When you buy an existing note for less than its balance, the gap is generally market discount under IRC 1276 through 1278, and the part of it that has accrued is taxed as ordinary income when principal comes in, when the note pays off or when you sell it. Original issue discount, or OID, is a different thing: discount built into the note when it was first made, which the holder generally reports as it accrues under IRC 1271 through 1275, whether or not cash arrives.
This is general information from note brokers, not tax advice. The basics of how note income is taxed sit in how income from notes is taxed. This page goes one level down, into the rules that decide when the discount is counted and whether it is ordinary income or capital gain. Elections made under these rules can bind later years, so work through them with a CPA before you file the first return that includes a discounted note.
Two kinds of discount
| Market discount | Original issue discount (OID) | |
|---|---|---|
| When it arises | When you buy a note after it was made, for less than its balance | When the note is first made, if the amount to be repaid exceeds the issue price |
| Main rules | IRC 1276, 1277 and 1278 | IRC 1271 through 1275, with IRC 483 for some sales |
| General timing | Recognized as principal is received or the note is disposed of, unless you elect to include it each year | Included in income as it accrues on a constant yield basis |
| Character | Ordinary income to the extent accrued | Ordinary income, treated like interest |
The difference is who created the discount. On the typical private note purchase, the seller financed a property at a stated rate, years later you bought the note below its balance, and your discount is market discount. OID enters the picture only if the note itself was written with one, for example a below-market or zero-interest seller-financed note where the tax rules impute interest, as covered in AFR and imputed interest on seller financing.
How market discount is taxed
Market discount is measured against the note’s remaining principal when you buy it (or against its adjusted issue price, if the note also carries OID). The tax code treats a note as a bond for this purpose, so a mortgage note or a business promissory note is covered.
Accrual
By default the discount accrues ratably, spread evenly over the days from your purchase to the maturity date. You can instead elect a constant yield method, which accrues less in the early years and more later. On a note paid in installments the accrual is more involved, and your CPA will want the amortization schedule.
Principal payments and payoffs
Under IRC 1276, each principal payment you receive is treated as ordinary income up to the market discount that has accrued and not yet been taxed. When the note pays off early or you sell it, gain is ordinary income to the extent of accrued market discount. An early payoff can therefore pull a large slice of discount into a single tax year.
The election to include it currently
IRC 1278(b) lets you elect to include market discount in income each year as it accrues, rather than waiting for principal or a sale. Once made, the election applies to every market discount bond you acquire in that year and later years, and it can be revoked only with IRS consent. Some holders like it for smoother income, and others prefer deferral.
Borrowing to buy
If you borrow to buy or carry a market discount note, IRC 1277 can defer part of your interest deduction until the discount is recognized. Leverage inside a retirement account raises a separate issue under the unrelated business income rules, discussed in UBIT and UDFI in a self-directed IRA.
The de minimis rule
A small discount can be treated as zero. Under IRC 1278(a)(2)(C), market discount below one quarter of one percent of the remaining principal, multiplied by the number of complete years to maturity after you buy, is disregarded. The same one-quarter-percent test applies to OID under IRC 1273(a)(3). Disregarded discount is not ignored forever: on a note held as an investment, it generally shows up as capital gain when the note pays off or is sold.
An illustrative example
Round numbers, simplified. You buy a note with $120,000 of principal remaining and 12 complete years to maturity.
- The de minimis threshold is 0.25% of $120,000, or $300, times 12 years, which is $3,600.
- Pay $102,000 and the market discount is $18,000, well above the threshold. Spread ratably, it accrues at roughly $1,500 a year, and principal payments you collect are ordinary income up to whatever has accrued and not yet been taxed.
- If the borrower refinances after three years, roughly $4,500 has accrued. Your CPA then works out how much of it was already taxed through principal payments and how the rest of the gain on the payoff is treated.
- Pay $117,000 instead and the $3,000 discount is under the $3,600 threshold, so it is treated as zero market discount and generally reported as capital gain at payoff.
Illustrative figures only. Real accrual on an amortizing note, partial payments and your own tax position will change the numbers.
The discount itself comes from pricing, not from tax. Setting your yield and solving for the price, as in how to price a note as a buyer, produces the discount, and these rules then decide how it is taxed.
Paying more than the balance
A note with a high rate can sell above its remaining principal. That excess is bond premium, and IRC 171 lets you elect to amortize it against the interest income. If a note with OID is bought for more than its adjusted issue price but no more than its remaining principal, the excess is acquisition premium, which reduces the OID you include each year.
Records and reporting
Private notes often come with no Form 1099-OID or broker statement, so the holder usually has to compute the figures. Keep the closing statement, the principal balance at purchase, the maturity date, the payment history and any election you make. IRS Publication 550 discusses market discount and Publication 1212 discusses OID, and both are a good starting point for the conversation with your CPA. A holder who buys and sells notes as a business may be treated as a dealer, which can change the character of the income altogether.
Notes we broker come with the balance, the buyer’s yield and the discount stated, which gives your CPA the starting figures. Investors can join the buyer list to see them, and the note investing guide covers the rest of the buying process.
Related questions
Is the discount on a note I bought taxed as capital gain?
Generally not, to the extent it is market discount that has accrued. IRC 1276 treats accrued market discount as ordinary income when principal is received or the note is sold or paid off. A discount small enough to fall under the de minimis rule is the usual exception. Confirm with your CPA.
Is market discount the same as OID?
No. Market discount arises when you buy an existing note below its balance. OID is built into a note when it is first made, for example when a seller-financed note carries too little stated interest. They follow different code sections and different timing rules.
Do I have to report market discount every year?
Not by default. It is generally recognized as principal comes in or when the note is disposed of. You can elect under IRC 1278(b) to include it each year as it accrues, but the election covers every market discount note you acquire afterward and needs IRS consent to revoke.
Will I get a Form 1099 showing the discount?
Often not on a private note. Holders of privately made notes usually have to compute the accrual themselves, so keep the purchase price, the balance at purchase, the maturity date and the payment history.