In the period between the time that businesses approve bonds and when those bonds go to market, interest rates often change. Should interest rates increase above the stated rate on the bond, the business typically sell bonds below face value so purchasers get an equivalent return on their money. The different between the amount raised and the face value of the bond is called the discount, and is accounted for as additional interest over the maturation of the bond.
Original Issue Discount
When you purchase the debt from the issuer for less than its value at maturity, you purchased it at an original issue discount. Tax laws require you to recognize the discount as taxable interest income over the life of the debt in most instances. The amount of interest you must report varies each year as your basis in the debt increases.
Reporting OID Interest
Internal Revenue Service procedures require brokers to calculate and report the amount of OID interest you must realize using a Form 1099-OID. While the IRS publishes tables of debts issued at a discount, along with tables to assist brokers in calculating reportable interest for clients, you can calculate OID interest using the imputed interest rate for the debt and your basis in it.
Your basis in the debt increases each year as you realize interest from the discount, ensuring that you won’t recognize any capital gain if you hold onto the debt until maturity. Each increase is equal to the amount of interest you reported the year before. For example, if you purchased a $1,000 bond for $600 and your first year’s OID interest was $50, your adjusted basis for the current year is $650.
Calculating OID Interest
The longhand calculation for determining OID interest involves multiplying the issue price by the yield to maturity divided by the number of compounding periods in the tax year, then subtracting the stated interest. For example, a $1,000 bond with 1 percent interest that you purchased for $600 with a 12 percent, compounded semiannually, yield to maturity would generate $600 times 6 percent less $10 or $26 of OID interest the first half of the year and $626 times 6 percent less $10 or $27.56 in the second half of the year for a total of $53.56 in OID interest for the year. The IRS prepares a publication that lists the amount of OID interest, per $1,000 of debt, you must report for each debt issued at a discount.
- Internal Revenue Service: Publication 1212, Guide to Original Issue Discount (OID) Instruments
- Internal Revenue Service: Publication 1212, Guide to Original Issue Discount (OID) Instruments: Figuring OID on Long-Term Debt Instruments
- American Association of Individual Investors: Discount and Premium Bonds: Dealing With The Tax Issue
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