Original Issue Discount (OID) is when a bond is issued at a price below its par value, meaning the amount you receive back when the bond matures. Generally it is talked about in regards to taxes on zero coupon bonds. Zero coupon bonds do not pay interest. Instead, they are issued at a discount to their face value, and the interest earned over the life of the bond is paid out all at once when the bond matures. While the interest is paid out all at once when the bond matures, the IRS requires you to account for the interest as if it was paid out over the life of the bond. This is where the original issue discount comes into play.
Most other types of bonds are issued at a price which is the same as their par value. There are exceptions however, where a bond is issued at a discount and pays a coupon interest payment as well. For this type of OID bond, you must account for both the portion of the original issue discount that is attributable to a specific tax year, and the coupon interest payments that were made during that time.
Accounting for Original Issue Discount
With original issue discount bonds that are bought in the primary market when they are originally issued and held to maturity, this process is relatively straightforward. Where things get complicated is when an OID bond is bought in the secondary market after it is issued, and/or not held until maturity. In these cases there are 3 potential tax liabilities:
- The interest attributable to the bond’s original issue discount.
- The coupon interest payment made on the bond (if any).
- Any capital gain or loss that is made on the bond during the time in which it is held.
If the amount of the original issue discount is small enough, then the IRS allows you to treat it as a capital gain instead of interest. This is something which is known as the De Minimus Rule, which you can learn more about here.
For the definition and explanation of more bond related words visit the Learn Bonds glossary where we give the meaning of many additional terms.