What Is Accreted Interest and How Is It Taxed?

Accreted interest is the return that builds up inside a bond or other debt instrument you bought below its face value, even though no cash reaches you until the instrument matures or you sell it. Buy a bond for $900 that will pay $1,000 at maturity, and that $100 gap is interest you earn gradually over the bond’s life. For most such instruments, the IRS expects you to report a slice of that buildup as income every year, whether or not you have actually collected anything. That mismatch between taxable income and cash in hand is why accreted interest is often called phantom income.

How the Buildup Works

When a debt instrument is issued at a price below its face value, the difference between what you paid and what you’ll receive at maturity is called the original issue discount, or OID. That discount is the total interest the instrument will earn over its life. Instead of sending you coupon checks, the instrument’s value climbs toward its face amount. Each year’s increase is the accreted interest for that period.

The buildup is not just bookkeeping. Every dollar of OID you include in income gets added to your cost basis in the instrument. If you bought a zero-coupon bond for $700 and have reported $200 of OID over several years, your adjusted basis is $900. Sell for $920, and the capital gain is $20, not $220. That basis adjustment is what stops you from being taxed twice on the same money.

Investments That Generate Accreted Interest

Several common holdings work this way rather than paying periodic interest:

Zero-coupon corporate and government bonds, which pay no interest and sell at a deep discount to face value.
Treasury STRIPS, created when the Treasury separates a bond’s coupon payments and principal and sells them as individual zero-coupon securities. The custodian sends a Form 1099 each year for the accrued amount.¹
U.S. Series EE and I savings bonds, which earn interest that accrues monthly and compounds semiannually into the bond’s redemption value.²
Treasury bills, short-term government debt sold at a discount with maturities from four weeks to 52 weeks.³
Deferred-interest CDs, long-term certificates structured like zero-coupon instruments that withhold all interest until maturity.

How the Annual Amount Is Calculated

Straight-Line Method

For short-term instruments like Treasury bills, the discount is spread evenly across the days between issuance and maturity. A 180-day T-bill purchased for $985 with a $1,000 face value has $15 of discount, or roughly 8.3 cents a day. Whatever days fall inside your tax year is your income for that year.

Constant Yield Method

Longer-term OID instruments, including corporate zero-coupon bonds and Treasury STRIPS, use the constant yield method. You start each accrual period with the bond’s adjusted issue price, multiply by the yield to maturity for that period length, and subtract any stated interest paid. The result is that period’s OID.⁴ Because the adjusted issue price grows each year as prior OID gets added to it, the annual accrual gets larger over time. Early years produce smaller inclusions, later years produce larger ones.

The De Minimis Rule

Not every discount triggers the OID rules. If the discount is small enough, the IRS treats it as zero. The threshold is 0.25% of the face value at maturity, multiplied by the number of complete years to maturity.⁵ A $1,000 bond with 10 years to maturity has a de minimis threshold of $25. A discount under $25 skips annual OID reporting and is instead treated as capital gain when you sell or redeem.

Phantom Income and How You Report It

Under Section 1272 of the Internal Revenue Code, holders of most OID debt instruments must include the accreted interest in gross income each year, whether or not any cash was received.⁶ That inclusion is ordinary interest income, taxed at your regular marginal rate rather than at capital gains rates.

Your broker or the issuer reports the annual OID on Form 1099-OID, and you carry it onto your return as interest income. If you hold multiple OID instruments or need to adjust the reported figure, use Schedule B of Form 1040.⁵ The good news is that every dollar you include this way raises your basis by the same dollar, so you are paying tax earlier than you’d probably like, not paying it twice.

Instruments That Escape Annual Reporting

Three categories sidestep the mandatory annual inclusion.

U.S. Savings Bonds

Series EE and I bonds let you defer reporting the accrued interest until you cash the bond or it reaches final maturity.⁷ You can elect to report annually instead, but most holders take the deferral. Switching from annual reporting back to deferral requires IRS permission.

Tax-Exempt Municipal Bonds

When a municipal bond is issued at a discount, the accretion still happens and still adjusts your basis each year, but the accreted amount is exempt from federal income tax.⁸ Tracking the accretion still matters if you sell before maturity, because it drives the basis you compare against the sale price.⁹

Short-Term Obligations

Debt with a fixed maturity of one year or less from the issue date, such as Treasury bills, is excluded from annual OID inclusion.⁶ The discount is recognized when the instrument matures, is sold, or is redeemed. Since these instruments rarely straddle more than one tax year, the practical difference for most investors is small.

Selling Before Maturity

You don’t have to hold an OID bond until maturity. If you sell on the secondary market, your gain or loss is the sale price minus your adjusted basis, which is the original purchase price plus every dollar of OID you’ve already reported.⁹ Sell above adjusted basis and the excess is capital gain. Sell below and you have a capital loss, assuming the bond was a capital asset in your hands. The OID for the year of sale is prorated to reflect only the days you held the bond. For covered securities, the broker reports the adjusted basis on Form 1099-B, so you generally won’t need to rebuild the running total yourself.

Market Discount Is Not the Same Thing

Accreted interest under the OID rules arises at issuance, when a bond is first sold below face value. Market discount is different: it arises when you buy an already-issued bond on the secondary market for less than its adjusted issue price. The tax rules also differ. With OID, annual inclusion is generally required. With market discount, you can accrue it annually as ordinary income or wait until sale or redemption. If you wait, any gain up to the accrued market discount is ordinary income rather than capital gain.¹⁰ The election to accrue market discount currently is irrevocable for the year and all future years, so think it through before making it.

Reducing the Tax Bite

The yearly bill on income you haven’t collected is the real downside of OID instruments. A few choices soften it.

Hold zero-coupon bonds and STRIPS inside an IRA or 401(k). The accretion happens without current tax, and you deal with the IRS only when you take distributions.
Use Series EE or I bonds when you want accretion economics without annual reporting. The deferral to redemption or final maturity does the work for you.
Consider tax-exempt municipal OID bonds if you are in a high bracket. Interest on U.S. Treasury obligations, including STRIPS, is exempt from state and local income tax but not from federal tax.¹¹
Match maturity to your income timeline. A zero-coupon bond maturing in a year you expect to be in a lower bracket delivers the face value when your rate is lower, even though you paid annual OID tax along the way.

1
TreasuryDirect. Separate Trading of Registered Interest and Principal of Securities (STRIPS)
2
eCFR. 31 CFR 351.30 – Interest Rates and Monthly Accruals
3
TreasuryDirect. Treasury Bills
4
eCFR. 26 CFR 1.1272-1 – Current Inclusion of OID in Income
5
Internal Revenue Service. Publication 550, Investment Income and Expenses
6
Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
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TreasuryDirect. Tax Information for EE and I Bonds
8
Office of the Law Revision Counsel. 26 USC 1288 – Treatment of Original Issue Discount on Tax-Exempt Obligations
9
Internal Revenue Service. Publication 1212, Guide to Original Issue Discount (OID) Instruments
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Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
11
Internal Revenue Service. Topic No. 403, Interest Received