A bond sells at a discount when you pay less than its face value, and at a premium when you pay more. The split between a bond discount vs. premium comes down to one thing: whether the bond’s fixed coupon rate is lower or higher than the interest rate the market currently demands. That gap changes your real return, how the IRS taxes what you earn, and how the bond is carried on the books until it matures.
Why Bonds Trade Above or Below Par
A bond’s price is the present value of its future cash flows, discounted at the current market rate. The coupon rate is locked in the day the bond is issued. Market rates keep moving. When the two match, the bond trades at par, typically $1,000 for a corporate bond.1Legal Information Institute. Par Value
A bond trades at a discount when its coupon is below the market rate. If comparable bonds yield 6%, nobody will pay full price for a bond paying 4%. The price falls until the combination of a lower purchase price and the fixed coupon payments produces a total return equal to the market rate. For a 10-year, 4% bond in a 6% market, that price might land near $850. The $150 gap is extra compensation for the undersized coupon, collected as a lump sum when the bond matures at $1,000.
Premiums work the other direction. A bond paying 8% in a 6% market is worth more than par, and buyers bid the price up until the yield lines up with the market. You might pay $1,150 for a bond that will only return $1,000 at maturity. The larger coupons are real, but you are guaranteed to lose the $150 premium by the time the bond pays off. The net yield comes back down to the market rate.
How Discount Bonds Are Taxed
Not every bond bought below par triggers special tax rules, and when the rules do apply, the treatment depends on whether the discount was baked in at issuance or developed later in the secondary market.
The De Minimis Threshold
The IRS ignores a small discount. The threshold is one-quarter of one percent (0.25%) of face value, multiplied by the number of complete years to maturity.2Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount On a $1,000 bond with 10 years left, that threshold is $25. Buy the bond for $980 and the $20 discount is treated as zero, so any gain at redemption is a capital gain. Buy it for $970 and the $30 discount crosses the line, and the full discount is taxed under the ordinary income rules below.
That line matters. Capital gains rates run lower than ordinary income rates for most taxpayers, so a bond that stays just inside the de minimis zone keeps more of your return.
Original Issue Discount
Original issue discount, or OID, exists when the bond was first sold below par. Zero-coupon bonds are the clearest case: no interest payments, a steep discount, and the entire return is the climb from purchase price to face value.3Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID)
OID accrues as interest income each year whether or not you receive any cash. You include your share using the constant yield method and pay tax on it annually.4eCFR. 26 CFR 1.1272-1 – Current Inclusion of OID in Income This is often called phantom income because the tax bill arrives before the money does. The accrued OID adds to your basis in the bond each year, so you aren’t taxed twice when the bond pays off.
Market Discount
Market discount is what develops after issuance, usually because rates rose or the issuer’s credit weakened and the price fell below the adjusted issue price in the secondary market.
You can generally wait. Market discount doesn’t have to be reported until you sell or redeem the bond, and at that point gain is treated as ordinary income up to the accrued market discount; anything above that is capital gain.5GovInfo. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income You can also elect to include market discount in income as it accrues, the way OID is handled. The election covers every market discount bond you later acquire and is effectively permanent without IRS approval.6Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules Paying sooner spreads the tax out instead of taking a large ordinary income hit in the year of sale.
How Premium Bonds Are Taxed
Buy a taxable bond at a premium and you have a choice to make: amortize the premium against interest income each year, or ignore it and absorb a capital loss at maturity.
The Amortization Election
You make the election by offsetting interest income with amortized premium on the return for the first year you want it to apply. Once elected, it covers every taxable bond you own and every one you buy later, and revoking it requires IRS approval on Form 3115.7Internal Revenue Service. Publication 550 – Investment Income and Expenses
Each year, the amortized portion reduces reported interest income, and your basis in the bond drops by the same amount.8eCFR. 26 CFR 1.171-4 – Election to Amortize Bond Premium on Taxable Bonds By maturity, your basis equals par and there’s no gain or loss on redemption.
Skipping the Election
If you don’t elect, you report the full coupon as interest income every year and realize a capital loss when the bond redeems at par. The arithmetic usually loses. Ordinary income rates on the coupons exceed what you recover from a capital loss, and capital losses only offset $3,000 of ordinary income a year, with the balance carried forward. The amortization election is the standard choice for a reason.
Callable Bonds
If the issuer can call the bond early and using the call date produces a smaller amortizable premium for the period, you have to amortize to the call date instead of maturity. That prevents stretching the premium over a life the bond may never reach.
Tax-Exempt Bonds Follow Their Own Rules
Municipal bonds are the main boundary case. OID on a tax-exempt bond accrues the same way mechanically, but because the underlying interest is federally exempt, the accrued OID is too.9Office of the Law Revision Counsel. 26 U.S. Code 1288 – Treatment of Original Issue Discount on Tax-Exempt Obligations Basis still steps up each year, which cuts or eliminates capital gain on a pre-maturity sale. Some states tax the accrued OID even though the federal government does not.
Premium amortization on a tax-exempt bond is mandatory, not elective. No deduction is allowed, since the interest it would offset is already exempt.10Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium The amortization simply drops your basis each year, which means you cannot generate a capital loss by holding a tax-exempt premium bond to maturity.
Amortizing on the Books
Whether the bond was bought at a discount or a premium, the gap between purchase price and face value is spread across the bond’s life. For discount bonds, amortization pushes the carrying value up toward par. For premium bonds, it pulls the carrying value down toward par. By maturity, both land at face value.
Effective Interest Method
GAAP requires the effective interest method. Multiply the current carrying value by the market rate at issuance to get interest expense for the period. The difference between that and the actual cash coupon is the amortization.
Consider a $100,000 bond issued at a $5,000 discount, 4% coupon, 6% market rate. Year one carrying value is $95,000. Interest expense is $5,700, the cash coupon is $4,000, and the $1,700 difference amortizes the discount, lifting carrying value to $96,700. The amortization amount grows a little each year because the carrying value does, producing a constant effective yield.
Straight-Line Method
Straight-line amortization splits the total discount or premium evenly across every period. On the same $5,000 discount over 10 years, that’s $500 a year. GAAP permits straight-line only when it produces results that aren’t materially different from the effective interest method. The gap is narrow for short maturities and small premiums or discounts, and widens for long maturities and prices far from par.
Where It Shows Up on Your Tax Return
Two forms carry the numbers from your broker to your 1040.
- Form 1099-OID reports original issue discount. Box 1 is taxable OID, Box 8 is OID on Treasury obligations, and Box 11 is tax-exempt OID. For covered securities with acquisition premium, the form may show a net OID that already accounts for the premium offset.11Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
- Form 1099-INT reports interest income in Box 1. For covered premium bonds, brokers may report gross interest with a separate premium amortization figure, or a net amount with the amortization already subtracted.
Both OID and interest income are reported on Schedule B. If the OID on your 1099 differs from your own constant yield calculation, enter the full reported amount, subtotal it, then show the adjustment on a line labeled “OID Adjustment” before arriving at the corrected figure.3Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID) For premium amortization on taxable bonds, subtract the amortizable premium below the interest subtotal on Schedule B with the label “ABP Adjustment.”7Internal Revenue Service. Publication 550 – Investment Income and Expenses