What Is "OID Interest"?

From the U.S. savings bonds that your grandmother may have purchased to help pay for your education to municipal bonds that are issued by a city to raise money for a new school, bonds are typically low-risk investments that may also come with some tax benefits. If you invest in bonds, you’ll earn interest at periodic intervals until the bond matures and your initial investment is returned.

Or for some types of bonds, you'll earn interest only when the bond matures. And if you happen to purchase a bond at a price that’s less than its mature value, you’ll often realize a bigger return on your investment over the life of this type of bond than other types. But you’ll also have to pay taxes on the interest as it accrues on this discounted bond, which is called an Original Issue Discount (OID) bond.

What Are Bonds?

In a nutshell, a bond is a loan that an investor extends to a company or government entity. Bonds are debt securities that raise money for various entities, including companies and governments. Perhaps the most familiar bond is a U.S. savings bond, which is issued by the U.S. Department of the Treasury.

How Do Bond Investments Work?

When you buy a bond as an investment, you’re essentially lending money to the issuer of the bond. For example, if you purchase a U.S. savings bond, you’re lending money to the U.S. government. If you purchase a municipal bond, you and the other bond investors are lending money to a city, for example, to repair roads or bridges. The bond issuer repays your loan based on the terms listed in the bond details. The interest you earn typically is paid twice yearly, but it may be more often – or less frequently – than that. At the bond’s maturity date, the bond issuer repays you its face value, which may be more than the original price you paid to purchase the bond (if you purchased the bond at a discount).

Types of Bonds

Types of bond investments include:

•  U.S. savings bonds – The federal government must pay back the loans that purchasers of U.S. savings bonds extend to it, so these bonds are considered part of the national debt.
  
• Municipal bonds – Also called “munis,” municipal bonds are issued by state and local governments to help fund projects such as road repairs or building improvements. The two primary types of municipal bonds are general obligation bonds and revenue bonds. General obligation bonds are not collateralized by assets but by the "full faith and credit" of the issuing entity. Revenue bonds are typically backed by project revenues. Government entities may also issue revenue bonds for other entities, such as hospitals and schools, which are called “conduit borrowers.” A conduit borrower repays the government entity that issues a bond, and the government entity pays the investors of the bond.
• Corporate bonds – Corporations sell bonds to investors in order to raise money for their operations. Compared to stocks, which give shareholders part ownership in a corporation, bonds are loans only, which do not make bond investors part owners in the corporation.

OID and Interest Rates

Interest rates on bonds are also called coupon rates. This type of interest is a fixed rate, which will not vary or adjust during the life of the bond, even though market interest rates will fluctuate over time. A bond’s interest rate is computed as a percentage of its face value at issuance, also called its par value. But a company may issue bonds at a discount, which is at a price less than their par value, because market fluctuations cause the prevailing interest rate to increase while a bond’s interest rate stays the same.

For example, to incentivize investors to purchase a bond with an original issue interest rate of 4 percent when market interest rates for other types of investments increase to 5 percent, a company may sell its bonds for less than their original face values. The redemption value stays the same – the value at the bond’s maturity date – but the reduced purchase price offers investors more return for their money in the long run. This difference in the amount of a bond’s face value and its discounted price is the original issue discount (OID).

OID and Zero-Coupon Bonds

Although an OID loan will typically pay investors interest on their loan on a periodic basis, there’s one notable exception. Zero-coupon bonds, simply referred to as “zeros,” are in a category all their own known as capital appreciation bonds (CABs). Zeros don’t pay any interest until a bond’s maturity date. With this type of bond, investors only make a return on their investment at the bond’s maturity date. To encourage investors to purchase zeros, a company sells these bonds at a deeply discounted price that’s significantly below par, or face value. Typically, it’s zeros that offer the highest OID rates.

OID Bond Advantages

Established by Congress in 1975, and overseen by Congress and the Securities and Exchange Commission (SEC), the Municipal Securities Rulemaking Board (MSRB) is a regulatory agency that helps protect investors of certain municipal securities, which include bonds.

The MSRB notes these advantages of investing in OID bonds:

• Realizing a higher yield – OID bonds typically pay a higher return on investment (sometimes a substantially higher return) than a bond that has a higher interest rate with no OID feature.
  
• Balancing current assets against future liabilities – If you’re thinking of investing in a zero bond as a way to fund your child’s future education costs or to establish retirement funds, you’ll be able to leverage your current assets against a future liability.
  
• Reinvesting interest automatically – If your OID bond is structured so that the interest you make is not paid to you on the periodic dates of the bond terms, this interest becomes automatically reinvested in the bond at the same interest rate as your original investment terms. This automatic reinvestment can increase the value of your bond if market interest rate falls below your bond interest.
  

OID Bond Disadvantages

On the flip side, the MSRB also notes some disadvantages of OID bonds, including:

• No cash flow to pay taxes – Any taxable interest you make on an OID bond means cash out of your pocket to cover the taxes without the benefit of cash receipts to pay the taxes.
  
• Difficulty in selling – If you purchase an OID bond at a significant discount, it may be difficult for you to sell the bond.
  
• Reinvesting interest automatically – The same scenario that could benefit you from an OID bond with an automatic reinvestment feature could also be detrimental. It all depends on market conditions. If the market interest rate rises above your bond interest rate, your bond decreases in value.
  

OID as Income

Typically, you must include OID interest as taxable income as it accrues each year, even if you don’t actually receive interest payments from the bond issuer. The issuer of an OID bond (or your broker, if you purchased the bond through the broker) must file Form 1099-OID (Original Issue Discount) with the IRS if you earned $10 or more in interest income from the bond during a tax year and the term of the bond was more than 1 year. Although the issuer has until Feb. 28 to file this copy with the IRS in the year that your tax return is due, the issuer must give you a copy by Jan. 31. The issuer should break down all the details of your OID bond on Form 1099-OID, including market discount, acquisition premium and investment expenses. The issuer will also note any tax-exempt OID.

IRS Publication 1212 (Guide to Original Issue Discount [OID] Instruments) helps taxpayers determine the amount of OID income they must report on their tax returns. You may need to refigure the OID that's shown in Box 1 or Box 8 of your 1099-OID to determine the corrected amount you'll need to include as income, and Publication 1212 can walk you through this calculation.

OID Income Exceptions

Not all OID amounts must be included in your income. Publication 1212 notes some exceptions, including U.S. savings bonds, some tax-exempt bonds and bonds that were issued before March 2, 1984. The IRS also points taxpayers to Publication 550 (Investment Income and Expenses) for more information on OID and other exceptions. A notable exception is “de minimis OID,” which allows you to treat the discount on a bond as zero if the amount of the discount is less than one-fourth of 1 percent (0.0025) of the bond’s maturity redemption price, multiplied by the number of complete years from the original issue date to the maturity date.

Reporting OID Interest

When you file your tax return, you'll report any OID interest income on Line 8a of Forms 1040 or 1040A, or on Line 2 of Form 1040EZ. You can't use 1040EZ in some instances; for example, if the amount of your OID interest income is greater than $1,500. Publication 1212 notes all the 1040EZ form restrictions. If you paid an early withdrawal penalty, you'll have to use Form 1040 to report OID. Use Schedule B to list each bond issuer's name and the amount you received from each issuer.

Filing Penalty

The IRS may assess a 20 percent accuracy-related penalty if you underpay the tax you owe on OID instruments, regardless of whether the error was because of negligence or your disregard for the rules and regulations of the OID bond. If you do not receive a 1099-OID from the bond issuer, you may have to calculate the OID amount to report on your tax return. Use Publication 1212 as a guide for how to do this.

Get Tax Help

Wading through the sea of OID definitions, requirements, exceptions and tax implications is not for the faint of heart. Your tax accountant is likely your go-to professional for making sure you properly report any OID income.

You can also view, download and print IRS publications and tax forms at IRS.gov. If you don't have a printer, you can order forms and publications free of charge by visiting IRS.gov/OrderForms.

If you are disabled or your annual income is $54,000 or less, you may qualify to receive free tax preparation assistance from the Volunteer Income Tax Association (VITA). Tax Counseling for the Elderly (TCE) is another free tax service. Despite its name, TCE is also available for taxpayers who are not senior citizens. Call 800-906-9887 to find the nearest VITA location, and call 888-227-7669 to find the nearest TCE location.