6.4.1.2. Discount Bonds
Bonds Issued at Par. When a bond is issued at par and bought at a market discount, the amount of the discount is taxed as ordinary income, unless it is equal to or below a de minimis amount. If the amount of the discount is equal to or below the de minimis amount, it will be taxed as capital gains. The discount will be taxed when the bond matures or is sold.
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.
If the bond is held to maturity, there will be no capital gains, but the discount will be taxed as ordinary income at maturity (assuming it is above the de minimis amount).
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 taxed at the capital gains rate.
It is still necessary to calculate the accreted value of a discount bond 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 adjusted cost basis of the bond is determined by accreting the discount each year until the bond is sold. 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: Three years after its issue date, Sarah purchases a $5,000 municipal bond with a 10-year maturity 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 original purchase is $4,300. Since the annual accretion on the