Tax Code 1272: Original Issue Discount Accrual and Reporting

The original issue discount rules require you to report a portion of a bond’s built-in discount as taxable interest each year you hold it, even when the issuer sends you no cash until maturity. That accrued amount is called original issue discount, or OID, and Internal Revenue Code Section 1272 treats it as interest that economically accrues over the life of the debt.¹ The practical result: you can owe tax on income you haven’t yet received, a situation investors often call phantom income.

What Counts as Original Issue Discount

OID is the difference between what the first buyer pays for a debt instrument and what the issuer will pay at maturity. Section 1273 defines it as the excess of the stated redemption price at maturity over the issue price.² Pay $900 for a bond that returns $1,000 at maturity, and $100 of OID exists on that bond. Because that $100 is economically the interest the issuer owes you for the use of your money, the tax code makes you recognize slices of it in income each year rather than waiting until maturity.

When the Discount Is Small Enough to Ignore

Section 1273(a)(3) sets a de minimis threshold. If total OID on a debt instrument is less than one-quarter of one percent of the stated redemption price multiplied by the number of complete years to maturity, the OID is treated as zero.²

Consider a 10-year, $1,000 face-value bond. The threshold is 0.25% × $1,000 × 10, or $25. Buy that bond for $980 and the $20 discount falls under the line. You accrue nothing each year and instead recognize the $20 as capital gain when the bond matures or you sell it.³ Capital gains rates are generally lower than ordinary income rates, so a bond sitting just above or below the de minimis line can produce meaningfully different results.

Which Bonds Trigger Annual Accrual

Section 1272 applies broadly to debt instruments issued after December 31, 1984, that carry OID above the de minimis amount.⁴ The instruments you’re most likely to encounter include:

Zero-coupon bonds, which pay no periodic interest and are always issued well below face, so the entire discount is OID.
Corporate bonds sold below par at issuance, where the gap between issue price and face value is OID.
Long-term certificates of deposit that mature beyond one year and defer all interest until the end, because the holder is effectively buying at a discount to the total payout.

Section 1272(a)(2) then carves out categories that escape annual accrual altogether:¹

Tax-exempt state and municipal obligations whose interest is excluded from federal income tax.
U.S. savings bonds, including Series EE and Series I. You can defer reporting the interest until redemption or maturity.
Short-term obligations with a fixed maturity of one year or less from the date of issue.
Small personal loans between individuals totaling $10,000 or less (counting prior outstanding loans from the same lender to the same borrower), so long as the lender isn’t in the business of lending.

The personal loan exemption disappears if one of the principal purposes of the loan is federal tax avoidance.⁴ A family loan structured to shift income won’t qualify no matter the dollar amount.

How You Calculate the Annual Amount

Section 1272(a)(3) requires the constant yield method, not a straight-line split of the total discount.¹ The mechanics track how compound interest actually behaves:

Find the yield to maturity, meaning the single rate that, compounded each accrual period, would grow the issue price to the redemption price.
For each accrual period, multiply the adjusted issue price at the start of the period by that yield (adjusted for the period’s length). Subtract any stated interest actually paid during the period; the remainder is that period’s OID.
Divide the period’s OID over its days and include the daily portions for every day you held the bond during the tax year.

Each period starts with a larger adjusted issue price because prior OID has been added in. That means the taxable amount grows every year. A zero-coupon bond held for 20 years produces small phantom income early and much larger amounts near maturity. The pattern surprises investors when their 1099-OID figures climb sharply in later years.

Basis Adjustments Prevent Double Taxation

Every dollar of OID you include in income also raises your adjusted basis in the bond by the same dollar.¹ Buy a zero-coupon bond for $600, accrue $400 of OID over its life, and your basis reaches $1,000 by maturity. When the issuer pays $1,000, you have zero capital gain because the basis already matches.

The same logic protects you on an early sale. If you’ve accrued $200 in OID, your basis has risen from $600 to $800. Sell for $850 and you report a $50 capital gain, not $250. Investors who forget to track basis adjustments end up paying tax twice on the same income, and it’s one of the more expensive mistakes with these bonds.

Buying an OID Bond on the Secondary Market

Special rules kick in when you buy a bond after original issue at a price different from its adjusted issue price (the original price plus all OID accrued to that point).

Acquisition Premium

Pay more than the adjusted issue price but less than face value, and the difference is acquisition premium. You still accrue OID each year, but you reduce it by a fraction: the acquisition premium divided by the total OID remaining from your purchase date to maturity.³ Your broker may show the reduction in Box 6 of Form 1099-OID or net it into Box 1 directly.

Bond Premium

Pay more than the stated redemption price at maturity and Section 1272 stops applying to you on that bond entirely.¹ You may instead elect under Section 171 to amortize the premium across the remaining life of the bond, which reduces your reported interest income each year.⁵ Once you make that election, it applies to all your taxable bonds and binds you in future years unless the IRS lets you revoke it.

TIPS and Inflation Adjustments

Treasury Inflation-Protected Securities adjust their principal based on Consumer Price Index changes. The IRS treats any increase in the inflation-adjusted principal as OID, even though you don’t receive that principal growth until a coupon or maturity payment.³ That’s the same phantom income problem zero-coupon bondholders face.

Positive inflation adjustments raise your basis. In periods of falling CPI, negative OID gets reported, but you can only use it to offset prior positive OID on the same bond; it can’t produce a net deduction. TIPS OID is taxable federally but generally exempt from state and local income tax.

Reporting OID and What Happens If You Get It Wrong

Issuers and brokers send Form 1099-OID when the year’s OID is at least $10.⁶ Box 1 shows total OID, Box 2 shows any stated interest paid, and Box 8 shows OID on inflation-indexed instruments. You list the amounts on Schedule B (Form 1040), Part I, by payer.³

Don’t copy those numbers over without checking them. If you bought on the secondary market, paid acquisition premium, or sold mid-year, the reported figure may not reflect your correct accrual. In those cases you calculate the right amount yourself under the constant yield method and report the adjusted number. Box 8 on a TIPS you purchased after original issue is particularly prone to needing a correction.

Underreporting OID exposes you to the accuracy-related penalty under Section 6662, which adds 20% of the underpayment when it results from negligence or a substantial understatement of income tax.⁷ Where the IRS finds fraud, Section 6663 raises the penalty to 75% of the fraudulent portion.⁸ The fraud rate is reserved for intentional wrongdoing, but the negligence penalty alone can be steep on a sizeable OID position.

1
Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
2
Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount
3
Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID) Instruments
4
Government Publishing Office. 26 U.S.C. 1272 – Current Inclusion in Income of Original Issue Discount
5
Office of the Law Revision Counsel. 26 USC 171 – Amortizable Bond Premium
6
Internal Revenue Service. About Form 1099-OID, Original Issue Discount
7
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
8
Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty