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.
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.
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
Part of the $15,000 needs to be reported each year as a capital gain. However, if Jane were to cash out the loan before it comes to term, the result could be a capital loss. This is because the bond has not fully matured.
De Minimus Rule
The OID can be zero if the total OID is less than one-quarter of one percent of the face value. This is the de minimus rule (a fancy Latin word meaning don't worry about it).
For example, a 10-year bond with a par value of $10,000, bought for $9,800 has an OID of only $200. 1/4 of 1% (.0025) times $10,000, times 10 (number of years until maturity) is $250. The OID is only $200, so don't worry about it.
The original issue discount (OID) is the difference between a bond's selling price and the face value (also called the par value). Some bonds don't pay any interest and have deep discounts (zero-coupon bonds). Typically, you must declare the OID on your taxes each year since it is a capital gain. The exception is the de minimus rule, in which case the discount is less than one-quarter of one percent (.0025) of the par value.
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