Guide to Bond Premium & Market Discount
By Corey Junk, Carol Warley, and Stefan Gottschalk, RSM US LLP
For Publication (by RSM US LLP and on the Federal Tax Policy Blog of the Texas Society of Certified Public Accountants)
Introduction: Market Purchases of Bonds, Adjustments to Taxable Income, and Forms 1099.
For taxpayers who purchase bonds or other debt instruments (“Bonds”), the Tax Code1 may require adjustments to ordinary interest income. This guide addresses two types of adjustments – bond premium and market discount.
Where they apply, the bond premium and market discount rules affect the characterization of Bond holders’ income as capital or ordinary, as well as the timing of certain ordinary interest income. Both the bond premium and market discount rules generally affect the amount of gain or loss and ordinary income recognized upon sale or disposition of a Bond. Bond premium adjustments to interest income may also apply while the taxpayer holds a Bond.
The bond premium and market discount rules both address situations where a Bond holder has purchased a debt instrument at a price that differs from a baseline amount. The applicable baseline amount is often, but not always, equal to the Bond’s stated principal amount (often known as its “face amount” or “par value). For bond premium, the baseline amount is the amount of all remaining payments other than qualified stated interest. For market discount, the baseline amount is the Bond’s adjusted issue price.
Bond premium and market discount arise because of market price changes. For example, a Bond’s value may decrease due to an increase in market interest rates or deterioration of the issuer’s credit quality. Conversely, a Bond value may increase due to a decrease in market interest rates or improvement of the issuer’s credit quality.
Bond holders generally receive Forms 1099 annually unless they are “exempt recipients.” Exempt recipients generally include corporations, governments, tax-exempt entities, and certain other taxpayers (S corporations, however, are not exempt recipients with respect to Forms 1099-B). Bond holders’ Forms 1099-B (regarding sales proceeds and tax basis) and 1099-INT/OID (regarding interest income) often reflect bond premium and market discount-related information.
The level of completeness and accuracy of the Form 1099 information, however, may vary. For example, variations in Form 1099 accuracy may arise because the Form 1099 rules authorize brokers to make certain assumptions about tax elections made by their customers. Where these assumptions are not consistent with the actual tax elections made by the customer, amounts shown on the Form 1099 may vary from those the customer is required to report on his or her tax return. This guide includes recommendations for dealing with some of these variations.
Certain taxpayers, such as banks and securities dealers, are subject to special rules that generally lessen the impact of the bond premium and market discount rules. This guide focuses on debt investors – taxpayers who hold Bonds as capital assets.
1 All references herein to “section,” “§” or “Tax Code” refer to the Internal Revenue Code of 1986, as amended, and all references to “Reg. section” or “Reg. §” are to the regulations issued thereunder.
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