Accrued Market Discount (I.R.C. § 1276)

June 7, 2014

Basic Rules

Remember: There is a “disposition” and recognition event at the time of redemption under sec. 1271(a).

There is Market Discount (MD) in the following situations:

  1. For an original issue discount (OID) debt instrument (DI):  MD if Buyer pays < Adjusted Issue Price
  2. For other debt instrument:  MD if Buyer pays < redemption price

Why would someone buy bonds at a price of less than redemption price?  Because other bonds may be available on the market with higher rates.

There is no immediate effect on the purchaser if the purchaser buys at a MD.  The effect is when the bond matures (remember, there is a “disposition” (sale or exchange) upon maturity) or when the bond is sold.  At that time, there is a determination of the “Accrued Market Discount,” and you have a gain at that time.  The gain is ordinary income to the extent it does not exceed the Accrued Market Discount (I.R.C. § 1276(a)(1)).  In other words:  The gain upon disposition doesn’t reflect capital appreciation of an asset (which would give capital gain) but instead reflects “mere” interest (which gives ordinary income).

Approach to addressing Market Discount issues:

  • First step: Calculate the MD at the time you buy.
  • Second step: Calculate the AMD upon disposition.
  • Third step: If you have gain upon sale, ordinary income up to AMD and thereafter capital gain.
  • Fourth step: If there is capital gain, determine short-term or long-term capital gain.
  • Fifth step: Ordinary income and capital gain is recognized at time of disposition, unless elected out.

Definition of Market Discount:

  • For OID DI: MD = Adj. IP – Buyer Cost
  • For other DI: MD = SRPM – Buyer Cost

Definition of Accrued Market Discount:  AMD = MD x (No. of days T held DI / No. of days to maturity of DI when bought)

Definition of Adjusted Issue Price:

  • Take the original IP and increase by the OID that you have already included.
  • Also sometimes referred to as the “revised issue price.”

Therefore, if you hold the DI all the way to maturity, AMD = MD, and all MD is ordinary income.  If you hold two of four years, AMD = MD x 2/4 = Ordinary Income.  The first dollars of the gain here are Ordinary Income. Rest is capital gain.

When to report Ordinary Income due to MD:  Ordinary income due to MD (or better, due to AMD) occurs at the time of disposition of the DI, which is when the holder sells it before maturity or when the holder receives the SRPM at the time of maturity. BUT:

  1. Holder may elect to recognize AMD each year, but who would?
  2. Holder can also elect to sell early and possibly have only part be OI.

Note: Disposition can also be by gift!

Also note for Tax-Exempt Obligations:  Market Discount is NOT tax-exempt income.  I.R.C. § 1276 says the MD is still ordinary income and fully taxable.  This is because, unlike OID, Market Discount occurs unrelated to any actions of the municipality.  It is simply based on market conditions, so policy should not cast this discount as tax-exempt interest.

Comparison of OID to MD:  For OID, remember that the imputed interest occurs on an effective yield to maturity basis each year the holder owns the DI.


Example 1

T buys a 5-year, $100,000 bond that pays 10% interest.  It is given that the bond is not an OID bond.  Interest rates rise and value of the bond goes down.  At the end of year 3, B buys the bond from T for $90,000, and holds to maturity.  At maturity, B has a gain of $10,000 ($100,000 A/R – $90,000 cost basis).

  • Step 1: MD = $10K.
  • Step 2: AMD = MD * Days Held/Days to Maturity = MD
  • Step 3: There is gain of $10K (given above).  Gain up to the AMD is ordinary income.  Thus, all is ordinary income.
  • Step 4: There is no leftover gain after ordinary income recognition, so there is no capital gain.
  • Step 5: The ordinary income is recognized by B at the time of disposition, not earlier, unless elected.

Therefore, on maturity, B has $10,000 of ordinary income (B really wanted $10,000 more interest on bond).

Example 2

Same facts, but B sells at the end of year 4 after owning it one year.  How much ordinary income and capital gain must B recognize?

  • Step 1: MD = $10K
  • Step 2: AMD = $10K * 1/2 = $5,000 (remember, B only holds for one year)
  • Step 3: Gain up to AMD is OI, so $5,000 is ordinary income.  The rest is capital gain.
  • Step 4: Rest is capital gain.  If B held for more than one year, this would be long-term capital gain.
  • Step 5: Ordinary income and capital gain is recognized at time of disposition, not before.

Example 3

What are the consequences if B’s sales price was $90,000 instead of $100,000?  In this case, B would have no gain (A/R $90K – A/B $90), and therefore there is no ordinary income.  H must only recognize ordinary income if there is gain on the disposition.

Example 4

What if sales price was $94,000?  B has gain of $4,000 and all is ordinary income because there is $5,000 of AMD at time of disposition (assuming he sells at end of fourth year).

Example 5

What if sales price was $98,000?  B has gain of $8,000 and must treat $5,000 (AMD) as ordinary income and balance of $3,000 as capital gain. If he held long enough, he can get long-term capital gain.

Other Matters

I.R.C. 1276(b) states that market discount is accrued using the ratable accrual method.  The bondholder may elect to accrue based on the basis of constant interest rate instead.  For a bond the principal of which may be paid in two or more payments, the amount of accrued market discount is to be determined under regulations.  As of 2015, no such regulations have been promulgated.