Sometimes bonds that you purchase have OID in the bond description. When does this happen, what does it mean, and how does it impact your cost basis accounting for tax purposes?
A bond is classified as OID for "original issue discount" if the price at issuance is less than par value by more than the margin allowed by the tax code. If it is a small difference, it is considered de minimis (too little to worry about) and can be ignored. If it is a large difference, the OID rules come into play.
Under the de minimis rule, a discount of 25 basis points times the number of years until maturity is allowed. As an example. a corporate bond due in ten years can sell for as little as 97.50 without creating OID reporting obligations on the Form 1099. This is based on 25 basis points (0.0025 or 0.25%) times ten years = 2.50% which equates to a price of $97.50 per $100.00 of par value.
The issuance price of the bond when it is first sold to the public determines the OID factor. The broker/dealer holding your bond in street name will report on your Form 1099 an additional interest income amount for OID. This amount is calculated using the yield to maturity method (also called constant yield method) and is the difference between the coupon interest collected in cash for the interest payment dates falling in that tax year and the actual interest earned for the yield to maturity at purchase.
It is fairly straight-forward if you buy the bond at the original issuance date (also called dated date)--you just pick up the OID amount on your tax return as additional interest income and you are done.
Where it gets complicated is if you are not the first purchaser but instead buy the bond later in the secondary market. The long-term OID based on the original issuance price will be calculated and reported to you as if you bought it on the dated date. However, you paid a different price later so you have to apply a market rate adjustment to correct the long-term OID to the actual additional interest income earned for your actual purchase price. How do you do this?
First of all, if you purchased the bond at a premium (you paid more than par value) you can stop right there. Your market rate adjustment is equal to the entire amount of long-term OID. Just report both amounts (add and subtract) on your Schedule B so that the IRS knows you did not just ignore it.
If your brokerage firm is really on the ball, there will be a market adjustment amount displayed as additional non-reportable information in your Form 1099 detail. (You always wondered what that meant.) However, it has been our experience that even when a bond is purchased through the same broker/dealer, the market rate adjustment often doesn't make it onto the Form 1099 report set (in the additional information section not reported to the IRS.)
If the market rate adjustment is given, you take it as a deduction from long-term OID amount that you report on your tax return. (Since it is shown as a positive number, it is often unclear to the taxpayer and even to tax preparers whether it is to be added or subtracted from interest income. It should be subtracted.)
If the market rate adjustment is not shown and you need to calculate it, or if you just want to check on what your brokerage firm is reporting as your market rate adjustment for a particular bond, here is what you do:
Find your original trade confirmation with the settlement date, dated date, first coupon date, interest coupon rate, purchase price, interest payment frequency, maturity date, and yield to maturity. Input these factors in our Amortization Calculator (see link above.) Add up each year's discount amortization displayed in the Amortization Calculator Results. This amount is your true total discount amortization for the year from that bond. Compare it to the long-term OID that is reported for that bond. The difference between the two is your market rate adjustment for the year. In other words, the sum of the long-term OID reported on Form 1099 and the market rate adjustment deduction should equal the total discount amortization for that calendar year on the amortization table you printed out.
How do you report it? First show "long-term OID" from your Form 1099 as a line item on your Form 1040 Schedule B Interest Income. On the next line of Schedule B show "market rate adjustment to long-term OID" as a negative amount. The net difference is then taxable interest income (if it is a taxable bond.)
Reporting this market rate adjustment can produce fairly large deductions from interest income when there have been major changes in interest rates between the time the bond was originally sold into the public markets and when you purchased it. Don't let that deduction go to waste.
The net difference between the long-term OID and the market rate adjustment computed above should be added to the cost basis of your bond each year. If you have calculated it properly each year, by the time the bond matures your adjusted cost basis will be at par value.
For those readers who want all the details, IRS Publication 1212 can be downloaded by clicking on the PDF icon. It is the official IRS explanation of how to account for Original Issue Discount bonds.