4.9.2 Discount Bonds
When a bond is bought in the secondary market at a discount to par, the bondholder has the same two alternatives at tax time. A bondholder who chooses not to accrete the discount and holds the bond to maturity will pay his regular tax rate on the discount at maturity. If the bondholder sells the bond prior to maturity, the adjusted cost basis will be used to determine how the proceeds will be taxed. The adjusted cost basis of the bond is determined by accreting the discount each year until the bond is sold. All profits up to the adjusted cost basis will be treated as ordinary income and taxed at the seller’s ordinary rate, while any additional profit will be taxed at the seller’s capital gains rate. The capital gains will be long-term if the seller has held the bonds for more than a year and short-term if he has held it for a year or less.
Note: If the amount of the discount is below the de minimis amount, it will always be taxed as capital gains. The IRS sets the de minimis amount for market discounts at 0.25% of par per year between the time of the acquisition and the bond’s maturity. Partial years are ignored for purposes of calculating the de minimis amount, even if the partial year is just one day short of a full year.
Example: Three ye