Market discount on bonds offsetting capital gain or loss


P

Phil Lucido

Suppose I have a bond bought on the secondary market with a
market discount. I'm really only interested in munis, but I
think that part's unimportant here. On sale or redemption
of the bond, I'm supposed to declare the accrued market
discount as regular income. But I'm confused as to how that
interacts with any capital loss or gain.

IRS pub 550 for 2003 says (page 14 under Market Discount
Bonds) "[y]ou must treat any gain when you dispose of the
bond as ordinary interest income, up to the amount of the
accrued market discount." And on page 49 it says "[r]eport
the sale or trade of a market discount bond on Schedule D
line 1 or line 8. If the sale or trade results in a gain
and you did not choose to include market discount in income
currently, enter 'Accrued Market Discount' on the next line
in column (a) and the amount of the accrued market discount
as a loss in column (f).... Also report the amount of
accrued market discount in column (f) as interest income on
Schedule B line 1, and identify it as 'Accrued Market
Discount.'"

So there are the following situations, depending on the
value of any gain or loss (after adjusting my cost basis)
relative to the accrued market discount:

* Gain greater than accrued discount - simple enough, I
report the entire gain on Sched D as a capital gain, report
the market discount as an offsetting capital loss on the
next line, then report the discount as interest income on
Sched B.

* Gain greater than zero, less than accrued discount - I
would think this gets treated the same as the previous case,
so in effect I take a capital loss (gain minus accrued
discount), and report the full discount as interest income.
But on closer reading of those quotes, I'm not so sure. In
the page 14 quote, "up to" seems to imply I can only enter a
loss for the discount up to the amount of the gain, because
I only start showing a capital gain once the real gain
exceeds the discount. In other words, I can't turn the gain
into a capital loss. But that doesn't agree with the page
49 quote, which clearly says what to put on Sched D, giving
a net capital loss.

* Loss on the sale, but I still have accrued market discount
- in this case, do I make any entry in Sched D reporting the
market discount as a loss? It doesn't look like it, which
is kind of surprising. The quotes above clearly talk about
how to handle any gain, so they don't seem to apply here. I
would think I still have to report the discount as regular
income.

To put it in equations:

G = gain or loss, selling proceeds minus adjusted cost basis
M = accrued market discount
C = net capital gain or loss, after any offsetting of gain
by the discount

Possibility 1 - just treat all cases the same:
C = G - M
report G and -M in sched D, M in sched B

Possibility 2 - only take a capital loss for the discount
if there's a gain:
If G > 0
C = G - M
report G and -M in sched D, M in sched B
Else
C = G
report G in sched D, M in sched B

Possibility 3 - cap the amount of capital loss for the
discount to the gain
If G > M
C = G - M
report G and -M in sched D, M in sched B
Else If G > 0 And G < M
C = 0
report G and -G in sched D, M in sched B
Else
C = G
report G in sched D, M in sched B

None of these seem to both make sense and match those
quotes. #1 seems to be out, because the quotes talk in
terms of "gain", not "loss". #3 seems out, because there's
nothing on page 49 about capping the Sched D entry for
"Accrued Market Discount". And #2 seems wrong, because the
amount of capital loss suddenly jumps back to zero as gain
gets smaller and turns into a loss. That is, suppose I've
got market discount of $50. If #2 is correct, which seems
to reflect the quotes, the capital gain looks like this:

Gain Discount Capital Gain
---- -------- ------------
100 50 50
50 50 0
25 50 -25
1 50 -49
0 50 0
-50 50 -50

That can't be right, can it?

Thanks to anyone that actually read this far.

....Phil
 
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