Category: Accounting Periods & Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Issue Answer For purposes of tax-exempt bonds purchased after April 30, 1993, another rule applies in addition to the OID rule set forth above. For such bonds, market discount (as distinct from OID) on a tax-exempt bond must be taken into account as taxable income, either when the bond is disposed of or currently at the taxpayer's election. Section 1276. Market discount on a tax-exempt bond is not tax-exempt irrespective of whether the taxpayer elects to include the amortization in income currently or waits until the bond is disposed. IRC Section 1278(b)(1). Very loosely speaking, market discount is the excess (if any) of the basis of a bond in the hands of the seller (after taking into account amortization of OID) over the purchase price paid for that bond. Section 1278. Consider the following example. Suppose a $10,000 bond is sold at original issuance for $9,000. The $1,000 difference between the face amount of the bond and the selling price is original issue discount (OID) and is amortized into the basis of the bond over its life under the constant yield method. If the bond is taxable, the amortization of OID is treated as interest income; if the bond is tax-exempt, OID amortization does not affect taxable income. Suppose further that the bond has been held for a period of time such that $400 of OID has been amortized and the holder's basis in the bond is now $9,400. The holder sells the bond to a new purchaser for $8,900. The $500 discount as between the new selling price and the old holder's basis is market discount. The new holder is required to continue amortization of the OID that resulted from the old holder's purchase. In addition, the new holder can elect to amortize market discount into income currently (Section 1278(b)) or alternatively wait until the bond is disposed. Any gain realized on disposition is treated as ordinary income to the extent of accrued market discount in existence at that time. Note that accrued market discount is oftentimes recognized even though the bond is disposed of in a transaction that would otherwise be tax free. See Section 1276(a)(1) and 1276(c). The whole area of bond discount is extremely complex. There are many issues involved and the taxpayer has the ability to make a number of elections that materially affect the taxation of the taxpayer's bond investments. This memo deals with only some of these issues and only then in an extremely cursory manner. If one is advising a client with significant bond activities or investments, an in-depth understanding of these rules is necessary. It is not the purpose of this memo to provide such an understanding. |
