Original Issue Discount (OID) Rules Under Section 1272
Understand the tax principles of original issue discount (OID), where accrued interest is taxed annually, and how basis adjustments prevent double taxation at sale.
Original Issue Discount, or OID, represents a form of interest earned by an investor but not paid in cash until the underlying debt instrument matures. This arrangement is governed by Section 1272 of the Internal Revenue Code, which requires taxpayers to include the accrued OID in their taxable income each year, even though no cash payment has been received. This concept is often called “phantom income” because the income is taxable before the cash is in the taxpayer’s hands. The purpose of these regulations is to align the recognition of income with its economic accrual, preventing a large tax deferral until the bond’s maturity.
Understanding Original Issue Discount
Original Issue Discount is the excess of a debt instrument’s stated redemption price at maturity over its issue price. The redemption price is the total amount the issuer pays the holder at maturity, while the issue price is the initial sale price. For example, if a five-year bond is issued for $800 and will be redeemed for $1,000, the OID is $200.
The OID rules are not triggered by small discounts. A de minimis rule disregards OID if it is less than one-quarter of one percent (0.25%) of the bond’s stated redemption price, multiplied by the number of full years to its maturity. If the discount is below this threshold, the OID is treated as zero for tax purposes.
Calculating the Annual OID Amount
The annual portion of OID included in a taxpayer’s income is calculated using the “constant yield method.” This method reflects the economic accrual of interest by applying a constant interest rate, the bond’s yield to maturity, to the bond’s adjusted issue price at the start of each accrual period. The yield to maturity is the overall rate of return an investor earns by holding the bond until redemption.
The adjusted issue price is the bond’s value for tax purposes. It starts as the original issue price and increases each year by the amount of OID included in the taxpayer’s income. For instance, a zero-coupon bond issued for $800 with a $1,000 face value and a 4.56% yield to maturity would have an includible OID of $36.48 in the first year. The adjusted issue price for the second year would then become $836.48.
This process is repeated annually, applying the constant yield to a progressively higher adjusted issue price. This results in smaller OID amounts in the early years and larger amounts in later years, similar to compound interest. For most investors, performing these calculations is not necessary, as the bond issuer or brokerage firm calculates the includible OID and provides this information to the investor for tax reporting.
Tax Reporting and Basis Adjustments
Information Preparation (Understanding Form 1099-OID)
An investor holding a debt instrument with OID will receive Form 1099-OID if the annual OID is $10 or more. This form is issued by the financial institution holding the investment and is the primary source for reporting this income.
Box 1, “Original issue discount for the year,” shows the amount of OID to report as taxable income. Box 2, “Other periodic interest,” reports any stated interest paid in cash during the year, which is also taxable. Box 8, “OID on U.S. Treasury obligations,” specifies the portion of OID from federal government debt. This income is subject to federal tax but is exempt from state and local income taxes. The form may also report items like penalties for early withdrawal.
Procedural Action (Reporting and Basis)
The amount from Box 1 of Form 1099-OID is reported on Schedule B (Interest and Ordinary Dividends) of Form 1040. This income is combined with other interest and taxed at the taxpayer’s ordinary income tax rate.
Along with reporting the income, an investor must adjust the investment’s cost basis. The basis of an OID instrument must be increased each year by the amount of OID included in income. This upward adjustment is mandatory and prevents the same income from being taxed twice. For example, if an investor buys a bond for $800 and reports $36 of OID in the first year, their adjusted basis becomes $836.
This process continues until the bond matures, at which point the adjusted basis should equal its redemption price. When the bond is redeemed, the difference between the cash received and the adjusted basis is zero, resulting in no capital gain. Without this annual adjustment, the investor would have a capital gain at maturity, causing the OID to be taxed a second time.
Common Debt Instruments with OID
OID can be found across a range of debt instruments, including:
- Zero-coupon bonds. These bonds do not make periodic interest payments and are issued at a significant discount to their face value. The entire difference between the issue price and the maturity value is OID.
- U.S. Treasury securities. Treasury bills (T-bills) are issued at a discount and mature at face value. Treasury STRIPS are created by separating the principal and interest of a Treasury bond into individual zero-coupon securities.
- Corporate bonds and notes. These may be issued with OID if their issue price is less than their stated redemption price, often due to credit quality or market interest rates.
- Certificates of Deposit (CDs). OID can occur on CDs with a maturity of more than one year that do not pay interest at least annually.
- Treasury Inflation-Protected Securities (TIPS). For TIPS, OID is created from any inflation adjustment that increases the principal value of the security. OID also occurs if the security is issued at a price lower than its face value.
Exceptions and Related Adjustments
Exceptions to OID Rules
Several types of debt instruments are exempt from the annual OID inclusion rules:
- Tax-exempt obligations. For municipal bonds, the OID is not subject to federal income tax. However, the holder must still accrue the OID to increase their cost basis for calculating capital gain or loss.
- U.S. savings bonds. For Series EE and Series I bonds, the taxpayer can choose to report interest as it accrues or defer reporting it until the bond is redeemed or matures.
- Short-term debt instruments. For instruments with a maturity of one year or less, the discount is reported as income at maturity, not accrued daily.
- Certain loans between individuals. This exception applies to non-business loans between individuals if the total outstanding loan amount does not exceed $10,000.
Related Adjustments
Investors who purchase bonds on the secondary market may need to make adjustments.
An acquisition premium is created when a bond is purchased for a price higher than its adjusted issue price but lower than its stated redemption price. This premium can be used to reduce the amount of OID that must be included in income each year.
Market discount occurs when a bond is purchased for a price less than its stated redemption price or, for an OID bond, less than its adjusted issue price. Unlike OID, market discount is not included in income annually. Instead, the accrued market discount is treated as ordinary interest income when the bond is sold or redeemed.