In last week’s article, “10 Intermediate-Term Bonds Yielding Over 4% ,” I presented 10 corporate bonds with yields-to-worst and current yields of at least 4%, maturities of less than 10 years, and credit ratings no lower than Ba3/BB-. Moreover, nine of the ten bonds were being offered at market discounts. According to IRS Publication 550. “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.” Individual bond investors purchasing bonds on the secondary market need to be aware of tax rules related to market discount bonds, specifically how to accrue market discounts. I am not a tax advisor, but will do my best to explain what you need to know about accrued market discount.

Before discussing your options for accruing market discount, we need to expand upon its definition. In addition to the definition stated above, it is important to remember that you may purchase a bond at a market discount but not need to do anything about it. This is because market discount is treated as zero if it is less than 0.25% of “the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond).”

For example, in the aforementioned article, I presented a Computer Sciences bond maturing 9/15/2022 and being offered for 99.713 cents-on-the-dollar. With nine full years to maturity and a discount of less than one cent to the par value of 100 cents-on-the-dollar, the Computer Sciences notes are definitely trading at a market discount that can be treated as zero. This is because the notes are being offered at a price greater than 97.75. Here’s the math to calculate the price below which the market discount could no longer be treated as zero:

9 × 0.0025 = 0.0225, 0.0225 = 2.25 cents-on-the-dollar, 100 – 2.25 = 97.75.

Also in the aforementioned article, I presented a Goldcorp bond maturing 3/15/2023 and being offered for 91.133 cents-on-the-dollar. With just nine full years to maturity and a discount of nearly nine cents-on-the-dollar, the Goldcorp notes are clearly trading at a discount that cannot be treated as zero. Again, here’s the math for calculating the price below which the market discount could no longer be treated as zero:

9 × 0.0025 = 0.0225, 0.0225 = 2.25 cents-on-the-dollar, 100 – 2.25 = 97.75.

If you purchased the Goldcorp notes at a basis of 97.75 or higher, the market discount would be treated as zero. Since the notes were offered in the secondary market at 91.133, unless you were charged an exorbitant markup or commission, the market discount would not be treated as zero.

Once you know that a bond you own has a market discount that is not considered de minimus (cannot be treated as zero), the next question to answer is, “What do I need to do about it?”

First, according to IRS Publication 550, you can choose to accrue the market discount over the period during which you own the bond as long as you have not revoked a previous choice to include market discount in your current income within the last five calendar years. Additionally, you would need to include with your tax return a statement mentioning that you’ve included market discount in your gross income under section 1278(b) of the Internal Revenue Code, and you would have to describe the method used to figure the exact amount of accrued market discount (more on that later). If you choose to accrue the market discount over the period during which you own the bond, you would include the amount accrued each year as interest income. It is also important to note that once you make the choice to accrue market discount over the life of your holding period, that choice will apply to all market discount bonds acquired during that tax year and in future years. Furthermore, you cannot revoke your decision without the permission of the IRS. If you do decide to accrue market discount over the life of your holding period, remember to increase your cost basis each year by the amount of the market discount included in your income. Should you decide to sell the bond prior to maturity, your capital gain/loss would be the difference between the sales proceeds and your adjusted basis.

Second, you can choose not to accrue the market discount over the period during which you own the bond. If you make this choice, and you hold the bond to maturity, you would then include in your interest income the difference between the redemption price and your costs basis. If, however, you sell the bond prior to maturity, you must treat as interest income any gains up to the amount of the accrued market discount. In other words, if you purchase a bond with five years to maturity at 95 and sell it for 98, while it may appear you have a capital gain of three cents-on-the-dollar, because the market discount on that bond is not treated as zero, some of the gain will be treated as interest income.

Finally, it is important to understand the two methods available to you for accruing market discount. They are “Ratable accrual method” and the “Constant yield method.” Below is what the IRS has to say about ratable accrual and constant yield:

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.

For information about using the constant yield method, see Constant yield method under Debt Instruments Issued After 1984 in Publication 1212. 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. Then apply the formula shown in Publication 1212”

Because of the incredibly low coupons at which many companies were able to issue notes in recent months/years and the sharp rise in interest rates during the second quarter, there are scores of bonds trading at market discounts that are not considered. Keep this in mind the next time you purchase an individual bond and consider going through your current inventory of bonds to make sure you’ve clearly marked which bonds were purchased at de minimus market discounts and which were not. Finally, please remember that the tax code is incredibly complex and that there are additional details concerning market discount bonds and accrued market discounts that are beyond the scope of this article.

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