How Bond Accretion Is Taxed: OID and Market Discount

When you buy a bond for less than its face value, tax rules on bond accretion require you to move that discount into income gradually over the bond’s life rather than treating it as a single gain when the bond matures or is sold. How that plays out depends on whether the discount was built in when the bond was issued or opened up later in the secondary market. The two categories use different calculation methods, follow different timing rules, and get reported on different forms.

OID vs. Market Discount

Accretion only comes into play for bonds bought below face value, and the tax code splits those discounts into two buckets. The bucket determines everything that follows.

An Original Issue Discount (OID) bond was sold by the issuer for less than face value from the start. The IRS treats that built-in discount as interest, and you must accrue it as ordinary income each year you hold the bond, whether or not the issuer pays you any cash that year.{¹ The issuer or your broker calculates the annual amount and reports it on Form 1099-OID.{²

A market discount bond was issued at or near par but later trades below par, usually because interest rates rose or the issuer’s credit deteriorated after issuance. Accrual here is not mandatory. By default, the ordinary income recognition is deferred until you sell or redeem. You can elect to accrue each year instead.{³

When the Discount Is Too Small to Matter

Not every below-par purchase triggers accretion. Both OID and market discount bonds have a de minimis threshold: if the total discount is less than 0.25% of the bond’s face value multiplied by the number of complete years remaining to maturity, the discount is treated as zero for tax purposes.{⁴ No annual accretion, no ordinary income reporting, and any gain at disposition is capital gain.

Take a $1,000 face value bond with 10 years to maturity. The de minimis threshold is $25 (0.25% × $1,000 × 10). Buy it for $980 and the $20 discount falls under the threshold, so you can ignore it. Buy it for $970 and the $30 discount crosses the line, meaning the full discount is subject to the accretion rules.

Check this first. Many bonds trade just slightly below par, and running a constant yield calculation on a discount the code treats as zero is wasted effort.

Calculating OID Accretion

OID bonds must use the constant yield method. There is no alternative.{¹ The method applies the bond’s yield to maturity (YTM) to its adjusted basis each period, so accretion amounts start small and grow as the basis rises.

The mechanics:

Find the YTM. This is the single discount rate that makes the present value of all future coupon payments plus the face value at maturity equal to your purchase price. Financial calculators and brokerage platforms compute it automatically.
Calculate total economic interest by multiplying the bond’s adjusted basis at the start of the period by the YTM. In the first period, the adjusted basis is what you paid.
Subtract the coupon payment. The stated coupon interest paid during the period comes off the top, and the remainder is the accretion amount for that period.
Increase the basis. Add the accretion to the prior adjusted basis, and that higher number becomes the starting point for the next period.

Consider a $1,000 face value bond purchased for $900 with five years remaining, a YTM of 4.5%, and a $20 annual coupon. In year one, total economic interest is $40.50 ($900 × 4.5%). Subtract the $20 coupon and the accretion is $20.50. That $20.50 is ordinary income for the year, and the adjusted basis rises to $920.50.

In year two, $920.50 × 4.5% = $41.42 of economic interest. After the $20 coupon, accretion is $21.42, and the basis climbs to $941.92. Each year the accretion grows because the base keeps increasing. By maturity, the adjusted basis should equal face value, and the entire discount will have been recognized as ordinary income.

Calculating Market Discount Accretion

Market discount works the opposite way from OID on two fronts. Accretion is optional unless you elect otherwise, and the default calculation is the simpler one. The more precise method is available by election.

Ratable (Straight-Line) Accrual

The default approach divides the total discount evenly across the days you hold the bond.{⁵ For a bond with a $100 market discount and 3,650 days remaining, the daily accrual is about $0.027, or roughly $10 per year. Every period gets the same number. The tradeoff is that it doesn’t reflect how discount bonds actually accrete value; more of the real return is earned toward the end, but straight-line spreads it evenly.

The Constant Yield Election

You can elect the constant yield method by attaching a statement to your timely filed return that identifies the bond and declares the election.{⁶ The math is the same as for OID: multiply the adjusted basis by the YTM, subtract coupon payments, and the remainder is the accrued discount for that period. Once made, the election is irrevocable for that particular bond.{⁵

Electing to Accrue Currently

Separately from the calculation method, you can elect under IRC 1278(b) to include market discount in income each year as it accrues rather than waiting until sale. This election is broader: once made, it applies to every market discount bond you acquire from that point on, and revoking it requires IRS consent.{³

The reason to elect current inclusion is avoiding a potentially large ordinary income hit in the year of sale. Hold a market discount bond for years without accruing and the entire accumulated discount becomes ordinary income at disposition. Spreading it out can keep you in a lower bracket. The cost is paying tax on income you haven’t received in cash, and locking yourself into that treatment for every future market discount bond.

Selling or Redeeming the Bond

The reason to track accretion is getting the right answer at the end. When you sell, redeem, or exchange a bond, gain or loss is the difference between what you receive and your adjusted basis. For an OID bond, adjusted basis is your original cost plus all OID you’ve included in income.{⁷

Suppose you bought an OID bond for $800 three years ago and have included $120 of OID income over that time. Your adjusted basis is $920. Sell for $950 and the capital gain is $30. Sell for $900 and the capital loss is $20. The $120 of ordinary income you already reported isn’t revisited, which is exactly why the accretion tracking matters. If you sell before maturity, prorate the current year’s OID to reflect only the days you held the bond during that year.{⁷

For a market discount bond where you did not elect to accrue annually, gain on sale is ordinary income up to the amount of accrued market discount, and only the portion of gain exceeding that accrued discount qualifies as capital gain.{⁵ If you elected current inclusion, you’ve been reporting that discount along the way and your basis has been climbing, so the gain at disposition is smaller.

Tax-Exempt Bonds Still Need Accretion

Tax-exempt bonds, primarily municipals, follow a variation on these rules. The OID on a tax-exempt bond is generally not taxable income. You still need to accrete the OID and add it to your basis so gain or loss is calculated correctly when you sell or redeem.{⁷ For covered securities, your broker handles the basis adjustment on Form 1099-B.

Skipping this on a muni is a common mistake. Ignore the accretion, use your original purchase price as basis, and you’ll overstate the gain at disposition and pay capital gains tax on what was really a return of tax-exempt discount.

Where It Goes on Your Return

For OID bonds, brokers and issuers report the annual inclusion on Form 1099-OID when the amount is $10 or more.{⁸ You report the income on Schedule B of Form 1040, listing each payer and the OID amount.{⁷ If your actual OID differs from what the form shows, Publication 1212 has a specific adjustment procedure you run directly on Schedule B.

Market discount bonds get no special form during the holding period. If you elected current inclusion, report the accrued discount as interest income on Schedule B. If you didn’t elect, there’s nothing to report until sale. At that point, the ordinary income portion flows through Form 8949 and Schedule D alongside any capital gain.{⁹

Any sale or redemption goes on Form 8949 with totals flowing to Schedule D. Your broker should report the adjusted basis on Form 1099-B for covered securities, but check that number against your own records. Brokerage calculations sometimes miss a mid-year purchase, use the wrong accrual period, or fail to account for a partial year of OID on a bond you sold. The IRS matches what you report against what the broker reports, and discrepancies generate notices. If you catch an error, your own calculation controls as long as you can document it.

1
Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount
2
Internal Revenue Service. About Form 1099-OID, Original Issue Discount
3
Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules
4
Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount
5
Office of the Law Revision Counsel. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
6
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
7
Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID) Instruments
8
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
9
Internal Revenue Service. Instructions for Form 8949