Market Discount

The market discount is the difference between a bond's stated redemption price and its purchase price on the secondary market, if it has been purchased at a price below par. Market discount arises when a bond's value on the secondary market decreases after it has been issued, usually because of an increase in interest rates. In the case of original issue discount (OID) securities such as zero-coupon bonds, the market discount is the difference between the purchase price and the issue price plus accrued OID.

Market discount on a bond is not subject to taxation annually in the U.S., but it is taxable as ordinary interest income in the year that the bond is sold or redeemed. The bond investor can also elect to include amortized market discount annually in income for tax purposes, although this would mean paying tax on it now rather than in the future. Note that market discount is taxable even if regular interest income from the bond in question is tax-exempt like it is for municipal securities.

For example, assume that a U.S. investor pays $900 for a bond that was originally issued with a par value of $1,000. The $100 difference between the par value and the purchase price is the market discount. This difference will have to be reported as ordinary interest income on the investor’s tax return either upon disposition or annually on an amortized basis, depending on the election made by the investor.

There are certain exceptions to the election rules, such as for U.S. savings bonds and for short-term obligations that mature in one year or less from the date of issue. Also, for tax-exempt bonds purchased before May 1, 1993, a gain arising from a market discount is treated as a capital gain rather than interest income.

Another exemption to the election of how market discount should be treated for tax purposes relates to “de minimis” or small market discounts. Under the “de minimis” rule, the market discount is treated as zero if the amount of the discount upon purchase is less than 0.25% of the bond's face value, multiplied by the number of full years from the time of purchase to the maturity date. If the market discount is less than the de minimis amount, the market discount would have to be treated as a capital gain – rather than ordinary income – when the bond is sold or redeemed.

As an example, if you buy a $1,000 par value bond maturing in 10 years for $985, the market discount is $1,000 - $985 = $15. Since this discount is less than the de minimis threshold of $25 (0.25% of $1,000 x 10 = $25), the market discount is considered to be zero. As a result, the $15 discount will be treated as a capital gain when you sell or redeem the bond.