Market Discount Bonds: Tax Rules on Secondary Market Purchases

When you buy a bond on the secondary market for less than its face value, the tax treatment of a market discount bond is unfavorable in a specific way: any gain up to the amount of the discount that has accrued during your holding period is taxed as ordinary interest income, not as a capital gain. For 2026, that means a federal rate as high as 37%, plus a possible 3.8% net investment income surtax. Only gain above the accrued discount reaches long-term capital gains rates. The rule applies to corporate bonds, Treasury debt, and even tax-exempt municipal bonds, each with its own wrinkle.¹²

When a Discounted Bond Falls Under These Rules

A bond is a market discount bond if you buy it for less than its stated redemption price at maturity, usually the face value printed on the bond. The gap between what you paid and that redemption price is the market discount.³

This situation usually shows up because interest rates have risen since the bond was issued. An older bond paying 3% looks unattractive when new bonds offer 5%, so the market pushes the older bond’s price down until its effective yield catches up.

Three categories of debt are carved out of the market discount rules entirely:

Short-term obligations with a fixed maturity of one year or less from issue.
U.S. savings bonds, including Series EE and Series I.
Installment obligations under IRC Section 453B.

If your bond falls into one of these categories, different tax provisions govern the gain.³

The De Minimis Escape

Small discounts are ignored. If the discount is less than 0.25% of the stated redemption price multiplied by the number of complete years remaining to maturity, the IRS treats the market discount as zero. Partial years don’t count.³

On a $1,000 bond with ten complete years to maturity, the threshold is $1,000 × 0.0025 × 10, or $25. Pay $980 and the $20 discount falls below the threshold, so any eventual gain is a capital gain. Pay $970 and the full $30 discount is subject to the ordinary income rules. For anyone shopping discounted bonds, this math is worth running before you buy.

Bonds With Original Issue Discount

If the bond was originally issued below face value, you don’t measure the market discount from face. You measure it from the adjusted issue price, which is the original issue price plus all OID that accrued before your purchase. Only the shortfall between that adjusted issue price and what you paid is market discount; the OID portion follows its own separate rules.⁴

How the Gain Splits Between Ordinary Income and Capital Gain

When you sell, redeem, or otherwise dispose of a market discount bond, gain up to the accrued market discount is taxed as ordinary income. Anything above that qualifies for capital gains treatment, long-term if you held the bond more than a year.¹⁵

An example makes the split concrete. You bought a bond for $900 with $60 of accrued market discount by the time you sell it for $990. The first $60 of your $90 gain is ordinary income. The remaining $30 is a capital gain.

The recharacterized gain is treated as interest income, not just generic ordinary income. That classification pulls it into interest-related provisions elsewhere in the code, including the 3.8% net investment income tax under IRC Section 1411. That surtax applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly), thresholds that are not indexed for inflation.⁶ Stacked on top of the 37% top ordinary rate, a high-income investor can face a combined 40.8% federal rate on accrued market discount.

When you include market discount in income, whether all at once at sale or annually under the election described below, your basis in the bond rises by the same amount. That basis adjustment keeps the discount from being taxed twice.⁵

How Much of the Discount Has Accrued

The amount classified as ordinary income turns on how much of the total market discount has “accrued” during your holding period. Two methods exist.

The default is ratable accrual. It spreads the discount evenly across every day from your purchase through maturity. Hold the bond for half the remaining term and half the discount has accrued.¹

You can elect the constant yield method instead. It applies a fixed rate to the bond’s growing accreted value, so less accrues in the early years and more accrues near maturity. For someone selling well before maturity, constant yield generally produces a smaller ordinary income component.¹ Brokers typically default to constant yield when reporting to the IRS unless you tell them otherwise, so your own calculations should use the same method or reconcile carefully on the return.⁷

Electing to Recognize Discount Annually

Under the default rules you owe nothing on the discount until you sell or redeem the bond. IRC Section 1278(b) lets you elect the opposite approach: include the accrued discount in gross income each year as it builds. You pay tax earlier, but your basis rises annually and there is no ordinary income surprise at sale. The election also switches off the interest expense deferral rules covered below.³

To make the election, attach a written statement to your timely filed return for the first year, saying you are including market discount in gross income under Section 1278(b) and identifying your accrual method. Once made, it applies to every market discount bond you acquire that year and afterward. You cannot revoke it without IRS consent, and the IRS will not grant consent if you revoked a prior election within the last five calendar years.⁵

Paying tax on income you haven’t yet received in cash is a real cost, so the election isn’t automatically right. It tends to fit investors who buy discounted bonds regularly and prefer predictable annual recognition to lumpy ordinary income at sale.

Tax-Exempt Municipal Bonds Are Not Fully Exempt

This is where many investors get caught. Buying a tax-exempt municipal bond on the secondary market at a discount leaves the regular coupon interest tax-exempt, but the market discount is not. Accrued market discount on a tax-exempt muni is taxable as ordinary income when the bond is sold, redeemed, or matures, the same as on a corporate bond.⁴

Original issue discount on a tax-exempt muni is generally treated as tax-exempt interest. Market discount is not. Two investors holding the same bond can end up with very different tax outcomes depending on whether the discount was baked in at issuance or opened up later in the secondary market. The de minimis rule still applies, so a small enough discount keeps the gain in capital gains territory.

Borrowing to Buy a Market Discount Bond

If you use debt to purchase or carry a market discount bond, IRC Section 1277 limits your interest deduction. The “net direct interest expense,” meaning interest paid on the loan minus the interest income the bond produces, is deductible in the current year only to the extent it exceeds the market discount allocable to that year. The rest is deferred.⁸

Say you pay $500 in loan interest and the bond throws off $300 in stated interest. Your net direct interest expense is $200. That $200 cannot offset other income now. It waits until you sell the bond or otherwise recognize the market discount as income, at which point the deferred amount becomes deductible. If you have made the Section 1278(b) annual inclusion election, these deferral rules don’t apply, because you are already recognizing the discount currently.³

Gifts, Exchanges, and Partial Principal Payments

Gifting a market discount bond hands the tax problem to the recipient. They are treated as having acquired the bond on your original purchase date at your basis, and all discount that accrued while you held it carries over.¹

In a tax-free exchange, if the replacement asset is also a market discount bond, the accrued discount transfers to it. If the replacement is not a market discount bond, the accrued discount triggers ordinary income at the time of the exchange.¹

When a bond returns principal in installments before maturity, each partial payment is ordinary income up to the accrued market discount at that point. Whatever you include reduces the accrued discount tracked for future payments or a final sale.¹

What Shows Up on Your Tax Forms

Brokers report accrued market discount in Box 10 of Form 1099-INT for covered securities when the holder has made the Section 1278(b) current inclusion election. For a bond that also carries OID, market discount accruals appear in Box 5 of Form 1099-OID instead.⁷

On the return, market discount you include in income goes on Line 1 of Schedule B (Form 1040) with your other interest income.⁹ If you chose ratable accrual but never told your broker, the figures on your 1099 will reflect constant yield, and you will need clear records of your acquisition date, purchase price, and chosen method to reconcile.⁷

1
Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
2
Internal Revenue Service. Federal Income Tax Rates and Brackets
3
Office of the Law Revision Counsel. 26 USC 1278 – Definitions and Special Rules
4
Internal Revenue Service. Publication 1212, Guide to Original Issue Discount (OID) Instruments
5
Internal Revenue Service. Publication 550, Investment Income and Expenses
6
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
7
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
8
Office of the Law Revision Counsel. 26 USC 1277 – Deferral of Interest Deduction Allocable to Accrued Market Discount
9
Internal Revenue Service. Instructions for Schedule B (Form 1040)