Discount Bonds
Bonds issued at par. When a bond is issued at par and bought at a market discount, the adjusted cost basis of the bond will be determined by accreting the discount over the bond’s remaining life. At maturity, the adjusted cost basis will equal the bond’s face value. If the investor holds the bond until maturity, and the difference is above a de minimis amount (see below), the difference between the discount amount and the bond’s face value (i.e., the bondholder’s profit) will be taxed as ordinary income. If the amount of the discount is equal to or below the de minimis amount, it will be taxed as capital gains.
The IRS sets the de minimis amount for market discounts at 0.25% of par per year between the time of the acquisition and the bond’s maturity.
Example: A 20-year municipal bond with a par value of $1,000 is purchased in the market for $990. This is a market discount of $10. If the discount is less than the de minimis amount, it will be treated as a capital gain rather than as ordinary income. For this bond, the minimum amount is $50 (0.25% x $1,000 x 20 years). Since the discount of $10 is smaller than this amount, it is treated as a capital gain.
So why calculate the accreted value of a discount bond if the discount bond will not be taxed until sale or redemption? The answer is that it is necessary in case the bond is sold prior to maturity. If the bond is sold prior to maturity, the adjusted cost basis will be used to determine how the proceeds will be taxed. The profits up to the adjusted cost basis will be treated as ordinary income and taxed at the seller’s normal rate, while any additional profit will be taxed at the seller’s capital gains rate.
Example: Sarah purchases a $5,000 municipal bond with a 10-year maturity three years after its issue date for $4,300. She then sells the same bond three years later for $4,700, a $400 profit. The cost basis for her bond at the time of origi