Is Accrued Market Discount Taxable as Ordinary Income?

Yes. When you sell, redeem, or otherwise dispose of a bond you bought at a discount on the secondary market, the accrued market discount is taxable as ordinary income up to the amount that built up during your holding period, and any gain beyond that is a capital gain. Because 2026 ordinary income rates reach 37 percent while long-term capital gains top out much lower, the split between the two often decides your after-tax return on the trade.¹

What Counts as Market Discount

A market discount bond is any bond you buy for less than its stated redemption price at maturity, where the discount comes from a secondary-market purchase rather than the original issuance. Short-term obligations maturing within one year of issuance and United States savings bonds are outside the definition.²

The market discount is the gap between the bond’s stated redemption price and what you paid. Pay $9,200 for a bond that will pay $10,000 at maturity, and your market discount is $800.²

If the bond was originally issued at a discount (it carries original issue discount, or OID), you measure market discount against the bond’s revised issue price rather than face value. The revised issue price equals the original issue price plus all OID that prior holders have already included in income. That keeps the discount you picked up in the market separate from the discount baked in at issuance.²

When the Discount Is Too Small to Matter

A small enough discount is treated as zero. The de minimis threshold equals 0.25 percent of the bond’s stated redemption price at maturity, multiplied by the number of complete years remaining to maturity after you bought it.²

Take a $10,000 bond with 10 complete years left to maturity. The threshold is 0.0025 × $10,000 × 10 = $250. Pay $9,800, and the $200 discount falls below $250 and drops to zero; any gain when you sell is a capital gain.³ Pay $9,700, and the whole $300 is market discount because it exceeds the threshold. The rule is all-or-nothing: it either zeroes out the full discount or has no effect.

How Much of Your Gain Becomes Ordinary Income

Ordinary income treatment applies up to the market discount that has accrued during your holding period. Any gain above that accrued amount is a capital gain, long-term if you held the bond for more than a year. The statute applies this rule “notwithstanding any other provision” of the code, so it overrides provisions that might otherwise allow deferral or nonrecognition.⁴

Say you bought a bond for $9,200 and sold it for $10,100. Your total gain is $900. If $600 of market discount had accrued when you sold, $600 is ordinary income and the remaining $300 is a capital gain.

Sell at a loss and the market discount rules do not apply, because there is no gain to recharacterize. The loss follows the ordinary capital loss rules.

Two Ways to Accrue the Discount

By default, the discount accrues ratably: evenly over each day you hold the bond. Compare the days you held the bond to the total days from your acquisition through maturity. A $10,000 bond with $800 of market discount, held for half the remaining days to maturity, has $400 of accrued market discount.⁴

You can instead elect the constant interest rate method, which tracks how interest actually compounds. Accrual is smaller in the early years and larger in the later years, so a long holding period may leave less ordinary income on the table if you sell before maturity. Once you pick a method for a bond, you keep it for the life of that bond.⁴

Partial Principal Payments

Some bonds return principal in installments. Each partial principal payment is ordinary income to the extent it does not exceed the accrued market discount at that point, and the remaining accrued market discount is then reduced by the same amount for any future payment or sale.⁴

Electing to Include Market Discount Each Year

You can elect to include accrued market discount in income each year as it builds up, instead of waiting for a lump sum at disposition. This is the Section 1278(b) election.²

Three consequences matter:

Your basis in the bond increases by the market discount you include each year, so you have less gain (and less ordinary income) when you sell.²
The Section 1277 interest expense limitation does not apply to bonds covered by the election, so you can deduct interest expense in the year you incur it.
The election covers every market discount bond you acquire in that year and every year afterward. You cannot pick and choose bonds, and revoking it requires IRS consent.

The election tends to make sense if you hold a large portfolio of these bonds, want to smooth your tax bill year to year, or borrow to carry the bonds and need the full interest deduction currently.

If You Borrowed to Buy the Bond

Without the annual inclusion election, Section 1277 limits your deduction for net direct interest expense on debt used to buy or carry a market discount bond. The deduction each year is capped at the amount exceeding the market discount allocable to the days you held the bond that year.⁵

The deferred piece is not lost. It becomes deductible when you dispose of the bond, and if the bond throws off net interest income in a given year, you can elect to recapture some of the deferred expense sooner.⁵ Net direct interest expense is the interest you pay on the acquisition or carrying debt, minus interest income (including OID) from the bond that year. If the bond’s income already exceeds your borrowing cost, the limit has no practical effect.

Municipal Bonds Are Not Fully Shielded

Buy a municipal bond at a discount on the secondary market and the coupon interest stays federally tax-exempt, but the market discount does not. The IRS treats market discount as taxable income because it comes from price movement in the secondary market rather than the issuer’s coupon obligation.²

When you sell or redeem a discounted muni, the accrued market discount is ordinary income, same as for a taxable bond. The tax-exempt label covers the stated interest payments, not gain attributable to a secondary-market discount.

Reporting Market Discount on Your Return

Without the annual inclusion election, your broker typically reports the accrued market discount in Box 1f of Form 1099-B when you sell. You report the sale on Form 8949, enter code “D” in the adjustment column, and use the IRS worksheet to separate the ordinary income portion from any capital gain.⁶ The ordinary income flows through Form 8949 into Schedule D but is taxed at ordinary rates despite appearing on a capital-transaction form.⁷

With the annual inclusion election in place, your broker may report the accrual in Box 10 of Form 1099-INT (for bonds without OID) or Box 5 of Form 1099-OID (for bonds with OID). Because you have already paid tax on the accruing discount and your basis rose to match, you enter zero in the adjustment column of Form 8949 when you eventually sell.⁸

Miscategorizing ordinary income as capital gain can trigger the accuracy-related penalty of 20 percent of the underpayment if the IRS finds negligence or a substantial understatement.⁹

Short-Term Obligations Sit Outside These Rules

Bonds maturing within one year of issuance are excluded from Sections 1276 through 1278 entirely and fall under a separate short-term obligation regime, which requires certain holders (including banks, accrual-method taxpayers, regulated investment companies, and dealers holding for resale) to include the acquisition discount in income daily as it accrues.¹⁰ Cash-method individual investors outside those categories generally recognize the discount at sale or maturity.¹¹

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
2
Office of the Law Revision Counsel. 26 USC 1278 – Definitions and Special Rules
3
Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount Instruments
4
Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
5
Office of the Law Revision Counsel. 26 USC 1277 – Deferral of Interest Deduction Allocable to Accrued Market Discount
6
Internal Revenue Service. Instructions for Form 8949
7
Internal Revenue Service. About Schedule D (Form 1040) – Capital Gains and Losses
8
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
9
Office of the Law Revision Counsel. 26 US Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments
10
Office of the Law Revision Counsel. 26 US Code 1281 – Current Inclusion in Income of Discount on Certain Short-Term Obligations
11
Office of the Law Revision Counsel. 26 US Code 1283 – Definitions and Special Rules