bond was issued at a discount of the issue price increased by original issue discount accruing since issue to the date of purchase) multiplied by the number of complete years until maturity, it is treated as if there were no market discount.<a href="#_ftn5" name="_ftnref5">5</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 1278(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 1278(a)(1)(D). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 1278(a)(2). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 1278(a)(2)(B). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 1278(a)(2)(C). </div>

March 13, 2024

7649 / Are interest expenses deductible if market discount bonds are purchased or carried with borrowed funds?

<div class="Section1">If interest is paid on borrowing or is incurred or continued by the taxpayer in order to purchase or carry taxable market discount bonds, deduction of the interest expense may be subject to limitation and deferral.<a href="#_ftn1" name="_ftnref1">1</a> Certain short sale expenses (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7529">7529</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7530">7530</a>) may be treated as interest within this rule.<a href="#_ftn2" name="_ftnref2">2</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a> for details. Any amount deductible under these rules will also be subject to the general limit on the otherwise allowable deduction of investment interest (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">8040</a>).<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 1277(a), 1278(a)(1)(C). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1282(c). See General Explanation–TRA ’84, p. 98. </div></div>

March 13, 2024

7646 / Does a donor include accrued market discount in income when making a gift of a market discount bond?

<div class="Section1">When a taxpayer makes a gift 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 the taxpayer acquired at a market discount and that has appreciated in value at the time of the gift, he or she must include in gross income an amount equal to the market discount accrued to the date of the gift, but limited to the amount of gain that would have been realized had the taxpayer received fair market value on making the gift.<a href="#_ftn1" name="_ftnref1">1</a> The amount is treated as interest income (but not for withholding at the source).<a href="#_ftn2" name="_ftnref2">2</a> Discount is considered to have accrued on a ratable basis, or, if the taxpayer elects (irrevocably), at a constant interest rate, just as if he or she had sold the bond (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a>). Had the taxpayer previously elected to include market discount in gross income as it accrued (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7644">7644</a>), no accrued discount would be includable as a result of the gift.<a href="#_ftn3" name="_ftnref3">3</a><div class="Section1"> If a bond was issued on or before July 18, 1984, and purchased before May 1, 1993, or if the bond is a tax-exempt issue purchased before May 1, 1993, no accrued market discount is included in income.<a href="#_ftn4" name="_ftnref4">4</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1276. <a href="#_ftnref2" name="_ftn2">2</a>.   General Explanation–TRA ’84, p. 94. <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1278(b). <a href="#_ftnref4" name="_ftn4">4</a>.   TRA ’84, § 44(c)(1). See IRC §§ 1276, 1277, and 1278. </div></div>

March 13, 2024

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

<div class="Section1">When a cash basis taxpayer sells a market discount bond (as defined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7643">7643</a>) 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.<a href="#_ftn1" name="_ftnref1">1</a> Only gain in excess of the amount of accrued market discount may be treated as capital gain. (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> 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.<a href="#_ftn2" name="_ftnref2">2</a> The rule reflects recognition that market discount is a substitute for stated interest.<div class="Section1"> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>).<a href="#_ftn3" name="_ftnref3">3</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7644">7644</a>). 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">8040</a>). However, accrued market discount will presumably not be treated as interest for withholding purposes.<a href="#_ftn4" name="_ftnref4">4</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>) that is deductible in the year of disposition.<a href="#_ftn5" name="_ftnref5">5</a> Loss on sale or disposition of a market discount bond is a capital loss (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>).<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> The installment method for reporting gain is not available for securities traded on an established securities market (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="667">667</a>). 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.<a href="#_ftn8" name="_ftnref8">8</a> If the disposition is by gift, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7646">7646</a>; by conversion of a convertible bond into stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7637">7637</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7648">7648</a>.If the bond sold was acquired by gift, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7647">7647</a>. If a market discount bond was held as part of a tax straddle, the additional rules and qualifications explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7593">7593</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a> apply. If a market discount bond was held as part of a conversion transaction, the additional rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> apply. Generally, neither gain nor loss is recognized on a transfer between spouses, or between former spouses if incident to divorce (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="789">789</a>).<a href="#_ftn9" name="_ftnref9">9</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 1276, 1278. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1278(b). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1276(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>.   General Explanation–TRA ’84, p. 94. <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1277(d), prior to repeal by OBRA ’93. <a href="#_ftnref6" name="_ftn6">6</a>.   Rev. Rul. 60-210, 1960-1 CB 38. <a href="#_ftnref7" name="_ftn7">7</a>.   2001-1 CB 742. <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 453(k). See Rev. Rul. 93-84, 1993-2 CB 225. <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 1041. </div></div>

March 13, 2024

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

<div class="Section1">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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a>).<a href="#_ftn1" name="_ftnref1">1</a> 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.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>).<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>). <a href="#_ftn5" name="_ftnref5">5</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1276(c). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC §§ 1276(c), 1278(b). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC §§ 1277(b)(2)(B), 1278(a)(1)(C). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1277(b)(2). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1277(d), prior to repeal by OBRA ’93. </div></div>

March 13, 2024

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

<div class="Section1">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.<a href="#_ftn1" name="_ftnref1">1</a> (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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>).) 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.<a href="#_ftn2" name="_ftnref2">2</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">8040</a>).<div class="Section1"> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a>).<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>). 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> The taxpayer who elects to include market discount as it accrues increases basis by the amounts included in gross income each year.<a href="#_ftn7" name="_ftnref7">7</a> The rules applicable to market discount on tax-exempt municipal bonds are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7663">7663</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1278(b). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1278(b)(3). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1276(a)(3). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1276(b)(3). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1276(b)(2). <a href="#_ftnref6" name="_ftn6">6</a>.   Rev. Proc. 92-67, 1992-2 CB 429; as modified by Rev. Proc. 99-49, 1999-2 CB 725; modified, amplified, and superseded by Rev. Proc. 2002-9, 2002-1 CB 327; Rev. Proc. 2008-52, 2008-2 CB 587, as modified by Rev. Proc. 2013-20, 2013-1 CB 744. <a href="#_ftnref7" name="_ftn7">7</a>.   IRC § 1278(b)(4). </div></div>