The term accrued market discount refers to the increase in the value of a bond as it approaches the day it is redeemable at par. The calculation of a bond's accrued market discount is not affected by falling interest rates.
When a bond is sold at a discount to par value, the market price of this security will increase as it approaches the maturity or redemption date. In addition to the interest payment on the security, the difference between the purchase price of the bond and its face value represents a return on the investment that may be taxable.
The rules for reporting accrued market discounts are fully explained in the Internal Revenue Service (IRS) Publication 550 (Investment Income and Expenses); in the section that describes Discounts on Debt Instruments. These guidelines provide for one important exception to this rule. Taxpayers must include in taxable income what is called the Original Issue Discount (OID) unless the discount is considered a De Minimis OID.
The taxpayer can treat the discount as zero if it is less than one-fourth of 1%, or 0.25% (0.0025) of the stated redemption price multiplied by the number of full years to maturity. For example, a discounted bond is purchased for 98.125, matures in ten years, and has a par value of 100. The first step in determining if an accrued market discount must be reported as income would be to test the discount to see if it is considered a De Minimis OID:
= 10 years to Maturity x 0.0025, or 2.500
The next step involves subtracting the above De Minimis OID value from the par value of the bond:
= 100.000 - 2.500, or 97.500
Since the purchase price of the bond (98.125) is greater than the OID (97.500), the bond has a De Minimis OID, and is not reportable as taxable income. If the bond does not qualify for the De Minimis OID exception, the taxpayer has the option of accruing the market discount over the remaining maturity of the bond, and classifying this accrual as interest income. Alternatively, the taxpayer could choose not to accrue the discount and include as interest income the difference between the purchase price and the eventual selling price of the bond.