Original Issue Discount: Definition & Taxation

Instructor: Martin Gibbs

Martin has 20 years experience in Information Systems and Information Technology, has a PhD in Information Technology Management, and a master's degree in Information Systems Management. He is an adjunct professor of computer science and computer programming.

Bonds are often purchased for a price that is not necessarily face value. This lesson will define the original issue discount and tax implications of these bonds.

Original Issue Discount

Bonds are not always purchased at their face value. Bond issuers can offer bonds at lower values in order to encourage investment.

The original issue discount (OID) is the difference between a bond's selling price and the face value. Face value is also called the par value of the bond. OID is a type of interest because the buyer will receive the face value of the bond, even if they bought it for less.

Unlike interest rates on a bond, OID is not calculated on a monthly basis. It is paid out when the bond matures as a total value plus the principal invested.

Consider the following example: You search the bond market and find a bond that is being sold for $500. The par value of the bond is actually $750. The reason the seller is willing to offer a lower price is because the interest rate on the bond is lower than the market rate. However, offering a lower price actually raises the interest rate for you. When you redeem the bond, you will receive the full $750.

Zero Coupon Bonds

The deepest discounts are offered on zero-coupon bonds. These bonds don't have any interest and are sold well below par. The only profit or gain is realized when the bond matures. They are a very safe and conservative investment.

Organizations issue zero-coupon bonds because they don't have to pay interest over the course of the bond's lifetime. At maturity, the owner can cash it in for the full face value. Investors buy zero-coupon bonds when they want a safe, solid investment, and a guaranteed return at the end. They forsake the interest over the life of the loan for a larger payout at the end. Typically, the longer the life of the loan, the larger the discount.

Tax Implications

As a general rule, OID income is declared as it accrues. However, the rules don't apply for US savings bonds. Except for the de minimus rule (discussed below), OID gains and losses must be claimed on your tax return. The gain (or loss) is the difference between what you made on the sale and your basis. Let's take a look at an example so the tax requirements are clear.

Jane purchased a bond with the following features:

  • 15-Year bond with a par value of $100,000
  • Purchased for $85,000

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