Question

Original issue discount must be amortized and included in gross income in addition to any interest payments taxpayers actually receive. Also, the tax basis of a bond or note is increased by the amount of original issue discount amortized into income. In contrast, market discount is not amortized into income unless taxpayers elect to do so. Rather, the market discount that would have been amortized into income (on an annual basis using a straight line method) if the taxpayer had elected to amortize the market discount into income is treated as ordinary income when the bond or note is sold or when it matures.Explain?

Answer 1

Original issue discount on bonds must be amortized and included in gross income, whereas market discount is not unless elected by the taxpayer. The present discounted value of a bond is influenced by its face value, coupon rate, maturity date, and prevailing market interest rates, which determines the bond's investment attractiveness.

Step-by-step explanation:

The discussion concerns the tax treatment of original issue discount (OID) and market discount on bonds for income tax purposes. Original issue discount is the difference between the face value of a bond and its offering price if issued at a discount. Taxpayers must include the amortized portion of OID in their gross income each year, which also increases the tax basis of the bond. Conversely, market discount arises when a bond's market price falls below its face value after issuance and generally, it is not included in gross income unless the taxpayer elects to amortize it. Without such an election, the market discount becomes ordinary income upon the sale or maturity of the bond.

Understanding the present discounted value (PDV) of a bond is crucial for investors. The PDV is influenced by the bond's face value, coupon rate, maturity date, and current market interest rates. These factors determine the maximum price an investor is willing to pay for the bond. If interest rates rise after a bond is issued, the bond's price typically decreases, and vice versa.