Discount on Debt Instruments Words you may need to know (see Glossary): Market discount Market discount bond Original issue discount (OID) Premium In general, a debt instrument, such as a bond, note, debenture, orother evidence of indebtedness, that bears no interest or bearsinterest at a lower than current market rate will usually be issued atless than its face amount. This discount is, in effect, additionalinterest income. The following are some of the types of discounteddebt instruments. Corporate bonds. Municipal bonds. Certificates of deposit. Notes between individuals. Stripped bonds and coupons. Collateralized debt obligations (CDOs). The discount on these instruments (except municipal bonds) istaxable in most instances. The discount on municipal bonds generallyis not taxable (but see State or Local Government Obligations,earlier, for exceptions). See also REMICs, FASITs, andOther CDOs, later, for information about applying the rulesdiscussed in this section to the regular interest holder of a realestate mortgage investment conduit, a financial asset securitizationinvestment trust, or other CDO. Original IssueDiscount (OID) OID is a form of interest. You generally include OID in your incomeas it accrues over the term of the debt instrument, whether or not youreceive any payments from the issuer. A debt instrument generally has OID when the instrument is issuedfor a price that is less than its stated redemption price at maturity.OID is the difference between the stated redemption price at maturityand the issue price. All instruments that pay no interest before maturity are presumedto be issued at a discount. Zero coupon bonds are one example of theseinstruments. The OID accrual rules generally do not apply to short-termobligations (those with a fixed maturity date of 1 year or less fromdate of issue). See Discount on Short-Term Obligations,later. For information about the sale of a debt instrument with OID, seechapter 4. De minimis OID.You can treat the discount as zero if it is less than one-fourth of1% (.0025) of the stated redemption price at maturity multiplied bythe number of full years from the date of original issue to maturity.This small discount is known as "de minimis" OID. Example 1.You bought a 10-year bond with a stated redemption price atmaturity of $1,000, issued at $980 with OID of $20. One-fourth of 1%of $1,000 (stated redemption price) times 10 (the number of full yearsfrom the date of original issue to maturity) equals $25. Because the$20 discount is less than $25, the OID is treated as zero. (If youhold the bond at maturity, you will recognize $20 ($1,000 -$980) of capital gain.) Example 2.The facts are the same as in Example 1, except that thebond was issued at $950. The OID is $50. Because the $50 discount ismore than the $25 figured in Example 1, you must includethe OID in income as it accrues over the term of the bond. Debt instrument bought after original issue.If you buy a debt instrument with de minimis OID at a premium, thediscount is not includible in income. If you buy a debt instrumentwith de minimis OID at a discount, the discount is reported under themarket discount rules. See Market Discount Bonds, later inthis chapter. Exceptions to reporting OID.The OID rules discussed here do not apply to the following debtinstruments. Tax-exempt obligations. (However, see Strippedtax-exempt obligations, later.) U.S. savings bonds. Short-term debt instruments (those with a fixed maturitydate of not more than 1 year from the date of issue). Obligations issued by an individual before March 2,1984. Loans between individuals, if all the following are true. The lender is not in the business of lending money. The amount of the loan, plus the amount of any outstandingprior loans between the same individuals, is $10,000 or less. Avoiding any federal tax is not one of the principalpurposes of the loan. Form 1099-OID The issuer of the debt instrument (or your broker, if you held theinstrument through a broker) should give you Form 1099-OID,Original Issue Discount, or a similar statement, if thetotal OID for the calendar year is $10 or more. Form 1099-OIDwill show, in box 1, the amount of OID for the part of the year thatyou held the bond. It also will show, in box 2, the stated interestthat you must include in your income. A copy of Form 1099-OIDwill be sent to the IRS. Do not file your copy with your return. Keepit for your records. In most cases, you must report the entire amount in boxes 1 and 2of Form 1099-OID as interest income. But see Refiguring OIDshown on Form 1099-OID, later in this discussion, and alsoOriginal issue discount (OID) adjustment under How ToReport Interest Income, later in this chapter, for moreinformation. Form 1099-OID not received.If you had OID for the year but did not receive a Form1099-OID, see Publication 1212, which lists total OID on certaindebt instruments and has information that will help you figure OID. Ifyour debt instrument is not listed in Publication 1212, consult theissuer for further information about the accrued OID for the year. Nominee. If someone else is the holder of record (the registered owner) ofan OID instrument that belongs to you and receives a Form1099-OID on your behalf, that person must give you a Form1099-OID. If you receive a Form 1099-OID that includes amountsbelonging to another person, see Nominee distributionsunder How To Report Interest Income, later. Refiguring OID shown on Form 1099-OID.You must refigure the OID shown in box 1 of Form 1099-OID ifeither of the following apply. You bought the debt instrument after its original issue andpaid a premium or an acquisition premium. The debt instrument is a stripped bond or a stripped coupon(including certain zero coupon instruments). See Figuring OIDunder Stripped Bonds and Coupons, later in thischapter. See Original issue discount (OID) adjustment underHow To Report Interest Income, later in this chapter, forinformation about reporting the correct amount of OID. Premium.You bought a debt instrument at a premium if its adjusted basisimmediately after purchase was greater than the total of all amountspayable on the instrument after the purchase date, other thanqualified stated interest. If you bought an OID debt instrument at a premium, you generally donot have to report any OID as ordinary income. Qualified stated interest.In general, this is stated interest that is unconditionally payablein cash or property (other than debt instruments of the issuer) atleast annually at a fixed rate. Acquisition premium.You bought a debt instrument at an acquisition premium if both ofthe following are true. You did not pay a premium. The instrument's adjusted basis immediately after purchase(including purchase at original issue) was greater than its adjustedissue price. This is the issue price plus the OID previously accrued,minus any payment previously made on the instrument other thanqualified stated interest. Acquisition premium reduces the amount of OID includible inyour income. For information about figuring the correct amount of OIDto include in your income, see Figuring OID on Long-Term DebtInstruments in Publication 1212. Refiguring periodic interest shown on Form 1099-OID.If you disposed of a debt instrument or acquired it from anotherholder during the year, see Bonds Sold Between Interest Dates,earlier, for information about the treatment of periodicinterest that may be shown in box 2 of Form 1099-OID for thatinstrument. Applying the OID Rules The rules for reporting OID depend on the date the long-term debtinstrument was issued. Debt instruments issued after 1954 and before May 28, 1969(before July 2, 1982, if a government instrument).For these instruments, you do not report the OID until the year yousell, exchange, or redeem the instrument. If a gain results and theinstrument is a capital asset, the amount of the gain equal to the OIDis ordinary interest income. The rest of the gain is capital gain. Ifthere is a loss on the sale of the instrument, the entire loss is acapital loss and no reporting of OID is required. In general, the amount of gain that is ordinary interest incomeequals the following amount: Number of full months you held the instrument Original Number of full Issue months from date Discount of original issue to date of maturity Debt instruments issued after May 27, 1969 (after July 1,1982, if a government instrument), and before 1985.If you hold these debt instruments as capital assets, you mustinclude a part of the discount in your gross income each year that youown the instruments. Effect on basis.Your basis in the instrument is increased by the amount of OIDthat you include in your gross income. Debt instruments issued after 1984.For these debt instruments, you report the total OID that applieseach year regardless of whether you hold that debt instrument as acapital asset. Effect on basis.Your basis in the instrument is increased by the amount of OIDthat you include in your gross income. luxury hotels in FaroCertificates of Deposit (CDs) If you buy a CD with a maturity of more than 1 year, you mustinclude in income each year a part of the total interest due andreport it in the same manner as other OID. This also applies to similar deposit arrangements with banks,building and loan associations, etc., including: Time deposits, Bonus plans, Savings certificates, Deferred income certificates, Bonus savings certificates, and Growth savings certificates. Bearer CDs.These are not issued in the depositor's name and are transferablefrom one individual to another. Banks must provide the IRS and the person redeeming the bearercertificate with a Form 1099-INT. CDs issued after 1982 generally must be in registered form. Formore information, see Bearer Obligations under CapitalGains and Losses in chapter 4. Time deposit open account arrangement.This is an arrangement with a fixed maturity date in which you makedeposits on a schedule arranged between you and your bank. But thereis no actual or constructive receipt of interest until the fixedmaturity date is reached. For instance, you and your bank enter intoan arrangement under which you agree to deposit $100 each month for aperiod of 5 years. Interest will be compounded twice a year at 7 1/2%, but payable only at the end of the 5-year period. Youmust include a part of the interest in your income as OID each year.Each year the bank must give you a Form 1099-OID to show you theamount you must include in your income for the year. Redemption before maturity.If, before the maturity date, you redeem a deferred interestaccount for less than its stated redemption price at maturity, you candeduct the amount of OID that you previously included in income butdid not receive. Renewable certificates.If you renew a CD at maturity, it is treated as a redemption and apurchase of a new certificate. This is true regardless of the terms ofrenewal. Face-Amount Certificates These certificates are subject to the OID rules. They are a form ofendowment contracts issued by insurance or investment companies foreither a lump-sum payment or periodic payments, with the face amountbecoming payable on the maturity date of the certificate. In general, the difference between the face amount and the amountyou paid for the contract is OID. You must include a part of the OIDin your income over the term of the certificate. The issuer must give you a statement on Form 1099-OIDindicating the amount you must include in your income each year. Inflation-IndexedDebt Instruments If you hold an inflation-indexed debt instrument (other than aseries I U.S. savings bond), you must report as OID any increase inthe inflation-adjusted principal amount of the instrument that occurswhile you held the instrument during the year. In general, aninflation-indexed debt instrument is a debt instrument on which thepayments are adjusted for inflation and deflation (such as TreasuryInflation-Indexed Securities). You should receive Form 1099-OIDfrom the payer showing the amount you must report as OID and anyqualified stated interest paid to you during the year. For moreinformation, see Publication 1212. Stripped Bonds and Coupons If you strip one or more coupons from a bond and sell the bond orthe coupons, the bond and coupons are treated as separate debtinstruments issued with OID. The holder of a stripped bond has the right to receive theprincipal (redemption price) payment. The holder of a stripped couponhas the right to receive interest on the bond. Stripped bonds and stripped coupons include: Zero coupon instruments available through the Department ofthe Treasury's Separate Trading of Registered Interest and Principalof Securities (STRIPS) program and government-sponsored enterprisessuch as the Resolution Funding Corporation and the FinancingCorporation, and Instruments backed by U.S. Treasury securities thatrepresent ownership interests in those securities, such as obligationsbacked by U.S. Treasury bonds that are offered primarily by brokeragefirms. Seller.If you strip coupons from a bond and sell the bond or coupons,include in income the interest that accrued while you held the bondbefore the date of sale to the extent you did not previously includethis interest in your income. For an obligation acquired after October22, 1986, you must also include the market discount that accruedbefore the date of sale of the stripped bond (or coupon) to the extentyou did not previously include this discount in your income. Add the interest and market discount that you include in income tothe basis of the bond and coupons. Allocate this adjusted basisbetween the items you keep and the items you sell, based on the fairmarket value of the items. The difference between the sale price ofthe bond (or coupon) and the allocated basis of the bond (or coupon)is your gain or loss from the sale. Treat any item you keep as an OID bond originally issued and boughtby you on the sale date of the other items. If you keep the bond,treat the amount of the redemption price of the bond that is more thanthe basis of the bond as the OID. If you keep the coupons, treat theamount payable on the coupons that is more than the basis of thecoupons as the OID. Buyer.If you buy a stripped bond or stripped coupon, treat it as if itwere originally issued on the date you buy it. If you buy a strippedbond, treat as OID any excess of the stated redemption price atmaturity over your purchase price. If you buy a stripped coupon, treatas OID any excess of the amount payable on the due date of the couponover your purchase price. Figuring OID.The rules for figuring OID on stripped bonds and stripped couponsdepend on the date the debt instruments were purchased, not the dateissued. You must refigure the OID shown on the Form 1099-OID youreceive for a stripped bond or coupon. For information about figuringthe correct amount of OID on these instruments to include in yourincome, see Figuring OID on Stripped Bonds and Coupons inPublication 1212. However, owners of stripped bonds and coupons shouldnot rely on the OID shown in Section II of Publication 1212, becausethe amounts listed in Section II for stripped bonds or coupons arefigured without reference to the date or price at which you acquiredthem. Stripped tax-exempt obligations.You do not have to pay tax on OID on any stripped tax-exempt bondor coupon that you bought before June 11, 1987. However, if youacquired it after October 22, 1986, you must accrue OID on it todetermine its basis when you dispose of it. See Original issuediscount (OID) on debt instruments under Stocks and Bondsin chapter 4. You may have to pay tax on part of the OID on stripped tax-exemptbonds or coupons that you bought after June 10, 1987. For informationon figuring the taxable part, see Tax-Exempt Bonds and Couponsunder Figuring OID on Stripped Bonds and Coupons inPublication 1212. Market Discount Bonds A market discount bond is any bond having market discount except: Short-term obligations (those with fixed maturity dates ofup to 1 year from the date of issue), Tax-exempt obligations that you bought before May 1, 1993, U.S. savings bonds, and Certain installment obligations. Market discount arises when the value of a debt obligationdecreases after its issue date, generally because of an increase ininterest rates. If you buy a bond on the secondary market, it may havemarket discount. When you buy a market discount bond, you can choose to accrue themarket discount over the period you own the bond and include it inyour income currently as interest income. If you do not make thischoice, the following rules generally apply. You must treat any gain when you dispose of the bond asordinary interest income, up to the amount of the accrued marketdiscount. See Discounted Debt Instruments underCapital Gains and Losses in chapter 4. You must treat any partial payment of principal on the bondas ordinary interest income, up to the amount of the accrued marketdiscount. See Partial principal payments, later in thisdiscussion. If you borrow money to buy or carry the bond, your deductionfor interest paid on the debt is limited. See Deferral ofinterest deduction for market discount bonds under When ToDeduct Investment Interest in chapter 3. Market discount.Market discount is the amount of the stated redemption price of abond at maturity that is more than your basis in the bond immediatelyafter you acquire it. You treat market discount as zero if it is lessthan one-fourth of 1% (.0025) of the stated redemption price of thebond multiplied by the number of full years to maturity (after youacquire the bond). If a market discount bond also has OID, the market discount is thesum of the bond's issue price and the total OID includible in thegross income of all holders (for a tax-exempt bond, the total OID thataccrued) before you acquired the bond, reduced by your basis in thebond immediately after you acquired it. Bonds acquired at original issue.Generally, a bond that you acquired at original issue is not amarket discount bond. If your adjusted basis in a bond is determinedby reference to the adjusted basis of another person who acquired thebond at original issue, you are also considered to have acquired it atoriginal issue. Exceptions.A bond you acquired at original issue can be a market discount bondif either of the following is true. Your cost basis in the bond is less than the bond's issueprice. The bond is issued in exchange for a market discount bondunder a plan of reorganization. (This does not apply if the bond isissued in exchange for a market discount bond issued before July 19,1984, and the terms and interest rates of both bonds are thesame.) Accrued market discount.The accrued market discount is figured in one of two ways. Ratable accrual method.Treat the market discount as accruing in equal daily installmentsduring the period you hold the bond. Figure the daily installments bydividing the market discount by the number of days after the date youacquired the bond, up to and including its maturity date. Multiply thedaily installments by the number of days you held the bond to figureyour accrued market discount. Constant yield method.Instead of using the ratable accrual method, you can choose tofigure the accrued discount using a constant interest rate (theconstant yield method). Make this choice by attaching to your timelyfiled return a statement identifying the bond and stating that you aremaking a constant interest rate election. The choice takes effect onthe date you acquired the bond. If you choose to use this method forany bond, you cannot change your choice for that bond. For information about using the constant yield method, seeFiguring OID using the constant yield method underDebt Instruments Issued After 1984 in Publication 1212. Touse this method to figure market discount (instead of OID), treat thebond as having been issued on the date you acquired it. Treat theamount of your basis (immediately after you acquired the bond) as theissue price. Then apply the formula shown in Publication 1212. Choosing to include market discount in income currently.You can make this choice if you have not revoked a prior choice toinclude market discount in income currently within the last 5 calendaryears. Make the choice by attaching to your timely filed return astatement in which you: State that you have included market discount in your grossincome for the year under section 1278(b) of the Internal RevenueCode, and Describe the method you used to figure the accrued marketdiscount for the year. Once you make this choice, it will apply to all market discountbonds that you acquire during the tax year and in later tax years. Youcannot revoke your choice without the consent of the IRS. Also see Election To Report All Interest as OID, later.If you make that election, you must use the constant yield method. Effect on basis.You increase the basis of your bonds by the amount of marketdiscount you include in your income. Partial principal payments.If you receive a partial payment of principal on a market discountbond that you acquired after October 22, 1986, and you did not chooseto include the discount in income currently, you must treat thepayment as ordinary interest income up to the amount of the bond'saccrued market discount. Reduce the amount of accrued market discountreportable as interest at disposition by that amount. You can choose to figure accrued market discount for this purpose: On the basis of the constant yield method, describedearlier, In proportion to the accrual of OID for any accrual period,if the debt instrument has OID, or In proportion to the amount of stated interest paid in theaccrual period, if the debt instrument has no OID. Under method (2) above, figure accrued market discount for a periodby multiplying the total remaining market discount by a fraction. Thenumerator (top part) of the fraction is the OID for the period, andthe denominator (bottom part) is the total remaining OID at thebeginning of the period. Under method (3) above, figure accrued market discount for a periodby multiplying the total remaining market discount by a fraction. Thenumerator is the stated interest paid in the accrual period, and thedenominator is the total stated interest remaining to be paid at thebeginning of the accrual period. Discount onShort-Term Obligations When you buy a short-term obligation (one with a fixed maturitydate of 1 year or less from the date of issue), other than atax-exempt obligation, you can generally choose to accrue any discountand interest payable on the obligation and include it in incomecurrently. If you do not make this choice, the following rulesgenerally apply. You must treat any gain when you sell, exchange, or redeemthe obligation as ordinary income, up to the amount of the ratableshare of the discount. See Discounted Debt Instrumentsunder Capital Gains and Losses in chapter 4. If you borrow money to buy or carry the obligation, yourdeduction for interest paid on the debt is limited. See Deferralof interest deduction for short-term obligations under WhenTo Deduct Investment Interest in chapter 3. Short-term obligations for which no choice is available. You must include any discount or interest in current income as itaccrues for any short-term obligation (other than a tax-exemptobligation) that is: Held by an accrual-basis taxpayer, Held primarily for sale to customers in the ordinary courseof your trade or business, Held by a bank, regulated investment company, or commontrust fund, Held by certain pass-through entities, Identified as part of a hedging transaction, or A stripped bond or stripped coupon held by the person whostripped the bond or coupon (or by any other person whose basis in theobligation is determined by reference to the basis in the hands ofthat person). Effect on basis.Increase the basis of your obligation by the amount of discount youinclude in income currently. Accrual methods.Figure the accrued discount by using either the ratableaccrual method or the constant yield method discussedpreviously in Accrued market discount under MarketDiscount Bonds, earlier. Government obligations.For an obligation described above that is a short-term governmentobligation, the amount you include in your income for the current yearis the accrued acquisition discount, if any, plus any other accruedinterest payable on the obligation. The acquisition discountis the stated redemption price at maturity minus your basis. If you choose to use the constant yield method to figure accruedacquisition discount, treat the cost of acquiring the obligation asthe issue price. If you choose to use this method, you cannot changeyour choice. Nongovernment obligations.For an obligation listed above that is not a government obligation,the amount you include in your income for the current year is theaccrued OID, if any, plus any other accrued interest payable. If youchoose the constant yield method to figure accrued OID, apply it byusing the obligation's issue price. Choosing to include accrued acquisition discount instead ofOID.You can choose to report accrued acquisition discount (definedearlier under Government obligations) rather than accruedOID on these short-term obligations. Your choice will apply to theyear for which it is made and to all later years and cannot be changedwithout the consent of the IRS. You must make your choice by the due date of your return, includingextensions, for the first year for which you are making the choice.Attach a statement to your return or amended return indicating: Your name, address, and social security number, The choice you are making and that it is being made undersection 1283(c)(2) of the Internal Revenue Code, The period for which the choice is being made and theobligation to which it applies, and Any other information necessary to show you are entitled tomake this choice. Choosing to include accrued discount and other interest incurrent income.If you acquire short-term discount obligations that are not subjectto the rules for current inclusion in income of the accrued discountor other interest, you can choose to have those rules apply. Thischoice applies to all short-term obligations you acquire during theyear and in all later years. You cannot change this choice without theconsent of the IRS. The procedures to use in making this choice are the same as thosedescribed for choosing to include acquisition discount instead of OIDon nongovernment obligations in current income. However, you shouldindicate that you are making the choice under section 1282(b)(2) ofthe Internal Revenue Code. Also see the following discussion. If you make the election toreport all interest currently as OID, you must use the constant yieldmethod. Election To ReportAll Interest as OID Generally, you can elect to treat all interest on a debt instrumentacquired during the tax year as OID and include it in incomecurrently. For purposes of this election, interest includes statedinterest, acquisition discount, OID, de minimis OID, market discount,de minimis market discount, and unstated interest as adjusted by anyamortizable bond premium or acquisition premium. See TreasuryRegulation 1.1272-3.