The tax treatment of a bond discount versus a bond premium comes down to a single split: a discount usually generates ordinary interest income, either accrued each year as original issue discount or recognized when you sell as market discount, while a premium lets you elect to amortize the extra you paid and offset your interest income year by year. The rules diverge again for tax-exempt municipal bonds, and a narrow de minimis exception can convert a small discount into capital gain.
What Counts as a Discount or a Premium
A bond sells at a discount when you pay less than its face value and at a premium when you pay more. For a $1,000 face value bond, $950 is a discount and $1,050 is a premium. Whether a particular bond is a discount or premium bond depends on how its fixed coupon rate compares to the market rate at the moment you buy: a below-market coupon pushes the price under par, and an above-market coupon pushes it above.
Discounts are further divided by when the gap arose. If the bond was originally issued below face value, the shortfall is original issue discount (OID). If the bond was issued at or near par but later trades below its adjusted issue price because rates rose or credit weakened, the shortfall you capture is market discount. Those two categories are taxed on completely different schedules, so identifying which one you hold is the first step.
Tax Rules for Discount Bonds
Original Issue Discount
The IRS treats OID as interest income that accrues annually, whether or not you receive any cash. Each year you include a portion of the accrued OID in gross income using the constant yield method.1eCFR. 26 CFR 1.1272-1 – Current Inclusion of OID in Income This is sometimes called phantom income, because tax is due on money you haven’t collected. Each year’s inclusion increases your basis in the bond, so the same dollars aren’t taxed again at maturity.2Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID)
Zero-coupon bonds are the clearest case. They pay no cash interest at all, so the entire return is OID accruing year after year until you receive the face value.
Market Discount
Market discount works differently. By default, you don’t recognize anything until you sell the bond or it matures. At that point, any gain up to the accrued market discount is taxed as ordinary income, and only gain above that amount qualifies as capital gain.3GovInfo. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
You can instead elect to include market discount in income as it accrues, similar to OID. The election applies to all market discount bonds you acquire from that point forward and is essentially permanent unless the IRS approves a revocation.4Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules You pay tax sooner, but you avoid a large ordinary income lump in the year of sale. For active bond investors, current inclusion can smooth the tax bill.
The De Minimis Rule
Not every bond bought below par produces ordinary income. Under the de minimis threshold, if the discount is less than 0.25% of face value multiplied by the number of complete years to maturity, the discount is treated as zero.5Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount
Take a $1,000 face bond with 10 years to maturity. The threshold is $25 (0.25% × $1,000 × 10). Buy it for $980, and the $20 discount falls under the threshold, so any gain at redemption is capital gain. Buy the same bond for $970, and the $30 discount crosses the line, so the full discount falls under the ordinary income rules for OID or market discount. Because capital gains rates are lower than ordinary rates for most taxpayers, a bond that squeaks under the de minimis line delivers a meaningfully better after-tax return.
Tax Rules for Premium Bonds
When you buy a taxable bond at a premium, you have a choice: elect to amortize the premium and offset your interest income each year, or ignore the option and settle up at maturity or sale.
Making the Amortization Election
The election is made by offsetting interest income with bond premium amortization on your tax return for the first year you want it to apply. Once made, it covers every taxable bond you own and every taxable bond you later acquire. Revoking it requires IRS approval through Form 3115.6Internal Revenue Service. Publication 550 – Investment Income and Expenses
Amortization lowers your reported interest income each year and reduces your basis by the same amount. If you paid $1,050 for a $1,000 bond paying 5% over 10 years, you would offset roughly $5 of interest income annually (the exact figure varies under the constant yield method). By maturity, your basis has stepped down to $1,000, so there is no gain or loss.7eCFR. 26 CFR 1.171-4 – Election to Amortize Bond Premium on Taxable Bonds
Skipping the Election
If you don’t elect, you report the full coupon as interest income each year and keep your original basis. When the bond matures at par, you realize a capital loss equal to the premium. The math usually works against this approach. Ordinary income rates on the coupons are higher than the capital loss benefit, and capital losses face an annual deduction limit of $3,000 against ordinary income, with the excess carried forward.
Callable Bonds
Callable bonds introduce a wrinkle to premium amortization. If using the earlier call date produces a smaller amortizable premium for the period than the maturity date would, you must amortize to the call date instead. That prevents spreading the premium over a longer period than the bond may actually stay outstanding.
Tax-Exempt Bonds Follow Different Rules
Municipal bonds and other tax-exempt obligations play by a separate rulebook on both ends.
OID on a tax-exempt bond accrues the same way it does on a taxable bond, but because the underlying interest is exempt from federal income tax, the accrued OID is also federally tax-exempt.8Office of the Law Revision Counsel. 26 U.S. Code 1288 – Treatment of Original Issue Discount on Tax-Exempt Obligations Your basis still steps up each year, which reduces or eliminates capital gain if you sell before maturity. Some states tax the accrued OID even when the federal government does not.
For premiums on tax-exempt bonds, amortization is mandatory rather than elective. You cannot deduct the amortized premium, because the interest it would offset is already tax-exempt.9Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium Amortization simply reduces your basis over time. The practical consequence: holding a tax-exempt premium bond to maturity cannot generate a capital loss.
Reporting on Your Tax Return
Two forms carry most of the information from your broker or the issuer.
- Form 1099-OID reports original issue discount. Box 1 shows taxable OID, Box 8 shows OID on U.S. Treasury obligations, and Box 11 shows tax-exempt OID. For a covered security with acquisition premium, the form may show a net OID amount that already reflects premium offsets.10Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
- Form 1099-INT reports interest income. Box 1 shows taxable interest. For covered securities bought at a premium, the form may show either a gross interest amount with a separate premium amortization figure, or a net amount that already reflects the amortization offset.
Both OID and interest income go on Schedule B of Form 1040. If the reported OID doesn’t match your own constant yield calculation, enter the full reported amount on line 1, subtotal it, then show your adjustment below with a label such as “OID Adjustment” before arriving at the corrected figure.2Internal Revenue Service. Publication 1212 – Guide to Original Issue Discount (OID)
For premium amortization on taxable bonds, subtract the amortizable bond premium from interest income on Schedule B. Below your interest subtotal, enter the adjustment with the label “ABP Adjustment.”6Internal Revenue Service. Publication 550 – Investment Income and Expenses