How Bond Accretion Is Taxed: OID and Market Discount

When you buy a bond below its face value, the IRS taxes that discount as ordinary interest income rather than as a capital gain at the end. How bond accretion is taxed depends on which kind of discount you have: an Original Issue Discount (OID), which the issuer built in when the bond was sold, or a market discount, which arose later because the bond’s price fell on the secondary market. OID must be reported as income each year you hold the bond. Market discount is deferred until you sell or redeem unless you elect otherwise. The split controls the calculation method, the timing, and the forms involved.

Original Issue Discount vs. Market Discount

An OID bond was sold by the issuer for less than face value from day one. The IRS treats that built-in discount as interest you earn over the bond’s life, so you include a slice of it in income every year, whether or not the issuer sends you cash.{¹ The issuer or your broker calculates it for you and reports it on Form 1099-OID.{²

A market discount bond was issued at or near par and later traded down, usually because rates rose or the issuer’s credit weakened. You do not have to accrue this discount annually. By default, the ordinary income piece is deferred until you sell or redeem the bond.{³ You can elect to accrue it currently instead, and some investors do for planning reasons.

When the Discount Is Small Enough to Ignore

Not every below-par purchase triggers these rules. Both OID and market discount bonds have a de minimis threshold: 0.25% of face value multiplied by the number of complete years remaining to maturity. If the total discount falls under that number, it is treated as zero for tax purposes.{⁴ No annual accretion, no ordinary income, and any gain at disposition is capital gain.

A $1,000 bond with 10 years to maturity has a threshold of $25. Buy it for $980 and the $20 discount is ignored. Buy it for $970 and the full $30 is subject to the accretion rules. Check this first. Running yield calculations on a discount that legally doesn’t exist is wasted work.

How OID Is Taxed Year by Year

OID must use the constant yield method. There is no alternative.{¹ Each period, the bond’s yield to maturity is applied to its adjusted basis to produce the period’s economic interest. The stated coupon is subtracted, and the remainder is the OID accrual for that period. That amount is ordinary income, and it also increases your basis in the bond, so next period’s calculation runs off a slightly higher number. By maturity, the basis equals face value and the full discount has been reported as income.

A quick illustration: a $1,000 bond bought for $900 with a 4.5% yield to maturity and a $20 annual coupon generates $40.50 of economic interest in year one. Subtract the coupon and the OID accrual is $20.50 of ordinary income. Your basis rises to $920.50, and year two’s calculation starts there.

You report the annual OID on Schedule B of Form 1040, listing each payer and the amount from Form 1099-OID.{⁵ Brokers and issuers are required to send a 1099-OID when the amount is $10 or more.{⁶ If your own records show a different figure, Publication 1212 gives you an adjustment procedure to make the correction directly on Schedule B.

How Market Discount Is Taxed

Market discount works almost in reverse. Accretion is optional, and if you do accrue, the default method is the simpler one. Any affirmative treatment, whether a different calculation method or current inclusion, requires an election.

The Default: Deferred, Ratable Accrual

If you make no elections, you report nothing during the holding period. The discount accrues in the background on a straight-line basis: the total discount divided evenly across the days from purchase to maturity.{⁷ You only need the number when you sell or redeem.

Electing Constant Yield Instead

You can elect to accrue market discount using the constant yield method by attaching a statement to a timely filed return identifying the specific bond.{⁸ The math mirrors OID: adjusted basis times yield to maturity, minus the coupon. The election is irrevocable for that bond.{⁷

Electing to Include the Discount in Income Each Year

Separately, you can elect under IRC 1278(b) to include market discount in income currently rather than wait until disposition.{³ This is broader than the calculation-method election. Once made, it applies to every market discount bond you acquire going forward, and revoking it requires IRS consent.

The reason to make it is bracket management. Holding a market discount bond for years without accruing means the entire accumulated discount becomes ordinary income in a single tax year when you sell. Spreading it out can keep more of it out of higher brackets. The cost is paying tax on income you haven’t yet received in cash, and locking yourself into the same treatment for every future market discount bond.

What Happens When You Sell or Redeem

The reason to track accretion carefully is that it determines the right answer at disposition. Gain or loss is sale proceeds minus adjusted basis, and adjusted basis is your original cost plus any discount already taken into income.{⁵

For OID bonds, the discount has been getting reported along the way, so by the time you sell, your basis has already climbed. Any remaining difference between sale price and that adjusted basis is capital gain or loss, long-term if you held for more than a year.{⁵ If you sell mid-year, you prorate that year’s OID for the days you actually held the bond.

For market discount bonds held under the default rules, the surprise comes at the end. Any gain on sale is recharacterized as ordinary income up to the amount of accrued market discount, and only gain beyond that qualifies as capital gain.{⁷ If you had elected current inclusion, you have already been reporting that discount as interest and your basis has climbed accordingly, so less of the sale proceeds shows up as gain.

Sales and redemptions get reported on Form 8949, with totals flowing to Schedule D.{⁹ Brokers report adjusted basis on Form 1099-B for covered securities, but the figure is worth checking against your own records before you file.

Tax-Exempt Municipal Bonds

Municipals follow a variation of these rules that trips people up. OID on a tax-exempt bond is generally not taxable, but you still have to accrete it and add the accrued amount to your basis.{⁵ Skip that step and your basis stays artificially low, which inflates the gain on sale or redemption and can turn tax-exempt discount into taxable capital gain. For covered securities, the broker handles the basis adjustment and reports it on Form 1099-B, but the arithmetic is still worth verifying.

1
Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount
2
Internal Revenue Service. About Form 1099-OID, Original Issue Discount
3
Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules
4
Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount
5
Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID) Instruments
6
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
7
Office of the Law Revision Counsel. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
8
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
9
Internal Revenue Service. Instructions for Form 8949