How to Treat Accrued Market Discount on a Tax Return?
The treatment of accrued market discount (AMD) on a tax return hinges on whether you’ve elected to include it in your income currently or deferred it until the bond’s disposition. If you elected to include AMD currently, you report the accrued amount as interest income each year. If you deferred it, the accumulated AMD is generally treated as ordinary income upon the sale, redemption, or maturity of the bond, to the extent of any gain recognized. This election and its implications significantly impact your tax obligations, demanding careful consideration.
Understanding Market Discount: A Deep Dive
Before we dissect the tax treatment, let’s ensure we’re on the same page regarding what constitutes market discount. A bond is considered to have market discount when you buy it on the secondary market for less than its face value (the amount the issuer promises to pay at maturity). This discount often arises because prevailing interest rates have risen since the bond was originally issued, making the older, lower-yielding bond less attractive.
The difference between your adjusted basis in the bond (typically your purchase price) and its face value is the market discount. However, there’s a de minimis exception. If the market discount is less than one-quarter of 1% of the bond’s face value multiplied by the number of complete years to maturity after you acquire the bond, the discount is considered de minimis and generally ignored for tax purposes.
The Crucial Election: Current Inclusion vs. Deferral
The Internal Revenue Code (IRC) provides two primary ways to handle market discount:
Elect to Include Accrued Market Discount Currently: This option requires you to include the accrued market discount in your gross income for each tax year the bond is held. The accrual method can be either the straight-line method (where the discount is divided equally over the remaining life of the bond) or the constant interest method (which mirrors how interest income is calculated). This election, once made, applies to all market discount bonds you acquire from that point forward and generally can’t be revoked without IRS consent. The advantage? By including the income currently, you increase your basis in the bond by the amount of AMD included in income. This reduces the capital gain (or increases the capital loss) when the bond is eventually sold or redeemed.
Defer Inclusion of Accrued Market Discount: This is the default method if you don’t make the election to include AMD currently. Under this method, you don’t recognize the market discount as income until you sell, redeem, or the bond matures. When that happens, the accumulated market discount is generally treated as ordinary income to the extent of any gain realized on the disposition. This can be less favorable than capital gains treatment, especially if you’re in a higher tax bracket for ordinary income.
Tax Treatment on Disposition: Sale, Redemption, or Maturity
The treatment of market discount upon disposition is where the choice between current inclusion and deferral truly matters:
If you elected to include AMD currently: Your basis in the bond is increased each year by the amount of market discount included in your income. When you sell, redeem, or the bond matures, the difference between the amount you receive and your adjusted basis will be treated as either a capital gain or a capital loss. The holding period determines whether it’s a long-term or short-term gain or loss.
If you deferred inclusion of AMD: Upon disposition, the realized gain is first characterized as ordinary income up to the amount of the accrued market discount. Any remaining gain is treated as a capital gain. For example, if you bought a bond with a face value of $10,000 for $9,000 (a $1,000 market discount) and sold it for $9,800, your gain is $800. This entire $800 would be treated as ordinary income because it’s less than the total market discount. However, if you sold it for $10,500, $1,000 would be ordinary income (the market discount), and the remaining $500 would be a capital gain.
Reporting on Your Tax Return: Forms and Schedules
Whether you include AMD currently or defer it, proper reporting is crucial.
If you elect to include AMD currently: You report the accrued market discount each year as interest income on Schedule B (Interest and Ordinary Dividends). You’ll also need to keep meticulous records of your bond purchases and the accrued market discount to properly adjust your basis.
If you defer inclusion of AMD: When you dispose of the bond, you’ll report the market discount treated as ordinary income on Schedule B. The remaining gain or loss, if any, will be reported on Schedule D (Capital Gains and Losses). Form 8949 (Sales and Other Dispositions of Capital Assets) is used to detail the transaction.
Frequently Asked Questions (FAQs)
Here are 12 frequently asked questions (FAQs) about market discount, designed to provide clarity and practical guidance:
What happens if I receive a partial principal payment on a bond subject to market discount? Partial principal payments are generally treated as a realization of a portion of the market discount. The amount of the market discount included as ordinary income is the lesser of the partial principal payment or the accrued market discount on the bond.
Can I deduct interest expense I incur to carry market discount bonds? The deductibility of interest expense is limited. You can only deduct the interest expense up to the amount of the market discount included in gross income for that year. The disallowed interest expense can be deducted in the year the bond is disposed of.
How does market discount apply to tax-exempt bonds? The rules regarding market discount apply to tax-exempt bonds as well. However, the ordinary income recognized upon disposition of the bond is tax-exempt, mirroring the tax-exempt nature of the bond’s interest payments.
What is acquisition premium, and how does it differ from market discount? Acquisition premium occurs when you purchase a bond for more than its face value. You can elect to amortize this premium over the remaining life of the bond, reducing your interest income each year. This is the opposite of market discount, where the bond is purchased for less than its face value.
How do I calculate accrued market discount using the constant interest method? The constant interest method requires calculating the yield to maturity of the bond and then applying that yield to the adjusted basis each year. The difference between the interest income calculated using the yield to maturity and the stated interest on the bond is the accrued market discount. This method requires more complex calculations but more accurately reflects the economic reality of the investment.
If I make the election to include AMD currently, does it apply to all bonds I own, or just the ones I purchase after making the election? The election to include AMD currently applies to all market discount bonds you acquire on or after the first day of the first tax year to which the election applies. It does not apply retroactively to bonds you already owned before making the election.
What happens if a market discount bond is gifted to me? What is my basis? Your basis in the gifted bond is generally the same as the donor’s adjusted basis, increased by any gift tax paid attributable to the appreciation. The market discount is calculated based on the bond’s face value and your basis in the bond.
Are there any exceptions to the ordinary income treatment of market discount upon disposition? Generally, the market discount is treated as ordinary income to the extent of any gain. There are no major exceptions to this rule, though specific circumstances might warrant further consultation with a tax professional.
How does original issue discount (OID) interact with market discount? Original issue discount (OID) occurs when a bond is issued at a discount. If a bond has both OID and market discount, the OID is generally taken into account first. The market discount rules then apply to the remaining difference between the adjusted issue price and the basis in the bond.
What are the record-keeping requirements for market discount bonds? Meticulous record-keeping is essential. You should retain records of the bond’s purchase price, face value, maturity date, any partial principal payments, and the method used to calculate accrued market discount (if applicable). This documentation is critical for accurately reporting your income and adjusting your basis.
Can I amend a prior-year tax return to make the election to include AMD currently? Generally, you cannot amend a prior-year tax return to make the election to include AMD currently. The election must be made in the year you first acquire market discount bonds. Revoking the election generally requires IRS consent.
Where can I find more information on market discount rules? IRS Publication 550, Investment Income and Expenses, provides detailed information on market discount and other investment-related topics. Consult this publication and, when needed, seek advice from a qualified tax advisor.
Navigating the intricacies of market discount requires a thorough understanding of the rules and careful planning. The decision to include AMD currently or defer it should be made after considering your individual tax situation and investment strategy. Seeking professional tax advice is highly recommended to ensure compliance and optimize your tax outcomes.
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