How the Constant Yield Method Works for Bond Taxes

The constant yield method for bond taxes spreads a bond’s discount or premium across every year you own it, using the bond’s yield to maturity to calculate how much belongs in each period. Federal tax law requires this approach for bonds carrying original issue discount, and it’s available as an election for bonds bought at a premium or at a market discount. Instead of one large gain or loss at maturity, you report a calculated slice each year, and your cost basis moves in lockstep so the numbers reconcile when you finally sell or redeem.

When You Have to Use It, and When It’s a Choice

Three situations pull the constant yield method into your return, and each follows different rules.

Original Issue Discount

Original issue discount (OID) exists when a bond is first issued for less than its face value. Buy a $1,000 bond at issuance for $950 and that $50 gap is OID. Federal law requires you to include a portion in gross income for every day you hold the bond, even though the cash won’t arrive until maturity.¹ The constant yield method is how you compute that annual inclusion. Your broker reports the annual OID on Form 1099-OID (Box 1 for corporate and other taxable bonds, Box 8 for U.S. Treasury obligations). If you bought on the secondary market and paid more than the original issue price, the reported figure may overstate your actual inclusion, and you’ll need to run the numbers yourself.

Bond Premium

You pay bond premium when you buy a bond for more than face value, usually because the coupon rate is higher than current market rates. For taxable bonds, amortizing that premium is elective. If you choose to amortize, the amortized amount reduces your taxable interest each year and simultaneously reduces basis. The election is binding once made and covers every taxable bond you currently hold or later acquire.² For tax-exempt bonds the rule is different: no deduction for the amortized premium, but you must still reduce basis using the constant yield method. IRS Publication 550 walks through choosing accrual periods and computing the amortization for each one.³

Market Discount

Market discount arises when you buy an existing bond on the secondary market for less than its adjusted issue price. By default, no annual inclusion is required; the accrued discount is treated as ordinary income when you sell, redeem, or otherwise dispose of the bond.⁴ You can elect to recognize the discount annually instead, and if you do, you pick either a straight-line (ratable) method or the constant yield method. The constant yield election for market discount is irrevocable once made for a given bond. If your bonds are held through a broker and you make the current-inclusion election, notify the broker in writing; without that notice, the broker defaults to constant yield for the accrued market discount it reports on Form 1099-OID.⁵

Exceptions and the De Minimis Rule

Not every below-par bond requires constant yield reporting. Federal law carves several categories out of the OID inclusion rules entirely:

Short-term obligations maturing in one year or less from the issue date.
U.S. savings bonds (Series EE, I, and HH), which follow their own reporting rules.
Tax-exempt obligations, though basis adjustments may still apply.
Personal loans of $10,000 or less between individuals outside of any business, so long as tax avoidance isn’t a principal purpose.¹

Even outside those categories, a de minimis rule lets you ignore very small discounts. The OID threshold is 0.25% of the bond’s stated redemption price at maturity multiplied by the number of complete years to maturity. On a 10-year, $1,000-face bond, the threshold is $25 (0.25% × $1,000 × 10). If actual OID is below that figure, you treat it as zero for annual reporting, and the gain attributable to that small discount is taxed as capital gain when you sell rather than ordinary income along the way.

Market discount has a parallel rule. If the discount is less than 0.25% of the stated redemption price at maturity multiplied by the number of complete years remaining after you acquired the bond, it’s treated as zero and rolls into capital gain at disposition.⁶

Running the Calculation

The core math is the same whether you’re dealing with OID, bond premium, or market discount. You need four inputs before you start: the bond’s adjusted basis at the beginning of the accrual period, the yield to maturity as an annual rate, the length of each accrual period, and the coupon payment received during the period. Yield to maturity is usually in the bond’s prospectus or available from your broker. Accrual periods follow the payment schedule (typically semiannual), and can be annual or any shorter interval up to one year.⁵

For each period:

Multiply the beginning adjusted basis by the yield to maturity, scaled to the period length. Semiannual compounding means dividing the annual yield by two.
Subtract the coupon paid during the period. A positive result is OID to include in income. A negative result is premium amortization that reduces your taxable interest.
Add the OID (or subtract the amortization) to basis. That new figure is the starting basis for the next period.

Repeat for each accrual period in the tax year and sum the results. The compounding is the point: for a discount bond, each period’s calculated interest is slightly larger than the last, producing a curve rather than a straight line.

A Worked Example

IRS Publication 1212 walks through a concrete case. Suppose you buy a 15-year corporate bond at original issue for $86,235.17, with a $100,000 face value, a 10% coupon rate, and a 12% yield to maturity compounded semiannually. The bond pays $5,000 in interest every six months.⁵

First six months: $86,235.17 × 0.06 = $5,174.11 of economic interest. Subtract the $5,000 coupon, and OID for the period is $174.11. Adjusted basis rises to $86,409.28.

Second six months: $86,409.28 × 0.06 = $5,184.56. Subtract $5,000, and OID is $184.56. Total OID for year one is $358.67, reported on top of the $10,000 in coupon payments. Basis entering year two is $86,593.84, and the cycle repeats from that higher starting point.

Partial Periods and Mid-Year Purchases

Buy or sell a bond partway through an accrual period and you only include OID for the days you actually held it. Federal regulations allow any reasonable method for computing OID over a short initial period. A common approach multiplies issue price by the period yield, then scales by a fraction: days in your short holding period over days in a full accrual period.⁷

Acquisition Premium on Secondary-Market OID Bonds

If you buy an OID bond on the secondary market and pay more than its adjusted issue price but still less than face value, the excess is acquisition premium. That premium reduces the daily OID you include in income, calculated as a ratio: the acquisition premium you paid divided by the total remaining OID on the bond, applied against each day’s OID.¹ Your broker should show the offset in Box 6 of Form 1099-OID. If your basis differs from the broker’s records, the reported offset may be off, and the fix is an adjustment on Schedule B.

Zero-Coupon Bonds, Treasury STRIPS, and TIPS

Zero-coupon bonds pay no periodic interest. You buy at a deep discount and receive face value at maturity, so the entire spread is OID, and constant yield accrual runs the whole way with no coupon to subtract. The full economic interest each period is OID, and basis grows accordingly.

Treasury STRIPS are the zero-coupon form of Treasury bonds, created when a dealer separates the principal payment from the interest coupons and sells each piece on its own. Each stripped piece is treated as if newly issued on the date you purchased it, with OID equal to the difference between the face amount (or coupon amount) and your purchase price.⁸ From there, the accrual rules work like any other OID bond.

Treasury Inflation-Protected Securities (TIPS) layer inflation on top. The annual inflation adjustment to principal is treated as additional OID and must be included in income for the year, even though you won’t receive the adjusted amount in cash until maturity or sale.⁹ In deflationary years the negative adjustment offsets other interest on the same instrument. If deflation exceeds the year’s interest, the excess is an ordinary loss (capped at the interest you’ve previously reported on the instrument) or carries forward against future interest. Because the annual tax hits before the inflation cash arrives, TIPS tend to sit better inside tax-advantaged accounts.

Making the Election When It’s Optional

Mandatory OID inclusion doesn’t require any election. You just calculate and report. Two other situations do require you to affirmatively elect the constant yield method.

For taxable bond premium, you elect amortization by reporting it on your return for the first year you want the treatment to apply, attaching a statement that references section 171. The election covers every taxable bond you own and every one you later acquire, and revoking it requires IRS approval on Form 3115.³

For market discount bonds, you can elect constant yield accrual instead of the default straight-line accrual, and that choice is irrevocable for the specific bond.⁴

A broader election is also available: treat all interest on a debt instrument (stated interest, OID, market discount, de minimis amounts, and acquisition premium) as a single pool calculated under the constant yield method. You make it by attaching a statement to your timely filed return for the year of acquisition, identifying the instruments or classes covered. It can’t be revoked without IRS approval and isn’t available for tax-exempt bonds.¹⁰

Reporting on Your Return

Interest income from bonds, including OID and coupon payments, goes on Schedule B of Form 1040, listed by payer.¹¹ For most investors, the totals on Form 1099-OID and Form 1099-INT match what’s owed and you copy them straight across.

When your own calculation differs from the broker’s (an unaccounted acquisition premium is the common cause), adjust on Schedule B. Report the full 1099-OID figure on one line, then on the next line write “OID Adjustment” with the difference as a positive or negative number.¹¹ Your taxable interest ends up correct and the return still ties to what the IRS already has on file. Unlabeled mismatches between your return and the 1099 are exactly what generates automated notices.

If you elected to amortize bond premium on a taxable bond, the amortization offsets your interest income. The broker should report the offset in Box 10 of Form 1099-OID or as a reduced figure on Form 1099-INT; verify against your own numbers.

Basis and What Happens at Sale

Every OID inclusion and every premium amortization moves the bond’s basis. Discount bonds see basis rise; premium bonds see it fall. That running total matters when you sell before maturity, because capital gain or loss is measured from adjusted basis, not the original purchase price.

Report the sale on Form 8949. Your broker will issue Form 1099-B with proceeds and a cost basis, and the reported basis frequently misses OID adjustments. If it’s wrong, enter the broker’s figure in column (e) anyway, then correct it with an entry in column (g) and put code “B” in column (f) to flag the basis correction.¹² Gain or loss is the difference between the sale proceeds and your true adjusted basis after every OID inclusion or premium amortization over the years.

Errors here cut both ways. Forget to increase basis for OID you’ve already reported, and you pay tax on the same income twice: once as OID, once again as capital gain. Forget to decrease basis for amortized premium, and you overstate your loss (or understate your gain), an understatement of income that can trigger a 20% accuracy-related penalty on the underpayment.¹³

1
Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount
2
Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium
3
Internal Revenue Service. Publication 550 – Investment Income and Expenses
4
Office of the Law Revision Counsel. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
5
Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID) Instruments
6
Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules
7
eCFR. 26 CFR 1.1272-1 – Current Inclusion of OID in Income
8
Office of the Law Revision Counsel. 26 U.S. Code 1286 – Tax Treatment of Stripped Bonds
9
eCFR. 26 CFR 1.1275-7 – Inflation-Indexed Debt Instruments
10
eCFR. 26 CFR 1.1272-3 – Election by a Holder to Treat All Interest on a Debt Instrument as OID
11
Internal Revenue Service. 2025 Instructions for Schedule B (Form 1040)
12
Internal Revenue Service. 2025 Instructions for Form 8949
13
Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments