Accrued market discount is the portion of a bond’s below-face purchase price that the IRS treats as disguised interest rather than price appreciation, and when you sell or redeem the bond, that accrued amount is taxed as ordinary income instead of capital gain. Any gain above the accrued discount keeps its capital gain character, and a loss stays a capital loss. The rule applies no matter how long you held the bond, so even a decade of ownership won’t convert the accrued portion into long-term capital gain.
Which Bonds the Rule Covers
A market discount bond is any bond you buy in the secondary market for less than its stated redemption price at maturity. The discount is the gap between face value and your purchase price (technically, your adjusted basis right after acquisition). That gap usually reflects interest rate moves or credit concerns since the bond was first issued.
Several categories sit outside the market discount rules entirely under Section 1278:1Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules
- Short-term obligations maturing within one year of original issue.
- U.S. savings bonds, including Series EE and Series I.
- Installment obligations subject to the installment sale rules.
- Bonds you bought at original issue directly from the issuer (these may instead carry original issue discount).
The De Minimis Floor
A small discount is ignored. The threshold is 0.25% of face value multiplied by the number of complete years remaining to maturity. Anything below that counts as zero discount, and the full gain on sale is capital gain.
Take a $1,000 face bond with 10 complete years left. The threshold is $1,000 × 0.0025 × 10 = $25. Pay $980 and the $20 discount falls below the floor, so it’s ignored. Pay $970 and the $30 discount clears the floor, so the rules apply to the full amount.
Not the Same as Original Issue Discount
Market discount is a secondary market phenomenon. Original issue discount (OID) arises when a bond is first sold below face value, and under Section 1272 it accrues as taxable interest each year the holder owns it, regardless of whether cash is received.2Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount Market discount sits under Sections 1276 through 1278 and is not taxed until you dispose of the bond, unless you affirmatively elect current inclusion.
Calculating the Accrual
Section 1276(b) gives you two methods for tracking how much of the total discount has accrued during your holding period. That accrued figure is the ceiling on the ordinary income recharacterization at sale.3Office of the Law Revision Counsel. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
Ratable (Straight-Line) Accrual
This is the default. Divide the total discount by the number of days from acquisition to maturity, then multiply by the days you’ve held the bond. No election needed.
Example: a $500 discount with 2,000 days remaining accrues at $0.25 per day. Sell after 800 days and your accrued market discount is $200. That $200 is the most of your gain that can be recharacterized as ordinary income.
Constant Yield Accrual
The alternative, elected on a bond-by-bond basis under Section 1276(b)(2), treats the bond as if newly issued on your purchase date at your purchase price, then accrues the discount using the yield-to-maturity implicit in that price. Because this curve starts shallow, less discount accrues in the early years than under the straight line. Investors expecting to sell well before maturity sometimes prefer it for that reason. The election is made on a timely filed return for the year of acquisition and cannot be revoked once made for that bond.
Whichever method you use, keep your own records. The IRS doesn’t track accrual for you, and your broker generally won’t either unless you’ve made a specific election and notified them.
How the Tax Hits When You Sell
Section 1276(a) sets the core rule: gain on sale, redemption, or other disposition is ordinary income up to the accrued market discount. Anything beyond that is capital gain, long-term or short-term depending on your holding period.
Say you bought a $10,000 face bond for $9,500 with five years to maturity. Total discount: $500. After three years under straight-line, $300 has accrued. Sell for $10,200 and your total gain is $700. The first $300 is ordinary income. The remaining $400 is long-term capital gain (assuming more than a year of ownership). No amount of additional holding time converts that $300 into capital gain.
Selling at a Loss
No gain, nothing to recharacterize. The loss is a capital loss and the market discount rules fall away. The accrued discount does not conjure phantom ordinary income when you’re underwater.
Partial Principal Payments
If the bond returns principal before maturity, each payment triggers ordinary income up to the accrued market discount at that point, with the remaining accrued balance reduced accordingly. You can’t collect principal tax-free and push all the ordinary income to a final sale.
Basis Adjustment
When you recognize accrued discount as ordinary income, your basis in the bond rises by the same amount. That prevents double counting, since the ordinary income you’ve already reported reduces the capital gain (or increases the capital loss) on the final disposition.
Municipal Bonds Are Not Exempt
The interest on a tax-exempt municipal bond is free from federal income tax. The market discount is not. Buy a muni below face value and the accrued market discount at sale or maturity is taxable as ordinary income, treated as interest income rather than tax-exempt interest.4Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses The Schedule B instructions call this out explicitly.5Internal Revenue Service. Instructions for Schedule B (Form 1040) This rule applies to municipal bonds purchased after April 30, 1993.
One narrow carve-out: for purposes of the Section 1277 interest deduction limitation discussed below, tax-exempt bonds are not treated as market discount bonds, so the interest deduction deferral rule does not apply if you borrowed to buy a discounted muni.
Electing to Include the Discount Each Year
By default, the accrued discount sits untaxed until you dispose of the bond. Section 1278(b) lets you instead elect to include the market discount in income as it accrues, year by year.
Two reasons to volunteer for earlier tax. First, the election removes the Section 1277 deferral on interest you pay to carry the bond, letting you deduct that interest expense in full each year. Second, reporting as you go is simpler than tracking a deferred balance across years and then unwinding it at sale.
The catch is that the election is close to permanent. Once made, it applies to every market discount bond you acquire in that year and every year after, and you need IRS consent to revoke it. For anyone who regularly buys discounted bonds, that’s worth thinking through before filing.
Once the election is in place, Sections 1276 and 1277 stop applying. The discount is interest income each year, your basis rises as it accrues, and there is nothing left to recharacterize when you sell.
If You Borrowed to Buy the Bond
Section 1277 deals with the mismatch that would otherwise arise when you deduct interest on borrowed funds now while deferring the discount income to the future.6Office of the Law Revision Counsel. 26 U.S. Code 1277 – Deferral of Interest Deduction Allocable to Accrued Market Discount It calculates your “net direct interest expense” (interest paid on debt used to buy or carry the bond, minus interest income from the bond for the year) and lets you deduct that net expense only to the extent it exceeds the market discount accruing that year. The rest is deferred.
Example: $600 of margin interest to carry the bond, $400 of coupon income received, so net direct interest expense of $200. If $150 of discount accrued that year, you can deduct $50 now. The other $150 is carried forward.
The deferred interest isn’t lost. When you finally sell or redeem the bond, the full accumulated deferral is treated as interest paid in the year of disposition. Making the current inclusion election eliminates this deferral going forward.
Gifts, Inheritance, and Transfers
Give a market discount bond away and the taint follows it. Under Section 1276(c), a nonrecognition transfer with a carryover basis means the recipient is treated as having bought the bond on your original acquisition date at your original cost, and the discount keeps accruing from where you left off. Any deferred interest expense under Section 1277 moves with the bond as well.
Death works differently. A bond held at death generally receives a stepped-up basis to fair market value, which typically shrinks or eliminates the market discount by closing the gap between basis and face value. Holding a discounted bond until death can therefore avoid the ordinary income recharacterization altogether.
Reporting It on Your Return
The paperwork depends on whether you elected current inclusion.
If you elected current inclusion, your broker should report the annually accruing discount on Form 1099-INT (Box 10) or Form 1099-OID (Box 5), provided you notified them of the election in writing.7Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID You then report it on Line 1 of Schedule B as taxable interest.
If you did not elect, you report nothing until disposition. In the year you sell or redeem, the accrued market discount shows up as interest income on Schedule B, and the capital gain portion goes on Schedule D and Form 8949 like any other bond sale. Your broker may issue a 1099-B for the disposition, but the ordinary income split often falls to you to calculate, because the broker may not know which accrual method you chose or what you accrued. Publication 550 covers the mechanics in more detail.4Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses Keep records of the acquisition date, purchase price, accrual method, and daily accrual figures for every discounted bond you hold.