For the 2025 U.S. federal tax year, an individual holds a long-term zero-coupon bond issued with original issue discount (OID) and receives no cash interest payments during the year because the bond does not mature until a future year. Under IRC Section 1272, how is the OID on this bond treated for the 2025 tax year?
- None of the OID is taxable in 2025, because OID is includible in income only in the year the bond is sold, redeemed, or matures, when the cash is actually received
- The OID is taxable in 2025 only if the individual elects to report it currently; otherwise, reporting may be deferred until a later year of the individual's choosing
- A portion of the OID must be included in the individual's gross income for 2025 as it accrues under the constant-yield method, even though the individual receives no cash payment from the issuer during the year
- The OID is treated as a nontaxable return of the individual's original investment each year until the bond matures, at which point the entire accumulated discount becomes taxable as a single lump sum
Why C? And why not the others?
Correct answer: C. A portion of the OID must be included in the individual's gross income for 2025 as it accrues under the constant-yield method, even though the individual receives no cash payment from the issuer during the year
IRC Section 1272 generally requires a holder of a debt instrument issued with OID to include a ratable portion of the discount in gross income each year as it accrues, computed under a constant-yield method, regardless of whether the holder actually receives any cash payment from the issuer during that year; this is why holders of zero-coupon bonds must report phantom income annually even though all cash is received only at maturity. The option deferring all taxation until sale, redemption, or maturity is wrong because Section 1272 specifically overrides cash-receipt timing and requires annual accrual-based inclusion. The option making current inclusion elective is wrong because the annual accrual of OID is a mandatory rule under Section 1272 for most debt instruments, not a taxpayer election to defer. The option treating the discount as a nontaxable return of investment until a lump-sum inclusion at maturity is wrong because it describes the opposite of how Section 1272 operates; the discount is recognized incrementally over the bond's life rather than being held back and taxed all at once at the end.
Source: IRS Publication 1212 (Rev. December 2025), Guide to Original Issue Discount (OID) Instruments (irs.gov/pub/irs-pdf/p1212.pdf)