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mectecinc wrote: If you buy a bond on the open market at a discount to its $1000 par value issue price (for say $900), the bond will ultimately mature at $1000 or could be called for $1000. That $100 "appreciation" is treated as interest not capital gain in bond tax accounting.

joelcorley answered: I don't believe this is generally true. Certainly not for a taxable bond with a market discount in a taxable account. I do know you can also amortize market bond premiums to reduce your effective income, but I don't think this generally applies to discounts.

Actually, mectecinc is correct. From IRS Pub 550 https://www.irs.gov/pub/irs-pdf/p550.pdf

Market Discount Bonds

A market discount bond is any bond having market discount except:
Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),
Tax-exempt obligations you bought before May 1, 1993,
U.S. savings bonds,
and Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date. Generally, this is due to 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.

You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments, later.
(my bolding)

You can go ahead and read more details in the cited publication.

I have held trust preferred stocks that paid interest in my taxable accounts. (The trusts held bonds and distributed interest payments to the preferred shareholders.) Those shares were all purchased at a discount and eventually called at par. The discount was treated as a capital gain. I'm not sure my situation differs materially from the one in your quote above.

It does differ, because you bought a trust preferred, not an actual bond. There is also generally a difference in the treatment of accrued interest between bonds and preferred stocks (including trust preferreds), since preferred stocks are expected to 'trade flat' while bond trades generally include an adjustment for accrued interest.

From a tax perspective, this may make preferreds and other exchange traded debt preferable to bonds. But from a capital structure perspective, senior bonds are generally superior to preferreds - even trust preferreds, since the bonds that trust preferreds are set up are generally junior bonds, and even if the underlying bonds for a trust preferred are senior bonds, the obligation is owed to the trust, not to the holder of the trust preferred. Therefore, when buying trust preferreds, you need to understand what obligation the trust has to the holder of the trust preferred security in the case of a bankruptcy of the company that issued the underlying bonds, for instance.

AJ
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