Tax treatment of market discount bonds.

• Author: Oberst, Timothy S.

Generally, gain or loss on the sale of a note will be capital gain or loss if the note is a capital asset in the holder's hands. Other than a note or trade receivable arising from the provision of a service or the selling of inventory or stock in wade, gain or loss recognized from the disposition of a note or account receivable will be capital gain or loss, unless the taxpayer is a dealer with respect to the note or account receivable (Sec. 122 l(a) (4)). A taxpayer who purchases a note at a discount as an investment might therefore assume that any gain realized will qualify for capital gain treatment if the note is held until maturity and paid off or sold for a profit. Prior to 1984, this assumption would have been correct. However, Congress reasoned that, from a holder's standpoint, there is no valid distinction between original issue discount (OLD) and market discount and that the holder of a debt instrument should take into account any gain realized from its sale attributable to such discount as interest income. Congress therefore enacted Secs. 1276 and 1278 in 1984, which require gain on the disposition of notes purchased at a discount to be reported as ordinary income to the extent of accrued market discount.

Market Discount Bonds

Relevant definitions are found in Sec. 1278(a). The term "bond" refers to any bond, debenture, note, certificate, or other evidence of indebtedness. "Market discount" is the excess of the stated redemption price of the bond at maturity over the basis of the bond immediately after its acquisition by the taxpayer. The term "market discount bond" refers to any bond having market discount. Market discount bonds generally do not include any bonds acquired at their original issue. Also, they do not include (1) short-term obligations that mature within one year of issuance; (2) installment obligations subject to Sec. 453B; (3) U.S. savings bonds; and (4) tax-exempt bonds purchased before May 1, 1993 (Sec. 1278(a)(1)).

When a taxpayer purchases a note at a discount, the gain to the purchaser on repayment of the note in full is interest income because the transaction does not involve a sale or exchange. The rules regarding dispositions of market discount bonds are outlined in Sec. 1276. Gain realized on the disposition of a market discount bond must be recognized as interest income to the extent of the accrued market discount, and any remaining gain will be capital if the bond is a capital asset in the hands of the holder. This ordinary income treatment applies to obligations issued after July 18, 1984, and to obligations issued on or before that date that were purchased after April 30, 1993. Under the general rule, market...