Capital Gains on Bond Premium and Discount

A bond purchased above par value is bought at a premium; one bought below par is at a discount. When you sell before maturity, the tax treatment of your gain or loss depends on how the IRS classifies the premium or discount, whether the bond is taxable or tax-exempt, and your holding period.

Premium Bonds: Amortization and Basis Reduction

You buy a corporate bond with 10 years to maturity at $1,050 when par value is $1,000. The $50 premium reflects the bond’s coupon rate being above current market interest rates. As time passes, the bond’s price will “roll down” toward par at maturity—a built-in depreciation.

For taxable bonds (corporate bonds, Treasury bonds), the IRS requires you to amortize the premium over the remaining life of the bond. You reduce your basis each year by the amortized amount, and you cannot claim a capital loss deduction on the difference when the bond matures or is redeemed. The amortization is a non-deductible reduction in basis—it simply lowers your cost basis, deferring the loss recognition until sale.

Example: You buy a 10-year corporate bond at $1,050 par. Straight-line amortization spreads the $50 premium over 10 years = $5 per year. Each year, your basis drops $5. After 3 years, your basis is $1,035. If you sell at $1,020 in year 3, your loss is $1,035 − $1,020 = $15, a capital loss.

If you held for more than one year, it’s a long-term capital loss, which offsets capital gains first, then up to $3,000 of ordinary income per year.

For tax-exempt municipal bonds, you cannot elect to amortize the premium. Instead, the premium simply reduces your basis—no annual deduction, no annual reduction in basis, no interest income. You absorb the premium as a basis reduction, and if you sell at a loss, the loss is not deductible (because municipal bond interest itself is not taxable, losses tied to that interest are also not deductible).

Market Discount: The 6-Month Rule

A different rule applies to bonds purchased below par value in the secondary market (market discount), distinct from original-issue discount.

You buy a bond for $950 when par is $1,000. The $50 discount reflects either:

1. The coupon rate being below current market rates, or
2. Credit deterioration pushing the bond’s price down.

When you sell, any gain attributable to the discount is taxed as ordinary income under Internal Revenue Code §1276 if you held the bond for six months or less. If you held it longer than six months, the gain is treated as a capital gain.

Example: You buy a bond at $950; par is $1,000. You hold 4 months and sell at $970. The $20 gain is entirely ordinary income (short holding period). If you’d held 7 months, the $20 gain would be a long-term capital gain.

This 6-month rule applies to the discount portion only. If market conditions improve and the bond price rises above par, any gain beyond par is always a capital gain, regardless of holding period.

Sale Before Maturity: Capital Gain vs. Ordinary Outcome

When you sell a bond in the secondary market before maturity, your gain or loss comprises:

1. The accretion or depreciation of price from your purchase price to the sale price.
2. The character of that gain (capital gain or ordinary income) depends on what portion relates to market discount.

If you bought a bond at par and sell it higher, the gain is a capital gain. If you bought at a market discount and sell within 6 months, part of the gain is ordinary income; after 6 months, all is capital gain.

The IRS does not tax the price appreciation on its own as ordinary income; only the discount portion qualifies as ordinary income under the short-holding rule. This distinction matters most for bonds trading at steep discounts—distressed corporates, older municipal bonds, or zero-coupon bonds.

Original-Issue Discount: Different Animal

Original-issue discount (OID) applies when a bond is first issued below par—e.g., a Treasury zero-coupon bond sold at $500 for $1,000 par due in 10 years. The $500 discount is built into the bond ab initio.

OID is accrued annually as phantom interest income, taxable each year even if you don’t receive cash. You cannot defer the tax until maturity or sale. This is handled on Form 1099-OID by the bond issuer or broker.

When you sell an OID bond, you’ve already reported the accrual annually, so your basis has effectively grown year by year. Any appreciation beyond accrued OID is a capital gain.

Which Bonds Face This Complexity?

Corporate bonds: Most subject to premium amortization if purchased above par; market discount rules apply to secondary-market purchases below par.

Treasury bonds and notes: Premium amortization applies. Discounts trigger the same 6-month rule.

Municipal bonds: Premiums do not reduce basis annually; losses on municipal bond sales are generally not deductible because municipal bond income is tax-exempt.

High-yield bonds: Often trade at discounts. If held short-term, discount gains are ordinary income. Long-term holdings enjoy capital gain treatment.

Convertible bonds: These hybrid bonds can trade at premiums (for the embedded option value). Premium amortization still applies.

Practical Example: Holding Through the 6-Month Threshold

You buy a bond trading at a $30 market discount: purchase price $970, par $1,000. You hold 5 months and sell at $985. The $15 gain is entirely ordinary income.

But if you held 6 months and a day before selling at $985, the $15 gain is a long-term capital gain. That one extra day shifts the tax bill from your marginal rate (potentially 37%) to the long-term capital gain rate (0%, 15%, or 20%). On a $15 gain, the savings is modest—but on larger discounts, reaching 6 months can materially reduce your tax.

Reporting on Taxes

• Capital gains from bond sales go on Schedule D and Form 8949.
• Premium amortization on taxable bonds is reported separately on Form 4952 or included in your basis reduction directly.
• OID accrual is reported on Form 1099-OID.
• Municipal bond premiums reduce basis with no annual deduction; losses are not deductible.

See also