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, or other evidence of indebtedness, that bears no interest or bears interest at a lower than current market rate will usually be issued at less than its face amount. This discount is, in effect, additional interest income. The following are some of the types of discounted debt 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) is taxable in most instances. The discount on municipal bonds generally is not taxable (but see State or Local Government Obligations, earlier, for exceptions). See also REMICs, FASITs, and Other CDOs, later, for information about applying the rules discussed in this section to the regular interest holder of a real estate mortgage investment conduit, a financial asset securitization investment trust, or other CDO.

Original Issue Discount (OID)

OID is a form of interest. You generally include OID in your income as it accrues over the term of the debt instrument, whether or not you receive any payments from the issuer.

A debt instrument generally has OID when the instrument is issued for a price that is less than its stated redemption price at maturity. OID is the difference between the stated redemption price at maturity and the issue price.

All instruments that pay no interest before maturity are presumed to be issued at a discount. Zero coupon bonds are one example of these instruments.

The OID accrual rules generally do not apply to short-term obligations (those with a fixed maturity date of 1 year or less from date of issue). See Discount on Short-Term Obligations, later.

For information about the sale of a debt instrument with OID, see chapter 4.

De minimis OID. You can treat the discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the 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 at maturity 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 years from the date of original issue to maturity) equals $25. Because the $20 discount is less than $25, the OID is treated as zero. (If you hold 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 the bond was issued at $950. The OID is $50. Because the $50 discount is more than the $25 figured in Example 1, you must include the 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, the discount is not includible in income. If you buy a debt instrument with de minimis OID at a discount, the discount is reported under the market discount rules. See Market Discount Bonds, later in this chapter.

Exceptions to reporting OID. The OID rules discussed here do not apply to the following debt instruments.

1. Tax-exempt obligations. (However, see Stripped tax-exempt obligations, later.)
2. U.S. savings bonds.
3. Short-term debt instruments (those with a fixed maturity date of not more than 1 year from the date of issue).
4. Obligations issued by an individual before March 2, 1984.
5. Loans between individuals, if all the following are true.
   1. The lender is not in the business of lending money.
   2. The amount of the loan, plus the amount of any outstanding prior loans between the same individuals, is $10,000 or less.
   3. Avoiding any federal tax is not one of the principal purposes of the loan.

Form 1099-OID

The issuer of the debt instrument (or your broker, if you held the instrument through a broker) should give you Form 1099-OID, Original Issue Discount, or a similar statement, if the total OID for the calendar year is $10 or more. Form 1099-OID will show, in box 1, the amount of OID for the part of the year that you held the bond. It also will show, in box 2, the stated interest that you must include in your income. A copy of Form 1099-OID will be sent to the IRS. Do not file your copy with your return. Keep it for your records.

In most cases, you must report the entire amount in boxes 1 and 2 of Form 1099-OID as interest income. But see Refiguring OID shown on Form 1099-OID, later in this discussion, and also Original issue discount (OID) adjustment under How To Report Interest Income, later in this chapter, for more information.

Form 1099-OID not received. If you had OID for the year but did not receive a Form 1099-OID, see Publication 1212, which lists total OID on certain debt instruments and has information that will help you figure OID. If your debt instrument is not listed in Publication 1212, consult the issuer for further information about the accrued OID for the year.

Nominee. If someone else is the holder of record (the registered owner) of an OID instrument that belongs to you and receives a Form 1099-OID on your behalf, that person must give you a Form 1099-OID.

If you receive a Form 1099-OID that includes amounts belonging to another person, see Nominee distributions under 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 if either of the following apply.

1. You bought the debt instrument after its original issue and paid a premium or an acquisition premium.
2. The debt instrument is a stripped bond or a stripped coupon (including certain zero coupon instruments). See Figuring OID under Stripped Bonds and Coupons, later in this chapter.

See Original issue discount (OID) adjustment under How To Report Interest Income, later in this chapter, for information about reporting the correct amount of OID.

Premium. You bought a debt instrument at a premium if its adjusted basis immediately after purchase was greater than the total of all amounts payable on the instrument after the purchase date, other than qualified stated interest.

If you bought an OID debt instrument at a premium, you generally do not have to report any OID as ordinary income.

Qualified stated interest. In general, this is stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer) at least annually at a fixed rate.

Acquisition premium. You bought a debt instrument at an acquisition premium if both of the following are true.

1. You did not pay a premium.
2. The instrument's adjusted basis immediately after purchase (including purchase at original issue) was greater than its adjusted issue price. This is the issue price plus the OID previously accrued, minus any payment previously made on the instrument other than qualified stated interest.

Acquisition premium reduces the amount of OID includible in your income. For information about figuring the correct amount of OID to include in your income, see Figuring OID on Long-Term Debt Instruments in Publication 1212.

Refiguring periodic interest shown on Form 1099-OID. If you disposed of a debt instrument or acquired it from another holder during the year, see Bonds Sold Between Interest Dates, earlier, for information about the treatment of periodic interest that may be shown in box 2 of Form 1099-OID for that instrument.

Applying the OID Rules

The rules for reporting OID depend on the date the long-term debt instrument 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 you sell, exchange, or redeem the instrument. If a gain results and the instrument is a capital asset, the amount of the gain equal to the OID is ordinary interest income. The rest of the gain is capital gain. If there is a loss on the sale of the instrument, the entire loss is a capital loss and no reporting of OID is required.

In general, the amount of gain that is ordinary interest income equals the following amount:

Number of full months you held the instrument ------------------------      x      Original Number of full               IssueDiscount months from date 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 must include a part of the discount in your gross income each year that you own the instruments.

Effect on basis. Your basis in the instrument is increased by the amount of OID that you include in your gross income.

Debt instruments issued after 1984. For these debt instruments, you report the total OID that applies each year regardless of whether you hold that debt instrument as a capital asset.

Effect on basis. Your basis in the instrument is increased by the amount of OID that you include in your gross income.

Certificates of Deposit (CDs)

If you buy a CD with a maturity of more than 1 year, you must include in income each year a part of the total interest due and report 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 transferable from one individual to another.

Banks must provide the IRS and the person redeeming the bearer certificate with a Form 1099-INT.

CDs issued after 1982 generally must be in registered form. For more information, see Bearer Obligations under Capital Gains and Losses in chapter 4.

Time deposit open account arrangement. This is an arrangement with a fixed maturity date in which you make deposits on a schedule arranged between you and your bank. But there is no actual or constructive receipt of interest until the fixed maturity date is reached. For instance, you and your bank enter into an arrangement under which you agree to deposit $100 each month for a period 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. You must 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 the amount you must include in your income for the year.

Redemption before maturity. If, before the maturity date, you redeem a deferred interest account for less than its stated redemption price at maturity, you can deduct the amount of OID that you previously included in income but did not receive.

Renewable certificates. If you renew a CD at maturity, it is treated as a redemption and a purchase of a new certificate. This is true regardless of the terms of renewal.

Face-Amount Certificates

These certificates are subject to the OID rules. They are a form of endowment contracts issued by insurance or investment companies for either a lump-sum payment or periodic payments, with the face amount becoming payable on the maturity date of the certificate.

In general, the difference between the face amount and the amount you paid for the contract is OID. You must include a part of the OID in your income over the term of the certificate.

The issuer must give you a statement on Form 1099-OID indicating the amount you must include in your income each year.

Inflation-Indexed Debt Instruments

If you hold an inflation-indexed debt instrument (other than a series I U.S. savings bond), you must report as OID any increase in the inflation-adjusted principal amount of the instrument that occurs while you held the instrument during the year. In general, an inflation-indexed debt instrument is a debt instrument on which the payments are adjusted for inflation and deflation (such as Treasury Inflation-Indexed Securities). You should receive Form 1099-OID from the payer showing the amount you must report as OID and any qualified stated interest paid to you during the year. For more information, see Publication 1212.

Stripped Bonds and Coupons

If you strip one or more coupons from a bond and sell the bond or the coupons, the bond and coupons are treated as separate debt instruments issued with OID.

The holder of a stripped bond has the right to receive the principal (redemption price) payment. The holder of a stripped coupon has the right to receive interest on the bond.

Stripped bonds and stripped coupons include:

1. Zero coupon instruments available through the Department of the Treasury's Separate Trading of Registered Interest and Principal of Securities (STRIPS) program and government-sponsored enterprises such as the Resolution Funding Corporation and the Financing Corporation, and
2. Instruments backed by U.S. Treasury securities that represent ownership interests in those securities, such as obligations backed by U.S. Treasury bonds that are offered primarily by brokerage firms.

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 bond before the date of sale to the extent you did not previously include this interest in your income. For an obligation acquired after October 22, 1986, you must also include the market discount that accrued before the date of sale of the stripped bond (or coupon) to the extent you did not previously include this discount in your income.

Add the interest and market discount that you include in income to the basis of the bond and coupons. Allocate this adjusted basis between the items you keep and the items you sell, based on the fair market value of the items. The difference between the sale price of the 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 bought by 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 than the basis of the bond as the OID. If you keep the coupons, treat the amount payable on the coupons that is more than the basis of the coupons as the OID.

Buyer. If you buy a stripped bond or stripped coupon, treat it as if it were originally issued on the date you buy it. If you buy a stripped bond, treat as OID any excess of the stated redemption price at maturity over your purchase price. If you buy a stripped coupon, treat as OID any excess of the amount payable on the due date of the coupon over your purchase price.

Figuring OID. The rules for figuring OID on stripped bonds and stripped coupons depend on the date the debt instruments were purchased, not the date issued.

You must refigure the OID shown on the Form 1099-OID you receive for a stripped bond or coupon. For information about figuring the correct amount of OID on these instruments to include in your income, see Figuring OID on Stripped Bonds and Coupons in Publication 1212. However, owners of stripped bonds and coupons should not rely on the OID shown in Section II of Publication 1212, because the amounts listed in Section II for stripped bonds or coupons are figured without reference to the date or price at which you acquired them.

Stripped tax-exempt obligations. You do not have to pay tax on OID on any stripped tax-exempt bond or coupon that you bought before June 11, 1987. However, if you acquired it after October 22, 1986, you must accrue OID on it to determine its basis when you dispose of it. See Original issue discount (OID) on debt instruments under Stocks and Bonds in chapter 4.

You may have to pay tax on part of the OID on stripped tax-exempt bonds or coupons that you bought after June 10, 1987. For information on figuring the taxable part, see Tax-Exempt Bonds and Coupons under Figuring OID on Stripped Bonds and Coupons in Publication 1212.

Market Discount Bonds

A market discount bond is any bond having market discount except:

1. Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),
2. Tax-exempt obligations that you bought before May 1, 1993,
3. U.S. savings bonds, and
4. Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date, generally because of an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

1. You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments under Capital Gains and Losses in chapter 4.
2. You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount. See Partial principal payments, later in this discussion.
3. If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Deferral of interest deduction for market discount bonds under When To Deduct Investment Interest in chapter 3.

Market discount. Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond).

If a market discount bond also has OID, the market discount is the sum of the bond's issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.

Bonds acquired at original issue. Generally, a bond that you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you are also considered to have acquired it at original issue.

Exceptions. A bond you acquired at original issue can be a market discount bond if either of the following is true.

1. Your cost basis in the bond is less than the bond's issue price.
2. The bond is issued in exchange for a market discount bond under a plan of reorganization. (This does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same.)

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 installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.

Constant yield method. Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond.

For information about using the constant yield method, see Figuring OID using the constant yield method under Debt Instruments Issued After 1984 in Publication 1212. To use this method to figure market discount (instead of OID), treat the bond as having been issued on the date you acquired it. Treat the amount of your basis (immediately after you acquired the bond) as the issue 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 to include market discount in income currently within the last 5 calendar years. Make the choice by attaching to your timely filed return a statement in which you:

1. State that you have included market discount in your gross income for the year under section 1278(b) of the Internal Revenue Code, and
2. Describe the method you used to figure the accrued market discount for the year.

Once you make this choice, it will apply to all market discount bonds that you acquire during the tax year and in later tax years. You cannot 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 market discount you include in your income.

Partial principal payments. If you receive a partial payment of principal on a market discount bond that you acquired after October 22, 1986, and you did not choose to include the discount in income currently, you must treat the payment as ordinary interest income up to the amount of the bond's accrued market discount. Reduce the amount of accrued market discount reportable as interest at disposition by that amount.

You can choose to figure accrued market discount for this purpose:

1. On the basis of the constant yield method, described earlier,
2. In proportion to the accrual of OID for any accrual period, if the debt instrument has OID, or
3. In proportion to the amount of stated interest paid in the accrual period, if the debt instrument has no OID.

Under method (2) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator (top part) of the fraction is the OID for the period, and the denominator (bottom part) is the total remaining OID at the beginning of the period.

Under method (3) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator is the stated interest paid in the accrual period, and the denominator is the total stated interest remaining to be paid at the beginning of the accrual period.

Discount on Short-Term Obligations

When you buy a short-term obligation (one with a fixed maturity date of 1 year or less from the date of issue), other than a tax-exempt obligation, you can generally choose to accrue any discount and interest payable on the obligation and include it in income currently. If you do not make this choice, the following rules generally apply.

1. You must treat any gain when you sell, exchange, or redeem the obligation as ordinary income, up to the amount of the ratable share of the discount. See Discounted Debt Instruments under Capital Gains and Losses in chapter 4.
2. If you borrow money to buy or carry the obligation, your deduction for interest paid on the debt is limited. See Deferral of interest deduction for short-term obligations under When To 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 it accrues for any short-term obligation (other than a tax-exempt obligation) that is:

1. Held by an accrual-basis taxpayer,
2. Held primarily for sale to customers in the ordinary course of your trade or business,
3. Held by a bank, regulated investment company, or common trust fund,
4. Held by certain pass-through entities,
5. Identified as part of a hedging transaction, or
6. A stripped bond or stripped coupon held by the person who stripped the bond or coupon (or by any other person whose basis in the obligation is determined by reference to the basis in the hands of that person).

Effect on basis. Increase the basis of your obligation by the amount of discount you include in income currently.

Accrual methods. Figure the accrued discount by using either the ratable accrual method or the constant yield method discussed previously in Accrued market discount under Market Discount Bonds, earlier.

Government obligations. For an obligation described above that is a short-term government obligation, the amount you include in your income for the current year is the accrued acquisition discount, if any, plus any other accrued interest payable on the obligation. The acquisition discount is the stated redemption price at maturity minus your basis.

If you choose to use the constant yield method to figure accrued acquisition discount, treat the cost of acquiring the obligation as the issue price. If you choose to use this method, you cannot change your 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 the accrued OID, if any, plus any other accrued interest payable. If you choose the constant yield method to figure accrued OID, apply it by using the obligation's issue price.

Choosing to include accrued acquisition discount instead of OID. You can choose to report accrued acquisition discount (defined earlier under Government obligations) rather than accrued OID on these short-term obligations. Your choice will apply to the year for which it is made and to all later years and cannot be changed without the consent of the IRS.

You must make your choice by the due date of your return, including extensions, for the first year for which you are making the choice. Attach a statement to your return or amended return indicating:

1. Your name, address, and social security number,
2. The choice you are making and that it is being made under section 1283(c)(2) of the Internal Revenue Code,
3. The period for which the choice is being made and the obligation to which it applies, and
4. Any other information necessary to show you are entitled to make this choice.

Choosing to include accrued discount and other interest in current income. If you acquire short-term discount obligations that are not subject to the rules for current inclusion in income of the accrued discount or other interest, you can choose to have those rules apply. This choice applies to all short-term obligations you acquire during the year and in all later years. You cannot change this choice without the consent of the IRS.

The procedures to use in making this choice are the same as those described for choosing to include acquisition discount instead of OID on nongovernment obligations in current income. However, you should indicate that you are making the choice under section 1282(b)(2) of the Internal Revenue Code.

Also see the following discussion. If you make the election to report all interest currently as OID, you must use the constant yield method.

Election To Report All Interest as OID

Generally, you can elect to treat all interest on a debt instrument acquired during the tax year as OID and include it in income currently. For purposes of this election, interest includes stated interest, acquisition discount, OID, de minimis OID, market discount, de minimis market discount, and unstated interest as adjusted by any amortizable bond premium or acquisition premium. See Treasury Regulation 1.1272-3.

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