Accrued market discount is the part of a bond’s below-face purchase price that the IRS treats as disguised interest, and when you sell or redeem the bond, that accrued amount is taxed as ordinary income rather than as capital gain. Any gain above the accrued discount keeps its capital gain character, and a loss stays a capital loss. The rule applies even if you held the bond long enough for long-term capital gain rates, so a bond you bought cheap and held for years can still throw off ordinary income at disposition.
What Counts as a Market Discount Bond
A market discount bond is any bond you buy in the secondary market for less than its stated redemption price at maturity. The discount is the gap between the bond’s face value and your adjusted basis right after acquisition. That gap usually reflects interest rate moves or credit concerns since the bond was originally issued.
Not everything bought below face qualifies. Section 1278 of the Internal Revenue Code carves out several categories:1Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules
- Short-term obligations that mature within one year of their original issue date.
- U.S. savings bonds, including Series EE and Series I.
- Installment obligations subject to the installment sale rules.
- Bonds you bought at original issue directly from the issuer. These may carry original issue discount instead, which is a different regime taxed annually under Section 1272.2Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
The De Minimis Threshold
Small discounts are ignored. The threshold is 0.25% of face value multiplied by the number of complete years remaining to maturity. If your discount comes in below that number, market discount rules don’t apply, and any gain on sale is taxed entirely as capital gain.
Say you buy a $1,000 face bond with 10 complete years left. The threshold is $1,000 × 0.0025 × 10 = $25. Paying $980 puts you at a $20 discount, below the threshold, so no recharacterization. Paying $970 puts you at $30, over the threshold, and the full discount is subject to the rules.
How the Discount Accrues
The tax rule caps ordinary income recharacterization at the accrued market discount as of the disposition date, so you need a method to track that accrual. Section 1276(b) gives you two choices.3Office of the Law Revision Counsel. 26 U.S. Code 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
Ratable Accrual
The default straight-line method spreads the total discount evenly across the days from your acquisition to maturity. No election required. Divide the discount by total days, then multiply by days held.
If you buy a bond with a $500 market discount and 2,000 days to maturity, the daily accrual is $0.25. Sell after 800 days, and $200 has accrued. That $200 is the ceiling on ordinary income recharacterization at sale.
Constant Yield Accrual
The alternative treats the bond as if newly issued on your purchase date at your purchase price, then accrues discount using the yield to maturity implicit in that price. Constant yield produces smaller accruals in the early years and larger ones later. Investors expecting to sell well before maturity often prefer it, because less accrual in the early years means less ordinary income on a quick sale. You elect it bond by bond on a timely filed return for the year of acquisition, and once made for a given bond, it stays.
Either method requires your own recordkeeping. The IRS doesn’t calculate the accrual for you, and your broker generally will not report it unless you’ve filed the current inclusion election described below.
How the Gain Is Taxed at Sale
The core rule from Section 1276(a): when you dispose of a market discount bond at a gain, the gain is ordinary income up to the accrued market discount, and any additional gain is capital gain.
Take a bond you buy for $9,500 with a $10,000 face value and five years to maturity. Total market discount is $500. After three years under straight-line accrual, $300 has accrued. If you sell for $10,200, your total gain is $700: $300 ordinary income, $400 long-term capital gain (assuming a holding period over a year). Holding longer would not have reclassified any of that $300.
The ordinary income is treated as interest for most other purposes in the tax code. And once you recognize it, your basis in the bond goes up by the same amount, so you don’t get taxed twice on the same dollars when you eventually dispose of the bond in full.
If You Sell at a Loss
No gain, no recharacterization. The loss is a capital loss, and the market discount rules stay dormant. Accrued discount never creates phantom ordinary income on a losing sale.
Partial Principal Payments
If the bond returns principal in pieces before maturity, each partial payment triggers ordinary income up to the accrued market discount at that point. The accrued balance is then reduced by what you recognized. This blocks the strategy of taking principal tax-free and pushing all the ordinary income to a final disposition.
Municipal Bonds Get Caught Too
Tax-exempt interest coupons stay tax-exempt, but market discount on a municipal bond does not. If you buy a muni below face and later sell at a gain or hold it to maturity, the accrued market discount is taxable as ordinary income, same as on a corporate bond.4Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
For municipal bonds purchased after April 30, 1993, gain attributable to market discount is ordinary income. For bonds purchased on or before that date, the gain from market discount is capital gain. The Schedule B instructions specifically note that market discount on a tax-exempt bond is taxable interest, not tax-exempt interest.5Internal Revenue Service. Instructions for Schedule B (Form 1040)
One narrow break: for the Section 1277 interest deduction deferral discussed below, tax-exempt bonds are excluded from the definition of a market discount bond. Borrowing to carry a discounted muni doesn’t trigger that particular deferral.
Electing to Include Market Discount Each Year
By default, nothing hits your return until disposition. But Section 1278(b) lets you elect to include market discount in income annually as it accrues.1Office of the Law Revision Counsel. 26 U.S. Code 1278 – Definitions and Special Rules
Why pay sooner? Two reasons. First, the election shuts off the Section 1277 interest deduction deferral, so if you borrow to buy bonds you can deduct your interest expense in full each year. Second, the recordkeeping gets simpler: you report the accrual as interest each year instead of tracking a deferred balance across the life of the bond.
The cost of the election is that it’s broad and durable. It applies to every market discount bond you acquire from that year forward, not just the bond that prompted it, and revocation requires IRS consent. Once you elect, Sections 1276 and 1277 stop applying: the discount is interest income each year, your basis rises as you include it, and there’s nothing left to recharacterize at disposition.
Borrowing to Buy Discounted Bonds
If you buy or carry a market discount bond with borrowed money and haven’t made the current inclusion election, Section 1277 defers part of your interest expense deduction. The rule stops you from writing off interest today while pushing the corresponding discount income into the future.6Office of the Law Revision Counsel. 26 U.S. Code 1277 – Deferral of Interest Deduction Allocable to Accrued Market Discount
The mechanics: calculate your “net direct interest expense” for the bond, meaning interest paid on debt used to carry it minus interest income (including OID) the bond generated during the year. That net expense is deductible only to the extent it exceeds the accrued market discount for the year. The remainder is disallowed for the year and carried forward.
Suppose you paid $600 in margin interest to carry a bond that produced $400 in coupon income. Net direct interest expense is $200. If $150 of market discount accrued for the year, you deduct $50 and defer $150.
The deferred amount isn’t lost. When you sell or redeem the bond, the whole accumulated deferral is treated as interest paid in the year of disposition. In a nonrecognition transfer, recovery of the deferred expense is limited to the gain recognized on the transfer.
Gifts, Nonrecognition Transfers, and Death
Giving away a market discount bond does not clean it. Under Section 1276(c), when the bond moves in a nonrecognition transaction and the recipient takes a carryover basis, the recipient steps into your shoes: your original acquisition date and cost carry over, and the accrued discount keeps building. When they sell, they face the same ordinary income recharacterization you would have. Any deferred interest expense under Section 1277 transfers with the bond.
Death works differently. A bond in the estate generally gets a stepped-up basis to fair market value, which typically eliminates or shrinks the market discount because the gap between basis and face closes. Holding discounted bonds until death is one way the ordinary income recharacterization can drop out entirely.
Reporting It on Your Return
Reporting depends on whether you elected current inclusion.
If you elected under Section 1278(b) and notified your broker in writing, the annual accrual should show up on Form 1099-INT Box 10 or Form 1099-OID Box 5.7Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID Report it on Line 1 of Schedule B (Form 1040) as taxable interest, listing the payer.5Internal Revenue Service. Instructions for Schedule B (Form 1040)
If you didn’t elect, nothing gets reported annually. At disposition, the accrued market discount portion of your gain goes on Schedule B as interest income, and the remaining gain goes on Schedule D and Form 8949. Your broker will typically report the sale on Form 1099-B, but the split between ordinary and capital often needs your own calculation, since the broker may not know your accrual method or your accrued figure.
The IRS points taxpayers to Publication 550 and Publication 1212 for the underlying calculations.4Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses Keeping your own file with the acquisition date, purchase price, chosen accrual method, and running accrual is the reliable way to get the reporting right, particularly if you hold several discounted bonds across accounts.