Market Discount Bonds: Investment Taxes (2025 IRS Guide)

This guide covers “Market Discount Bonds” 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

A debt instrument, such as a bond, note, debenture, or other evidence of indebtedness, that bears no interest or bears interest at a lower than current market rate usually will be issued at less than its face amount. This discount is, in effect, additional interest income. The following are some types of discounted debt instruments.

• U.S. Treasury bonds.

• Corporate bonds.

• Municipal bonds.

• Certificates of deposit.

• Notes between individuals.

• Stripped bonds and coupons.

• Collateralized debt obligations (CDOs).

Market Discount Bonds

A market discount bond is any bond having market discount except:

• Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),

• Tax-exempt obligations you bought before May 1, 1993,

• U.S. savings bonds, and

• Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date. Generally, this is due to an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

• You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments, later.

• You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount. See Partial principal payments, later in this discussion.

• If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Limit on interest deduction for market discount bonds, later.

Market discount.

Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than one-fourth of 1% (0.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond).

If a market discount bond also has OID, the market discount is the sum of the bond's issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.

Bonds acquired at original issue.

Generally, a bond you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you also are considered to have acquired it at original issue.

Exceptions.

A bond you acquired at original issue can be a market discount bond if either of the following is true.

• Your cost basis in the bond is less than the bond's issue price.

• The bond is issued in exchange for a market discount bond under a plan of reorganization. (This does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same.)

Accrued market discount.

The accrued market discount is figured in one of two ways.

Ratable accrual method.

Treat the market discount as accruing in equal daily installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.

Constant yield method.

Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond.

See Pub. 1212 for information about using the constant yield method. To use this method to figure market discount (instead of OID), treat the bond as having been issued on the date you acquired it. Treat the amount of your basis (immediately after you acquired the bond) as the issue price and apply the formula shown in Pub. 1212.

Choosing to include market discount in income currently.

You can make this choice if you have not revoked a prior choice to include market discount in income currently within the last 5 calendar years. Make the choice by attaching to your timely filed return a statement in which you:

• State that you have included market discount in your gross income for the year under section 1278(b) of the Internal Revenue Code, and

• Describe the method you used to figure the accrued market discount for the year.

Once you make this choice, it will apply to all market discount bonds you acquire during the tax year and in later tax years. You cannot revoke your choice without the consent of the IRS. See Rev. Proc. 2025-23, section 31, for information on how to revoke your election.

Also, see Election To Report All Interest as OID, later. If you make that election, you must use the constant yield method.

Effect on basis.

You increase the basis of your bonds by the amount of market discount you include in your income.

Partial principal payments.

If you receive a partial payment of principal on a market discount bond you acquired after October 22, 1986, and you did not choose to include the discount in income currently, you must treat the payment as ordinary interest income up to the amount of the bond's accrued market discount. Reduce the amount of accrued market discount reportable as interest at disposition by that amount.

There are three methods you can use to figure accrued market discount for this purpose.

1. On the basis of the constant yield method, described earlier.

2. In proportion to the accrual of OID for any accrual period, if the debt instrument has OID.

3. In proportion to the amount of stated interest paid in the accrual period, if the debt instrument has no OID.

Under method (2) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator (top part) of the fraction is the OID for the period, and the denominator (bottom part) is the total remaining OID at the beginning of the period.

Under method (3) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator is the stated interest paid in the accrual period, and the denominator is the total stated interest remaining to be paid at the beginning of the accrual period.

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: Investment Income — Discount on Debt Instruments — Market Discount Bonds — 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.