Accretion of discount is a crucial accounting and tax concept for bond investors who purchase fixed-income securities at prices below their face (or par) value. It refers to the systematic increase of the bond’s cost basis over its life, gradually recognizing the gain that arises because the bond will pay its full face value at maturity even though it was bought for less.

Why Bonds Trade at a Discount

Bonds often trade below face value due to several factors:

  • Interest Rate Changes: When market interest rates rise above a bond’s coupon rate, the bond’s price generally falls to offer a comparable yield.
  • Issuer’s Credit Risk: If the issuer’s creditworthiness declines, the bond’s price will drop to compensate investors for added risk.
  • Time to Maturity: Longer-term bonds are more sensitive to interest rate fluctuations, which can lead to greater discounts over time.

Purchasing discounted bonds implies buying future income greater than the current price paid. Accretion of discount is a method to reflect this upcoming income incrementally.

How Accretion of Discount Works

When you buy a bond at a discount, such as paying $900 for a bond with a $1,000 face value, the $100 difference represents a gain to be recognized over the bond’s term. Accretion involves increasing your cost basis each year by adding a portion of this $100 discount.

There are two main methods used for accretion:

  1. Constant Yield Method: This is generally required for tax purposes and calculates accretion by applying a constant effective yield to the bond’s adjusted basis annually, reflecting the bond’s true yield to maturity (YTM). It’s more precise but mathematically complex.

  2. Straight-Line Method: Simpler and less accurate, this method divides the total discount evenly over the number of years until maturity. It is typically allowed only for certain tax-exempt bonds if elected.

Example of Straight-Line Accretion

Buying a $1,000 bond at $900 with 10 years to maturity results in a $100 discount. Using straight-line:

  • Annual accretion = $100 ÷ 10 = $10
    Each year, your cost basis increases by $10 until, at maturity, it equals $1,000, eliminating additional taxable gain on redemption.

Tax Implications

According to IRS guidelines, accretion of discount affects how income from bonds is reported:

  • Taxable Bonds (e.g., Corporate, Treasury): Accretion must generally use the constant yield method. The yearly accreted amount is reported as taxable interest income on your tax return—even if not received in cash—also known as “phantom income.” This approach distributes the tax liability over the life of the bond.
  • Tax-Exempt Bonds: The accreted discount is usually tax-exempt income, just like the coupon interest, but accretion must be reflected to maintain proper tax basis and avoid taxable capital gains if sold before maturity.

Original Issue Discount (OID) vs. Market Discount

It’s essential to distinguish between:

  • Original Issue Discount (OID): Issued below face value at inception, these bonds require mandatory accretion using strict IRS rules.
  • Market Discount: Bonds purchased below face value in the secondary market but originally issued at or near par. Investors may elect to accrete annually or defer recognition until sale or maturity, where the gain is treated as ordinary income to the extent of market discount.

Investors often find it beneficial to accrete market discount annually to avoid larger tax bills at sale.

Common Mistakes to Avoid

  • Ignoring accretion can cause incorrect gain or loss reporting.
  • Confusing accretion of discount with amortization of premium (the opposite, relevant for bonds bought at a premium).
  • Misapplying the straight-line method for taxable bonds where constant yield is required.
  • Overlooking the tax implications, leading to unexpected tax liabilities.

Who Should Understand Accretion of Discount?

Bond investors, tax professionals, and accountants must know how accretion impacts taxable income and cost basis reporting. Accurate accretion accounting aids in compliance and strategic tax planning.

Additional Resources and Interlinks

To understand related topics, see our detailed articles on Bond Premium Amortization and Market Discount.

For official guidance, consulting IRS Publication 550 on investment income is highly recommended.

Summary: Accretion of discount distributes the taxation of gains from discounted bonds over their term, helping investors recognize income annually rather than all at once at maturity. This method protects accurate tax reporting and aligns accounting with the economic reality of bond investments.

(Last updated for tax year 2025.)