What Is Accrued Market Discount and How Does It Affect Taxes?
Understand accrued market discount, its tax implications, calculation methods, and how it affects your investment's tax basis and reporting.
Accrued market discount is a concept that can significantly impact the taxation of bonds and other debt instruments. It arises when an investor purchases a bond at a price lower than its face value in the secondary market, potentially leading to additional taxable income upon sale or maturity. Understanding how it affects taxes is crucial for investors aiming to optimize their tax liabilities.
Conditions That Trigger the Discount
Accrued market discount applies when an investor buys a bond in the secondary market for less than its redemption value. This typically occurs due to shifts in interest rates, changes in the issuer’s credit quality, or fluctuations in market demand. For example, rising interest rates can reduce the value of existing bonds with lower coupon rates, creating a market discount. Under Internal Revenue Code Section 1278, market discount is defined as the difference between the bond’s redemption price at maturity and its purchase price. This discount is treated as ordinary income when the bond is sold or matures. However, the rules apply only to bonds purchased after July 18, 1984, and exclude tax-exempt bonds or those with negligible discounts—defined as less than 0.25% of the face value multiplied by the years to maturity.
Calculation Methods
Investors can calculate accrued market discount using either the ratable accrual method or the constant yield method. The ratable accrual method spreads the discount evenly over the bond’s remaining life. For instance, a $100 discount on a bond with 10 years to maturity would result in $10 of discount recognized annually. The constant yield method, while more complex, calculates the yield to maturity based on the purchase price and adjusts the accrual annually to reflect changes in the bond’s yield curve. The choice of method impacts both the timing and amount of taxable income, making it important to consult IRS guidelines or a tax professional.
Timing of Recognition
Investors must decide whether to defer recognition of accrued market discount until the bond is sold or matures, or to recognize it annually. Deferring recognition postpones tax liability but may lead to a larger tax bill later. Recognizing the discount annually spreads the tax burden over the bond’s life, aligning with economic accrual. This decision, made in the year the bond is acquired, is irrevocable and requires careful consideration of financial goals and tax strategies.
Recording on Tax Documents
Accurate reporting of accrued market discount is essential for compliance. Investors report it as ordinary income on Schedule B of Form 1040. Those opting for annual recognition must ensure consistent yearly reporting. The constant yield method requires recalculating yield and documenting the accrued amount annually. Form 1099-OID, issued by brokers, assists in verifying the recognized discount.
Adjusting the Basis
Adjusting the bond’s basis prevents double taxation. When recognizing the discount annually, the bond’s basis increases each year by the reported income. For example, a $50 market discount recognized over five years increases the basis by $10 annually. For deferred recognition, the entire accrued discount is added to the purchase price upon sale or maturity. This adjustment ensures the market discount is not taxed again as capital gain, helping investors implement strategic tax planning.