Bond accretion is the yearly increase in the carrying value of a bond you bought or that was issued below its face value, and federal tax law generally requires you to report that increase as interest income each year even though no cash changes hands. The discount gets parceled out over the bond’s remaining life as original issue discount (OID), and the amount you accrete raises your cost basis so you aren’t taxed twice when the bond is sold or redeemed. Getting the mechanics right controls both your annual tax bill and the gain or loss you report at the end.
Which Bonds Accrete
Zero-coupon bonds are the clearest case. You pay a steep discount, receive no interest checks, and collect the full face value at maturity. The entire spread between purchase price and par is OID, and accretion is the mechanism that spreads it into annual taxable amounts.
Coupon-paying bonds can also carry OID when they are first issued below par. A corporation might issue a bond with a 4% coupon at $970 per $1,000 face value. That $30 gap is OID, and you accrete it alongside the coupon payments.
Treasury Inflation-Protected Securities involve a related form of accretion. When the Consumer Price Index rises, the principal of a TIPS bond adjusts upward, and the IRS treats that inflation adjustment as taxable income in the year it occurs, even though you won’t see the cash until you sell or the bond matures. TIPS are exempt from state and local income taxes but not federal.1TreasuryDirect. Treasury Inflation-Protected Securities (TIPS)
One boundary worth knowing: debt instruments that mature in one year or less are excluded from the standard OID accretion rules entirely. Short-term obligations fall under a separate set of timing provisions.2Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount
The De Minimis Line
Not every bond issued below par produces OID. If the discount is small enough, the tax code treats it as zero. The threshold is 0.25% of face value multiplied by the number of complete years to maturity.3Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount
A 10-year, $1,000 face bond has a de minimis threshold of $25. Issued at $980, the $20 discount falls below the line. Nothing accretes annually, and at maturity the $20 is capital gain rather than ordinary interest. Cross the line by a dollar and the entire discount becomes OID, subject to annual accretion and ordinary income treatment. The cutoff is sharp, so check the math before buying.
How the Annual Amount Is Calculated
Two methods exist, and the choice controls how much OID you recognize in each year.
Straight-Line Method
Straight-line divides the total discount evenly across all remaining years. A bond bought at $900 with a $1,000 face value and 10 years to maturity accretes $10 per year. Simple, but it ignores the time value of money by recognizing the same dollar amount when the invested balance is small and when it’s much larger. This approach is generally used for bonds issued before 1985 or where the difference between methods is negligible.
Constant Yield Method
The constant yield method, also called the effective interest method, is the IRS-preferred approach for most bonds issued after 1984. Rather than adding a flat dollar amount each year, it applies the bond’s yield to maturity to the growing adjusted issue price. For each accrual period, multiply the adjusted issue price at the start of the period by the yield to maturity (divided by the number of accrual periods per year), then subtract any qualified stated interest paid during the period. What remains is the OID for that period.4Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID) Instruments
Consider a bond bought at original issue for $86,235 with a $100,000 face value, a 15-year maturity, and a 12% yield to maturity compounded semiannually. For the first six-month period, multiply $86,235 by 6% (half the annual yield), giving $5,174. If the bond pays $5,000 in semiannual coupon interest, subtract that, leaving $174 in OID. For the second period, the adjusted issue price rises to $86,409, and the OID climbs to about $185. Each period’s accretion is slightly larger than the last because the base keeps growing.
Early periods produce less taxable OID than straight-line would, later periods produce more, and the pattern better reflects the actual economics. Publication 1212 includes worked accrual tables for different bond structures.4Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID) Instruments
What You Owe, and When
Under IRC §1272, you must include accreted OID in your gross income each year you hold the bond, regardless of whether any cash arrives. The IRS treats it as ordinary interest income, not capital gain.5Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
Investors call this phantom income. You owe tax on money you haven’t pocketed, and for a large zero-coupon position the annual bill can be substantial. You need cash from other sources to pay it. Investors who overlook this often get surprised in April.
The counterweight is that your cost basis rises by the same amount you include in income each year.5Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount When the bond matures, your adjusted basis equals face value and redemption triggers no additional tax. If you sell early, your adjusted basis reflects everything you’ve already been taxed on, reducing or eliminating the gain you’d otherwise report. Without that basis adjustment, the same dollars would be taxed twice.
Tax-Exempt Municipal Bonds
OID on tax-exempt state and local government bonds is treated as tax-exempt interest. You don’t include it in gross income the way you would with a corporate or Treasury OID bond.6Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
The accretion still matters for the basis calculation at sale. For tax-exempt bonds issued after September 3, 1982, and acquired after March 1, 1984, you increase your adjusted basis by your share of the accreted OID. For a covered security, your broker’s reported basis should already reflect this. Ignoring the adjustment could cause you to overstate a loss or understate a gain when you dispose of the bond.6Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
One wrinkle catches municipal investors: if you buy a muni on the secondary market below its adjusted issue price, the resulting market discount is taxable, even though the original OID is not.
Market Discount Is Not the Same as OID
OID exists at the moment a bond is first issued below par. Market discount arises later, when a bond’s price falls on the secondary market after issuance, typically because interest rates rose. The tax treatment is different.6Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
With OID, you include the accretion in income annually. With market discount, the default rule is the opposite: nothing is reported until you sell or redeem. At that point, gain is treated as ordinary income to the extent of the accrued market discount, and only any excess qualifies for capital gain treatment.7Office of the Law Revision Counsel. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount
You can elect under IRC §1278(b) to include market discount in income currently as it accrues rather than deferring it. Making the election avoids the ordinary income recapture at disposition, but it applies to all market discount bonds you acquire afterward, and revocation requires IRS permission.8Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules The same two calculation methods apply: straight-line (ratable) or constant interest rate.
Acquisition Premium Reduces Your OID
Sometimes you buy an OID bond on the secondary market for more than its current adjusted issue price but still less than par. The excess is acquisition premium, and it reduces the amount of OID you include in income each year.4Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID) Instruments
The reduction is a fraction: the acquisition premium over the total remaining OID at your purchase date, applied against each period’s OID. If you paid $50 more than the adjusted issue price and $200 of OID remained, each dollar of OID would be reduced by 25 cents. The result is a lower annual phantom income figure.
Your broker generally handles this on covered securities. Form 1099-OID Box 6 shows the acquisition premium offset for the year, or your broker may report a net OID figure in Box 1 that already reflects the reduction. If Box 1 is already net, don’t subtract the acquisition premium a second time on your return.
Reporting It on Your Return
Financial institutions issue Form 1099-OID when the total OID for the year is at least $10. Box 1 shows the taxable OID for the portion of the year you owned the bond, and that amount goes on your return as interest income.9Internal Revenue Service. Form 1099-OID (Rev. January 2024) Original Issue Discount
You transfer the amount to Schedule B, required whenever your taxable interest exceeds $1,500 for the year. List the payer and amount alongside any other interest income.10Internal Revenue Service. 2025 Schedule B (Form 1040) – Interest and Ordinary Dividends The total flows to Line 2b of Form 1040.
Hold onto every 1099-OID and your purchase documentation until at least three years after you file the return for the year the bond matures or is sold. Those records prove your adjusted basis and prevent double taxation if the return is ever questioned.11Internal Revenue Service. How Long Should I Keep Records?
What Missing OID Costs You
Because OID is phantom income, it’s easy to overlook, and the consequences match any other underreporting. The failure-to-pay penalty runs at 0.5% of the unpaid tax for each month or partial month the balance is outstanding, up to 25%, with interest accruing from the original due date until you pay in full.12Internal Revenue Service. Topic No. 653, IRS Notices and Bills, Penalties and Interest Charges
Ignoring OID for several years also compounds a second problem: your basis never gets adjusted upward, so an inflated taxable gain appears when the bond matures. You’d owe back taxes and penalties on the unreported annual OID plus tax on a gain that shouldn’t exist if you’d been reporting correctly all along. Fixing multi-year omissions usually requires amended returns for each affected year and often professional help.