Discounted Debt Instruments: Investment Taxes (2025 IRS Guide)

This guide covers “Discounted Debt Instruments” within investment taxes. The following material presents the IRS treatment of this topic, including the qualifications, exceptions, and examples in the source section. Read the rules alongside the facts of your own situation before deciding what to report, deduct, or document.

Adapted from Publication 550 (2025), Investment Income and Expenses, published by the Internal Revenue Service. This guide retains the source edition’s years, amounts, deadlines, and examples. It is guidance for that edition, not a statement that the same figures apply to every tax year.

Context for these rules

If you have a taxable gain or a deductible loss from a transaction, it may be either a capital gain or loss or an ordinary gain or loss, depending on the circumstances. Generally, a sale or trade of a capital asset (defined next) results in a capital gain or loss. A sale or trade of a noncapital asset generally results in ordinary gain or loss. Depending on the circumstances, a gain or loss on a sale or trade of property used in a trade or business may be treated as either capital or ordinary, as explained in Pub. 544. In some situations, part of your gain or loss may be a capital gain or loss, and part may be an ordinary gain or loss.

Discounted Debt Instruments

Treat your gain or loss on the sale, redemption, or retirement of a bond or other debt instrument originally issued at a discount or bought at a discount as capital gain or loss, except as explained in the following discussions.

Short-term government obligations.

Treat gains on short-term federal, state, or local government obligations (other than tax-exempt obligations) as ordinary income up to your ratable share of the acquisition discount. This treatment applies to obligations with a fixed maturity date of not more than 1 year from the date of issue. Acquisition discount is the stated redemption price at maturity minus your basis in the obligation.

However, do not treat these gains as income to the extent you previously included the discount in income. See Discount on Short-Term Obligations in chapter 1 for more information.

Short-term nongovernment obligations.

Treat gains on short-term nongovernment obligations as ordinary income up to your ratable share of OID. This treatment applies to obligations with a fixed maturity date of not more than 1 year from the date of issue.

However, to the extent you previously included the discount in income, you do not have to include it in income again. See Discount on Short-Term Obligations in chapter 1 for more information.

Tax-exempt state and local government bonds.

If these bonds were originally issued at a discount before September 4, 1982, or you acquired them before March 2, 1984, treat your part of OID as tax-exempt interest. To figure your gain or loss on the sale or trade of these bonds, reduce the amount realized by your part of OID.

If the bonds were issued after September 3, 1982, and acquired after March 1, 1984, increase the adjusted basis by your part of OID to figure gain or loss. For more information on the basis of these bonds, see Discounted tax-exempt obligations, earlier in this chapter.

Any gain from market discount is usually taxable on disposition or redemption of tax-exempt bonds. If you bought the bonds before May 1, 1993, the gain from market discount is capital gain. If you bought the bonds after April 30, 1993, the gain from market discount is ordinary income.

You figure market discount by subtracting the price you paid for the bond from the sum of the original issue price of the bond and the amount of accumulated OID from the date of issue that represented interest to any earlier holders. For more information, see Market Discount Bonds in chapter 1.

A loss on the sale or other disposition of a tax-exempt state or local government bond is deductible as a capital loss.

Redeemed before maturity.

If a state or local bond issued before June 9, 1980, is redeemed before it matures, the OID is not taxable to you.

If a state or local bond issued after June 8, 1980, is redeemed before it matures, the part of OID earned while you hold the bond is not taxable to you. However, you must report the unearned part of OID as a capital gain.

Example.

On July 2, 2014, the date of issue, you bought a 20-year, 6% municipal bond for $800. The face amount of the bond was $1,000. The $200 discount was OID. At the time the bond was issued, the issuer had no intention of redeeming it before it matured. The bond was callable at its face amount beginning 10 years after the issue date.

The issuer redeemed the bond at the end of 11 years (July 2, 2025) for its face amount of $1,000 plus accrued annual interest of $60. The OID earned during the time you held the bond, $73, is not taxable. The $60 accrued annual interest is also not taxable. However, you must report the unearned part of OID, $127 ($200 − $73), as a capital gain.

Long-term debt instruments issued after May 27, 1969 (or after July 1, 1982, if a government instrument).

If you hold one of these debt instruments, you must include a part of OID in your gross income each year you own the instrument. Your basis in that debt instrument is increased by the amount of OID that you have included in your gross income. See Original Issue Discount (OID) in chapter 1.

If you sell or trade the debt instrument before maturity, your gain is a capital gain. However, if at the time the instrument was originally issued there was an intention to call it before its maturity, your gain is generally ordinary income to the extent of the entire OID reduced by any amounts of OID previously includible in your income. In this case, the rest of the gain is capital gain.

An intention to call a debt instrument before maturity means there is a written or oral agreement or understanding not provided for in the debt instrument between the issuer and original holder that the issuer will redeem the debt instrument before maturity. In the case of debt instruments that are part of an issue, the agreement or understanding must be between the issuer and the original holders of a substantial amount of the debt instruments in the issue.

Example 1.

On February 9, 2024, you bought at original issue for $7,600, Jones Corporation's 10-year, 5% bond which has a stated redemption price at maturity of $10,000. On February 13, 2025, you sold the bond for $9,040. Assume you have included $334 of OID in your gross income (including the amount accrued for 2025) and increased your basis in the bond by that amount. Your basis is now $7,934. If at the time of the original issue there was no intention to call the bond before maturity, your gain of $1,106 ($9,040 amount realized minus $7,934 adjusted basis) is capital gain.

Example 2.

If, in Example 1, at the time of original issue there was an intention to call the bond before maturity, your entire gain is ordinary income. You figure this as follows:

Because the amount in (3) is more than your gain of $1,106, your entire gain is ordinary income.

Market discount bonds.

If the debt instrument has market discount and you chose to include the discount in income as it accrued, increase your basis in the debt instrument by the accrued discount to figure capital gain or loss on its disposition. If you did not choose to include the discount in income as it accrued, you must report gain as ordinary interest income up to the instrument's accrued market discount. See Market Discount Bonds in chapter 1. The rest of the gain is capital gain.

However, a different rule applies if you dispose of a market discount bond that was:

• Issued before July 19, 1984; and

• Purchased by you before May 1, 1993.

In that case, any gain is treated as interest income up to the amount of your deferred interest deduction for the year you dispose of the bond. The rest of the gain is capital gain. (The limit on the interest deduction for market discount bonds is discussed in chapter 3 under When To Deduct Investment Interest.)

Report the sale or trade of a market discount bond in Form 8949, Part I or Part II, whichever is appropriate. Use the table How To Complete Form 8949, Columns (f) and (g) in the Instructions for Form 8949 to help you figure the amounts to report for a sale or trade of a market discount bond. Also report the amount of accrued market discount in column (g) as interest income on Schedule B (Form 1040), line 1, and identify it as “Accrued Market Discount.”

Retirement of debt instrument.

Any amount you receive on the retirement of a debt instrument is treated in the same way as if you had sold or traded that instrument.

Notes of individuals.

If you hold an obligation of an individual issued with OID after March 1, 1984, you must generally include the OID in your income currently, and your gain or loss on its sale or retirement is generally capital gain or loss. An exception to this treatment applies if the obligation is a loan between individuals and all the following requirements are met.

• The lender is not in the business of lending money.

• The amount of the loan, plus the amount of any outstanding prior loans, is $10,000 or less.

• Avoiding federal tax is not one of the principal purposes of the loan.

If the exception applies, or the obligation was issued before March 2, 1984, you do not include the OID in your income currently. When you sell or redeem the obligation, the part of your gain that is not more than your accrued share of OID at that time is ordinary income. The rest of the gain, if any, is capital gain. Any loss on the sale or redemption is capital loss.

Using the guidance

Keep the documents that establish the dates, amounts, and circumstances described above. References to other chapters, forms, worksheets, or earlier and later sections refer to the linked IRS publication. Check the full publication and its updates before relying on a rule for a different tax year or a situation not addressed here.

Sources and further reading

• Publication 550 (2025), Investment Income and Expenses: Sales and Trades of Investment Property — Capital Gains and Losses — Capital or Ordinary Gain or Loss — Discounted Debt Instruments — Internal Revenue Service; 2025 edition.

The cited U.S. government text is in the public domain. Source accessed October 28, 2026. Fynoptic has organized this material for educational use and is independent of, and not endorsed by, the IRS.