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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121219  
Subject: Re: Market Discount on Bonds Date: 7/14/1999 9:33 PM
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[["Under the market discount rules, if a holder of a Note purchases it at
market discount (i.e., at a price below its stated redemption price at
maturity) in excess of a statutorily-defined de minimis amount and
thereafter recognizes gain upon a disposition or retirement of the Note,
then the lesser of the gain recognized or the portion of the market discount
that accrued on a ratable basis (or, if elected, on a constant interest rate
basis) generally will be treated as ordinary income at the time of the
disposition."

This leaves me with two questions...

1) What is the "statutorily-defined de minimis amount" made reference to here?]]

Seems like two easy questions, right? But the discussion on the issues is much broader. I would highly recommend that you read IRS Publication 550 on this issue for much more additional information. The explanation goes on for pages and pages. But I'll try to hit the highlights of your questions. But again, read ALL of the information for a much better understanding.

De minimis Original Issue Discount: You can treat the discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity. This small discount is known as "de minimis" OID. That's the definition...does it make any sense? I thought not...which is why Pub 550 is really required reading.

[[ 2) what would the "portion of the market discount that accrued on a ratable
basis" be?]]

This is even more complicated. In general, a debt instrument, such as a bond, note, debenture, or other evidence of indebtedness, that bears no interest or bears interest at a lower than current market rate will usually be issued at less than its face amount. This discount is, in effect, additional interest income.

But the specific rules that would answer your question is really based upon what you are buying. Since it sounds like a market discount bond, I'll give you the highlights on those rules...but remember that different instruments have different rules.

A market discount bond is any bond having market discount except:

1) Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),

2) Tax-exempt obligations that you bought before May 1, 1993,

3) U.S. savings bonds, and

4) Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date, generally because of an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

1) You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount.

2) You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount.

3) If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited.

Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond).

If a market discount bond also has OID (again...different rules), the market discount is the sum of the bond's issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.

Generally, a bond that you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you are also considered to have acquired it at original issue.

Exceptions. A bond you acquired at original issue can be a market discount bond if either of the following is true.

1) Your cost basis in the bond is less than the bond's issue price.

2) The bond is issued in exchange for a market discount bond under a plan of reorganization. (This does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same.)

The accrued market discount is figured in one of two ways:

Ratable accrual method. Treat the market discount as accruing in equal daily installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.

Constant yield method. Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond.

For information about using the constant yield method, see Publication 1212. To use this method to figure market discount (instead of OID), treat the bond as having been issued on the date you acquired it. Treat the amount of your basis (immediately after you acquired the bond) as the issue price. Then apply the formula shown in Publication 1212.

Help any? Likely not, because there is a BUNCH of backround information that you'll need to make all of the pieces of the puzzle fit together. And, again, you can do that by reading IRS publication 550.

TMF Taxes
Roy

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