What Are Original Issue Discount Bonds?

Bonds are debt instruments where an issuer borrows money from investors, promising to repay the principal (face value) at a future date, often with regular interest payments. While many bonds are issued at par or a premium, some are initially sold for less than their face value. This difference defines Original Issue Discount (OID) bonds. This article explains OID bonds, how they differ from other debt instruments, and their tax implications.

What Are Original Issue Discount Bonds?

Original Issue Discount (OID) bonds are debt instruments initially sold at a price lower than their stated redemption price at maturity. The discount represents additional interest income received when the bond matures or is redeemed. For example, a $1,000 bond issued for $950 has a $50 OID, unlike bonds issued at par or a premium.

Issuers use OID to make bonds attractive, especially when the bond’s coupon rate is lower than prevailing market rates. It provides a competitive yield without requiring high periodic cash payments, which can benefit companies during periods of tight cash flow. The discount functions as deferred interest, paid at maturity.

OID differs from a market discount. OID is inherent to the bond’s original issuance terms, part of the initial offering when first sold. A market discount occurs when a bond is purchased in the secondary market below its face value, typically due to changes in interest rates or issuer credit quality. While both involve a discount, OID is established at creation, whereas market discount arises from subsequent market fluctuations.

Common OID instruments include zero-coupon bonds, which pay no periodic interest and are issued at a deep discount, with the entire return coming from the difference between purchase price and face value at maturity. Stripped bonds or coupons, components of a bond separated and sold individually, also involve OID. Certain long-term corporate or government bonds can be issued with OID if their coupon rate is below market expectations.

Taxation Principles for OID Bonds

The discount on Original Issue Discount (OID) bonds must generally be included in the bondholder’s gross income each year as it accrues, even if no cash interest payments are received. This “phantom income” or “accrual taxation” means bondholders pay taxes on income they have not yet physically received. This rule prevents investors from deferring income recognition until the bond matures or is sold.

The amount of OID that accrues each year is calculated using the constant yield method. This method spreads the total discount over the bond’s life, allocating a portion to each accrual period. While the specific calculation can be complex, it generally involves determining the bond’s yield to maturity and applying that yield to the bond’s adjusted issue price at the beginning of each accrual period. This results in an increasing amount of OID recognized as income over time, reflecting the compounding nature of interest.

As OID is included in income, the bondholder’s tax basis in the OID bond increases by the amount of OID reported. This adjustment to the basis reduces taxable gain or increases deductible loss when the bond is sold or redeemed. For instance, if an investor buys a bond for $950 with a $50 OID and reports $10 of OID income in a given year, their basis increases to $960. When the bond matures at $1,000, the taxable gain is calculated from this adjusted basis, not the original purchase price.

A “de minimis” rule applies to small OID discounts. If the total discount is less than one-fourth of one percent (0.25%) of the stated redemption price at maturity, multiplied by the number of full years from issue date to maturity, it can be treated as zero OID. For example, a $1,000, 10-year bond with an OID of $20 is de minimis ($20 is less than $25). If a bond falls under this rule, the discount is typically treated as a capital gain upon sale or maturity, rather than accrued interest income.

Tax-exempt OID bonds, such as certain municipal bonds, accrue OID using the constant yield method, and the accrued OID is generally exempt from federal income tax. Bondholders must still increase their basis in the bond by the OID amount that would have been included in income if the bond had been taxable. This basis adjustment remains important for determining any gain or loss upon the bond’s sale or maturity. While federally tax-exempt, some state and local governments may tax the OID from certain municipal bonds.

Reporting Original Issue Discount Income

Reporting Original Issue Discount (OID) income on a tax return involves specific procedures. Taxpayers typically receive Form 1099-OID, Original Issue Discount, from their broker or financial institution. This form details the OID income to be reported for the tax year. Financial institutions are required to issue Form 1099-OID if the reportable OID is $10 or more.

Form 1099-OID contains several boxes with relevant information. Box 1 shows the OID amount for the year that is generally taxable interest, representing the portion of deferred interest accrued during the tax period. Box 2 reports any other periodic interest paid on the debt instrument. If the bond is a U.S. Treasury obligation, Box 8 indicates the OID amount, which is federally taxable but exempt from state and local income taxes.

This income is primarily reported on Schedule B, Interest and Ordinary Dividends, of the federal income tax return (Form 1040). If total taxable interest, including OID, exceeds $1,500 or specific reporting conditions apply, Schedule B must be filed. The amount from Box 1 of Form 1099-OID is typically entered on Line 1 of Schedule B, along with other taxable interest. For tax-exempt OID, reported in Box 11 of Form 1099-OID, it is generally shown on Line 2a of Form 1040 as tax-exempt interest, though it is not included in taxable income.

The amount of OID reported on Form 1099-OID may not always be the exact amount to include on a tax return. This can occur if the bond was acquired in the secondary market at an acquisition premium, or if it is a stripped bond or coupon. In such cases, the bondholder may need to refigure the OID to report the correct amount.

If a Form 1099-OID is not received or appears incorrect, taxpayers should first contact the issuer or their broker. If the issue cannot be resolved, they may need to calculate the OID themselves or consult tax guidance from the Internal Revenue Service. The adjusted basis of a covered security, which includes the accrued OID, is typically reported to the taxpayer on Form 1099-B when the bond is sold.