You buy a $10,000 bond for $9,200, hold it to maturity, and pocket the $800 difference. Feels like a capital gain — you bought low and the bond paid off at full face value. But when you file your return, that $800 shows up as ordinary interest income, taxed at your full marginal rate instead of the lower capital gains rate. And your neighbor who bought a similar bond for $10,600 faces the mirror image: she paid a $600 premium that quietly evaporates as the bond slides toward par, and whether she gets any tax benefit from it depends on an election she may never have heard of.
Bonds rarely trade at exactly par on the secondary market. Rising rates push prices below face value, falling rates push them above it, and the tax code treats the gap between what you paid and what the bond redeems for as its own category of income. This guide explains both sides — market discount when you buy below par, bond premium when you buy above it — plus the de minimis exception that decides which rate applies, the elections that change the timing, and what lands in boxes 10 through 13 of your Form 1099-INT.
Market Discount: Buying Below Par
Market discount is the difference between a bond's stated redemption price at maturity (usually par, $1,000 per bond) and your basis immediately after you acquire it. If you pay $920 for a $1,000 bond on the secondary market, you hold $80 of market discount. It typically arises because interest rates rose after the bond was issued: the bond's fixed coupon is now below market, so the price drops to compensate.
This is different from original issue discount (OID). OID exists when a bond is issued below par — a zero-coupon bond sold at $600 that redeems at $1,000, for example. Market discount arises when a bond already outstanding falls in value and you buy it at the depressed price. The two have separate rule sets, though they interact: if a market discount bond also carries OID, your market discount is measured from the bond's revised issue price (original issue price plus OID already accrued), not from par.
The default tax treatment surprises most investors. If you do nothing, you do not report the discount year by year. Instead, when you sell or redeem the bond, any gain is recharacterized as ordinary interest income up to the amount of accrued market discount. Only gain beyond the accrued discount gets capital treatment. In the $920 example, if you hold to maturity and collect $1,000, the full $80 is ordinary income. If you sell early for $970 after $40 of discount has accrued, $40 of your $50 gain is ordinary income and $10 is capital gain.
The same recharacterization applies to partial principal payments. If you receive a paydown on a market discount bond acquired after October 22, 1986, the payment counts as ordinary interest income up to the accrued discount — it does not simply reduce your basis.
How discount accrues: ratable vs. constant yield
To know how much of your gain is ordinary, you need the accrued market discount at disposition. The default method is ratable accrual: divide the total discount by the number of days from the day after purchase through maturity, then multiply by the days you held the bond. It spreads the discount in equal daily slices.
Alternatively, you can elect the constant yield method, which accrues discount at a constant interest rate — smaller amounts early, larger amounts later, mirroring economic reality. You make this choice per bond by attaching a statement to your timely filed return identifying the bond, and it is irrevocable for that bond. The constant yield method usually produces less accrued discount in the early years, which matters if you expect to sell before maturity: less accrued discount means less of your sale gain is ordinary income. Publication 1212 has the worksheets.
The election to report discount currently
Instead of deferring the discount to disposition, you can elect under section 1278(b) to include accrued market discount in income each year as interest. You do it by attaching a statement to your timely filed return saying you are including market discount currently and describing your accrual method.
Three consequences come with that statement, so read them before signing. First, the election applies to all market discount bonds you acquire that year and in later years — you cannot pick and choose. Second, it is binding: you need IRS consent to revoke it (see Revenue Procedure 2025-23 for the procedure), and you cannot make a fresh election within five years of revoking one. Third, every dollar of discount you include increases your basis in the bond, so you are not taxed on it again at sale.
Why elect? Currently reported discount is still ordinary income, so the election does not change the character — it changes the timing. It makes sense when you want income smoothed across years, when you are in a temporarily low bracket, or when you hold the bond in a year you have offsetting deductions. Most buy-and-hold investors skip it and accept the lump of ordinary income at maturity.
The de minimis exception: the cliff that changes the rate
Not every discount counts. The discount is treated as zero — meaning the entire gain can be capital — if it is less than one-fourth of 1 percent (0.0025) of the redemption price multiplied by the number of full years from purchase to maturity. For a $1,000 bond with 8 full years left, the threshold is $1,000 × 0.0025 × 8 = $20. Buy at $985 (a $15 discount) and the discount is de minimis: your gain at maturity is capital gain. Buy at $975 (a $25 discount) and the full $25 is ordinary income.
Note the cliff. A discount one dollar over the threshold does not get partial relief — the entire discount is subject to the market discount rules. This makes pricing near the threshold worth a second look: paying a few dollars more per bond to land under the de minimis line can convert ordinary income into capital gain. Municipal bond buyers in high brackets feel this most acutely, because the spread between ordinary rates and capital gains rates is widest for them.
The same 0.25-percent-per-year formula also defines de minimis OID at issuance. If you buy a bond with de minimis OID at a further discount, that additional discount is tested under the market discount rules.
Two traps: borrowed money and munis
If you borrow to buy or carry a market discount bond, your interest deduction is deferred. You can generally deduct interest expense only up to the interest income (including any discount you elect to report currently) from the bond; the excess is carried forward and becomes deductible when you dispose of the bond. The rule exists to stop the obvious play: deducting borrowing costs today against discount income you will not report for years.
And a warning for muni buyers: market discount on a tax-exempt bond is not tax-exempt. The coupon stays exempt, but discount accreted after April 30, 1993 is taxable — as ordinary income, unless de minimis. Investors who assume everything about a muni is tax-free discover this one at filing time, when the 1099-INT arrives with an amount in Box 10.
Bond Premium: Buying Above Par
Bond premium is the mirror image: you pay more than the bond's redemption price. A $1,000 bond bought for $1,060 carries $60 of premium. Premiums appear when rates have fallen since issuance, or when the bond's coupon is rich relative to the market. Economically, the premium is prepaid interest you are handing the seller — the fat coupon payments gradually return it to you — and the tax rules try to reflect that.
Taxable bonds: amortization is elective
For taxable bonds (corporates, Treasuries), amortizing premium is your choice under section 171. If you elect, each year's amortized premium offsets that year's coupon interest, so you are taxed only on the bond's true yield rather than the full coupon. A 5 percent coupon on a bond whose yield to maturity is 4 percent taxes you at roughly 4 percent — the extra point is your own premium coming back.
The mechanics use the constant yield method for bonds issued after September 27, 1985: multiply your adjusted basis by your yield, subtract the result from the stated interest, and the difference is that period's amortization. Each year's amortization reduces your basis, so a bond held to maturity ends with a basis of par and no loss to claim.
Like the market discount election, this one is broad and sticky: it applies to all taxable bonds you hold and all you acquire afterward, and you need IRS consent to revoke it. Run the comparison before electing. If you skip amortization, you report the full coupon as interest each year and claim a capital loss for the unamortized premium when the bond matures or is sold. Amortizing converts what would be a capital loss at the end into ordinary income reductions along the way — usually the better answer for a bond held in a taxable account, but the election binds your whole portfolio, so one bond's math should not decide it alone.
Tax-exempt bonds: amortization is mandatory
For munis and other tax-exempt bonds, you must amortize premium. There is no election and no deduction — amortizing simply grinds your basis down toward par over the bond's life. The rule prevents a manufactured loss: without it, you could collect tax-exempt coupons for years and then claim a capital loss for the premium evaporating at maturity. With it, your basis reaches par at maturity and there is nothing to deduct. If you sell early, your reduced basis means a smaller loss (or a larger gain) than your purchase price suggests.
When premium exceeds the coupon
Occasionally the amortizable premium for a period is larger than the interest for that period. The excess is not wasted — it is deductible — but the reporting depends on the bond type and year, so this is the one premium scenario worth confirming in Publication 550 or with your preparer rather than guessing on the form.
Reading Your Form 1099-INT
Your broker tracks all of this for covered securities and reports it in the numbered boxes of Form 1099-INT:
- Box 10, Market discount. The market discount that accrued (or was realized) on the bond. This is the ordinary-income piece of a discounted bond — verify it against your own purchase price and holding period, especially if you bought the bond before transferring the account.
- Box 11, Bond premium. Premium amortization on taxable bonds, which reduces the interest income shown in Box 1.
- Box 12, Bond premium on Treasury obligations. The same concept for Treasuries, reducing the Box 3 amount (which matters because Box 3 interest is exempt from state tax — the reduction must come off the right box).
- Box 13, Bond premium on tax-exempt bond. Premium amortization that reduces the tax-exempt interest in Box 8.
Two cautions. First, brokers apply default elections when computing these boxes, and their defaults may not match yours — particularly whether premium is being amortized. If your election differs from the broker's assumption, you report the correct number on your return (Schedule B instructions walk through the adjustment) rather than copying the form. Second, basis reported for older or transferred positions is a frequent error source: if Box 10 looks wrong, recompute the discount from your own trade confirmation before assuming the broker is right.
Tracking It in Your Books
Broker statements reconstruct this history poorly, especially across account transfers, so keep your own record per bond lot: purchase date and price, par value, coupon, maturity, accrued discount or unamortized premium to date, and adjusted basis. A plain-text ledger makes the adjustments explicit. Buying a $10,000-par bond at 96:
2026-03-15 * "Buy 10-yr corporate bond, $10,000 par at 96"
Assets:Investments:Bonds:Corp-2036 9,600.00 USD
Assets:Checking -9,600.00 USDEach year, record the amortization or accretion as its own entry so the lot's basis stays honest. Here is a year of premium amortization reducing both the asset and the interest income:
2026-12-31 * "Amortize bond premium, Corp-2036 lot"
Income:Interest:Bonds 42.18 USD
Assets:Investments:Bonds:Corp-2036 -42.18 USDAt sale or maturity, the lot's balance is your adjusted basis — the number that decides how much of the proceeds is ordinary income, capital gain, or return of capital. If your books cannot produce that number without reconstructing it from trade confirms, the tracking is not done.
The Decisions, in Order
When a bond in your portfolio trades away from par, work through four questions. First, is the discount de minimis — below 0.25 percent of par per full year to maturity? If yes, stop worrying: the gain is capital. Second, if the discount is real, do you want the section 1278(b) election to report it currently, knowing it binds every market discount bond you buy from now on? Third, if you paid a premium on a taxable bond, do you want the section 171 amortization election, knowing it binds your whole taxable bond portfolio? Fourth, does your 1099-INT reflect the elections you actually made — Boxes 10 through 13 computed the way you compute them?
Answer those four with your own numbers before filing season, and neither the discount nor the premium will surprise you.
