Accrued market discount

What Is Accrued Market Discount?

Accrued market discount refers to the portion of a bond's market discount that has accumulated over the period an investor has held the bond. It falls under the broader category of fixed income taxation within financial instruments. A market discount occurs when a bond is purchased in the secondary market at a price below its par value (also known as face value or stated redemption price at maturity). This discount represents an additional form of interest income for the investor, realized when the bond matures or is sold. The accrued market discount must be accounted for tax purposes and typically treated as ordinary income rather than capital gains.

History and Origin

The tax treatment of market discount bonds, and consequently, the concept of accrued market discount, has evolved over time in U.S. tax law. Prior to 1984, any gain realized from a bond purchased at a discount was often treated as a capital gain if the bond was held until maturity or sold for a profit. However, Congress enacted Sections 1276 and 1278 of the Internal Revenue Code in 1984. These sections fundamentally changed the tax landscape for market discount bonds by requiring that gain on the disposition of such bonds be reported as ordinary income to the extent of the accrued market discount. The rationale was to align the tax treatment of market discount with that of original issue discount (OID), recognizing that both represent a form of interest. This ordinary income treatment applies to obligations issued after July 18, 1984, and to bonds issued on or before that date but purchased after April 30, 1993.²⁰

Key Takeaways

• Accrued market discount is the portion of a bond's market discount that has accumulated over the holding period.
• It arises when a bond is bought in the secondary market below its par value.
• For tax purposes, accrued market discount is generally treated as ordinary income upon the bond's disposition, not as a capital gain.
• Investors typically have the option to include the accrued market discount in their income annually or defer it until the bond is sold or matures.
• The Internal Revenue Service (IRS) outlines rules for calculating and reporting accrued market discount, primarily in IRS Publication 550.¹⁸, ¹⁹

Formula and Calculation

The calculation of accrued market discount can generally be done using one of two methods: the ratable accrual method (also known as the straight-line method) or the constant yield method. The IRS generally assumes the ratable accrual method unless an election is made for the constant yield method.¹⁷

Ratable Accrual Method:
This method allocates the total market discount evenly over the remaining life of the bond from the date of acquisition.

Where:

• Total Market Discount = Bond's Stated Redemption Price at Maturity - Investor's Cost Basis
• Number of days held = The number of days the investor has owned the bond.
• Number of days from acquisition to maturity = The total number of days remaining until the bond's maturity from the date of the investor's purchase.

The constant yield method, also known as the constant interest rate method, is generally preferred by brokers and aligns with the method used for Original Issue Discount (OID). This method uses the bond's yield to maturity at the time of purchase to determine the daily accrual. While more complex, it provides a more economically accurate allocation of the discount over time. Investors usually do not need to calculate this themselves, as brokerage firms often provide the accrued market discount on tax forms like Form 1099-OID.¹⁶

Interpreting the Accrued Market Discount

Understanding accrued market discount is crucial for investors, particularly regarding tax implications. When a bond is sold or redeemed, any gain attributable to the accrued market discount is generally taxed as ordinary income, not as a more favorably taxed capital gain. This classification can significantly impact an investor's net return. The accrued market discount effectively increases the bond's adjusted basis over time, reducing the potential for a capital gain or increasing a capital loss upon disposition. Investors can choose to include the market discount in their income annually, which increases their basis, or defer it until the bond is disposed of.¹⁵ This decision influences the timing of tax payments and can impact overall taxable income in a given year.

Hypothetical Example

Suppose an investor purchases a corporate bond with a par value of $1,000 for $900 in the secondary market. The bond has five years remaining until maturity from the purchase date. The total market discount is $1,000 - $900 = $100.

Using the ratable accrual method:

1. Calculate daily accrual: Assume 365 days per year for simplicity. Total days to maturity = 5 years * 365 days/year = 1,825 days.
   Daily accrued market discount = $100 / 1,825 days ≈ $0.0548 per day.

2. Accrued discount over a period: If the investor holds the bond for one year (365 days), the accrued market discount for that year would be:
   Accrued Market Discount = $0.0548/day * 365 days = $20.

3. Taxation: If the investor sells the bond after one year for $950, the $20 of accrued market discount would be treated as ordinary income. The remaining gain of $30 ($950 sale price - $900 original cost - $20 accrued discount already recognized as ordinary income) would be treated as a capital gain. This illustration highlights how the accrued market discount impacts the character of income received from the bond.

Practical Applications

Accrued market discount primarily impacts investors in fixed income securities, particularly those dealing with bonds purchased below par in the secondary market. It is a key consideration in personal tax planning and portfolio management. For instance, an investor seeking tax efficiency might compare bonds with market discount to those with original issue discount (OID) or premium bonds, understanding the differing tax treatments. The Internal Revenue Service provides detailed guidance on this topic, particularly in Publication 550, which explains how to calculate and report various forms of investment income and expenses. T¹⁴his publication serves as a comprehensive resource for individual investors to navigate the complexities of investment income taxation.

Limitations and Criticisms

One of the primary "limitations" from an investor's perspective regarding accrued market discount is its taxation as ordinary income, rather than potentially lower capital gains rates. This treatment can make market discount bonds less appealing from a tax optimization standpoint compared to other investment vehicles that might yield long-term capital gains. While investors have the option to include the discount in their income annually, the default is to recognize it upon disposition, which could lead to a larger lump sum of ordinary income in that year. A¹³dditionally, the complexity of calculating accrued market discount, especially using the constant yield method, can be a burden for individual investors, though brokers generally handle these calculations and report them on tax forms. For professional bond traders, the rules regarding market discount can also differ, potentially leading to all gains being treated as ordinary income if they are considered dealers.

¹²## Accrued Market Discount vs. Original Issue Discount

While both accrued market discount and original issue discount (OID) represent a bond being acquired at a price below its par value, a fundamental difference lies in when the discount originates. Original Issue Discount arises when a bond is initially issued by the issuer at a price below its stated redemption price at maturity. The discount is part of the bond's original terms, and typically, the OID is systematically included in the investor's income each year over the bond's life, even if no cash payment is received. Accrued market discount, conversely, occurs when a bond is purchased in the secondary market at a price below its par value, after it has already been issued. This discount reflects changes in prevailing interest rates or the bond's credit quality since its original issuance. Unlike OID, investors generally have a choice with market discount: they can elect to include the discount in their income annually (ratable accrual or constant yield method), or they can defer recognition until the bond is sold or matures.

¹⁰, ¹¹## FAQs

Is accrued market discount always taxable as ordinary income?

Yes, generally, gain on the disposition of a market discount bond is treated as ordinary income to the extent of the accrued market discount. Any additional gain beyond the accrued discount may be treated as a capital gain if the bond is a capital asset in the holder's hands.

⁹### How do I report accrued market discount on my tax return?
The specific forms required can vary, but generally, information related to bond income, including accrued market discount, is reported on Schedule B (Form 1040) for interest and ordinary dividends, and potentially Form 8949 and Schedule D for capital gains and losses if there's gain beyond the accrued discount. The IRS provides guidance in Publication 550.

⁸### Does accrued market discount apply to all types of bonds?
No, certain bonds are excluded from market discount rules. These typically include short-term obligations (maturing within one year or less), U.S. savings bonds, and tax-exempt bonds purchased before May 1, 1993. H⁶, ⁷owever, for tax-exempt bonds purchased after April 30, 1993, market discount rules generally apply, and the accrued market discount is still considered taxable ordinary income, even if the bond's coupon interest is tax-exempt.

⁵### Can I choose how to accrue market discount?
Yes, investors can typically choose between the ratable accrual method (straight-line) or the constant yield method. The ratable accrual method is the default, but an election can be made to use the constant yield method. Y⁴our broker will often use the constant yield method and report it on Form 1099-OID.

³### Does accrued market discount affect my bond's cost basis?
Yes, if you elect to include the accrued market discount in your income annually, your bond's cost basis is increased by the amount of the discount accrued. This adjustment helps to prevent double taxation when the bond is eventually sold or matures, as your adjusted basis will be closer to the bond's redemption price.¹, ²