Original issue discount (OID) bonds are bonds issued at a price less than their face value. The difference between the issue price and the face value is the original issue discount. The OID is treated as interest and is taxable as it accrues over the term of the bond. You also get to increase your basis in the bond by the amount of OID included in income. This reduces your capital gain — or increases your loss — when you sell it.
Example: You purchase a 10-year bond with a face value of $1,000 for $875. The OID on the bond is $125 -- the difference between the face value ($1,000) and the issue price ($875). You must report the $125 OID as income over the 10-year term of the bond ($12.50 per year), even though you don’t receive the interest until the bond matures. In addition, your basis in the bond will increase by $12.50 each year over the 10-year period ($887.50 in year 1).
The bond issuer will send you a Form 1099-OID that shows the amount of OID (box 1) that you need to include in your income. In some cases, though, you might need to recalculate the OID. For example, you might need to recalculate the OID because you purchased the bond after the date it was originally issued and you paid a premium for it, or because of a market discount.
For more information, see IRS Publication 1212: Guide to Original Issue Discount (OID) Instruments.