Market discount arises where the price of a bond declines below its face amount because it carries an interest rate that is below the current rate of interest.
When you realize a profit on the sale of a market discount bond, the portion of the profit equal to the accrued discount must be reported as ordinary interest income rather than as capital gain. Alternatively, an election may be made to report the accrued market discount annually instead of in the year of disposition.
These rules apply to taxable as well as tax-exempt bonds bought after April 30, 1993. However, there are these exceptions: (1) bonds with a maturity date of up to one year from date of issuance; (2) certain installment obligations; and (3) U.S. Savings Bonds. Furthermore, you may treat as zero any market discount that is less than one-fourth of one percent (.0025) of the redemption price multiplied by the number of full years after you acquire the bond to maturity. Such minimal discount will not affect capital gain on a sale.