IRC 1278: Market Discount, Accrual Methods, and Elections

When you buy a bond on the secondary market for less than its face value, the tax rules for a market discount bond treat that built-in profit as ordinary interest income rather than capital gain. You have a choice about timing: recognize the whole amount when you sell or redeem the bond, or spread it into income year by year while you hold it. Sections 1276 through 1278 of the Internal Revenue Code control both the character and the timing.

What Market Discount Actually Is

Market discount is the gap between a bond’s stated redemption price at maturity, usually its face value, and the lower price you paid for it on the secondary market.¹ Pay $940 for a $1,000 face-value corporate bond and you have $60 of market discount. Your basis is what you paid plus transaction costs.

This is different from original issue discount. OID arises when the issuer first sells the bond below face value, and it accrues into income over the bond’s life for every holder. Market discount only appears after issuance, when a bond trades down because interest rates rose or the issuer’s credit weakened. A single bond can carry both. If a bond originally issued at $980 later trades at $950, a buyer at $950 has $20 of OID and $30 of market discount, each governed by its own rules.²

The De Minimis Threshold

Small discounts are ignored. Multiply 0.25% of face value by the number of complete years from acquisition to maturity. If the actual discount falls below that number, market discount is treated as zero and any gain at sale is capital gain.¹

Say you buy a $1,000 bond with 10 complete years to maturity for $976. The threshold is $25 (0.0025 × $1,000 × 10). Your $24 discount is below the line, so there is no market discount to worry about. Pay $974 instead and the entire $26 is market discount subject to ordinary income treatment. One dollar of price can flip the character of the whole gain.

The Default Rule: Ordinary Income When You Sell or Redeem

If you do nothing, you owe no tax on the discount while you hold the bond. The tax event happens on sale, exchange, or redemption at maturity. At that point, your gain is recharacterized as ordinary income to the extent of the accrued market discount.³

Three outcomes to keep in mind. If the total gain is less than the accrued discount, only the actual gain becomes ordinary. If the gain exceeds the accrued discount, the excess is capital gain. Sell at a loss and there is no market discount income at all; the whole loss is capital.

The ordinary income is treated as interest for most federal tax purposes.³ That matters for the investment interest expense limitation under Section 163(d) and for the net investment income tax.

Electing to Include the Discount Each Year

Section 1278(b) lets you skip the deferral and include accrued market discount in ordinary income annually, on the same footing as OID.¹ Your basis rises each year by the amount you include, which reduces the gain you eventually recognize. Over a long holding period, more of the eventual proceeds becomes capital gain, or the gain shrinks entirely.

You make the election simply by reporting accrued market discount as income on a timely filed return. No separate form. The commitment is broad: it applies to every market discount bond you acquire on or after the first day of the taxable year of election, and it stays in effect for all future years unless the IRS consents to a revocation.¹

For someone buying a single discounted bond with cash and holding to maturity, the default deferral is usually the better answer. You know ordinary income is coming at redemption, and there is nothing else to track. The election starts to look attractive when you own many discount bonds, when you borrow to buy them, or when you expect to be in a lower bracket in later years.

The Interest Expense Trap If You Borrow to Buy

If you finance a market discount bond with debt and stay with the default deferred-recognition treatment, Section 1277 limits how much of that interest you can deduct each year. This is the single biggest reason leveraged bond investors elect current inclusion.

The rule works in two steps. First, figure your net direct interest expense: interest you paid on debt used to buy or carry the bond, minus any interest or OID income the bond produced that year.⁴ If the bond’s own income exceeds your borrowing cost, nothing gets deferred.

Second, compare that net expense to the market discount that accrued that year. You can deduct only the portion of net direct interest expense that exceeds the year’s accrued market discount. The rest is disallowed for the year.⁴

The disallowed deduction is not gone. In later years when the bond produces net interest income, you can elect to recover deferred amounts up to that net income. Anything still deferred becomes fully deductible in the year you dispose of the bond.⁴ Tracking those carryforwards across several bonds and several years is enough work that many investors elect current inclusion just to avoid it. Once you elect, Section 1277 does not apply — borrowing costs run through the ordinary investment interest rules.

How the Discount Accrues

Whether you defer or elect current inclusion, you need to know how much discount has accrued at any given point. Two methods are available.

Ratable Accrual

The default. Total market discount is spread evenly across the days from acquisition to maturity. Cumulative accrued discount equals total discount times a fraction: days held over total days remaining at purchase.³ Simple math, but it front-loads accrual relative to the bond’s actual economics, since it ignores the time value of money.

Constant Yield Method

You can elect a constant yield accrual that mirrors OID. The bond is treated as if newly issued on your purchase date at your purchase price, and accrual tracks the bond’s yield to maturity.³ Less accrues in the early years, more in the later years, matching the economic reality more closely.

The constant yield election is made bond by bond and is irrevocable for the bond once made.³ You can use ratable for one bond and constant yield for another. For an investor already electing current inclusion, pairing it with constant yield pushes the ordinary income into the latest possible years.

Which Bonds the Rules Do and Do Not Reach

Several categories of debt sit outside the market discount framework:

Short-term obligations with a fixed maturity one year or less from issue. These fall under separate acquisition discount rules.¹
U.S. savings bonds, which have their own statutory interest deferral rules.¹
Installment obligations described in Section 453B.¹

Tax-exempt municipal bonds are not excluded, despite a widespread belief that they are. If you buy a muni at a discount beyond the de minimis threshold, the market discount is taxable as ordinary income at disposition, even though the coupon interest remains federally tax-exempt. The statute explicitly denies tax-exempt treatment to market discount on these bonds.³ The Section 1277 interest deferral also applies if you borrow to carry a discounted muni.

Reporting It on Your Return

How the numbers show up depends on which path you chose. Under a current-inclusion election, your broker reports accrued market discount on Form 1099-OID (Box 5) for bonds that also carry OID, or on Form 1099-INT (Box 10) for bonds without OID.⁵ Brokers default to constant yield accrual unless you have notified them otherwise.

Under the default deferral, the income shows up at sale or redemption. Report the transaction on Form 8949 and Schedule D like any other security sale, then report the accrued market discount portion as interest on Schedule B (Form 1040), labeled “Accrued Market Discount.”⁶ The Form 8949 instructions include a worksheet for the column (g) adjustment.⁷

If you hold a mix of bonds under different elections, keep records that tie each bond to its treatment. Reconstructing the accrual history from scratch at filing time is the kind of task that convinces investors to standardize on a single method across the whole portfolio.

1
Office of the Law Revision Counsel. 26 USC 1278 – Definitions and Special Rules
2
eCFR. 26 CFR 1.1272-1 – Current Inclusion of OID in Income
3
Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
4
Office of the Law Revision Counsel. 26 USC 1277 – Deferral of Interest Deduction Allocable to Accrued Market Discount
5
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
6
Internal Revenue Service. Publication 550 – Investment Income and Expenses
7
Internal Revenue Service. Instructions for Form 8949