Question

On January 1, 2018, Kunto, a cash basis taxpayer, pays $46,228 for a 24-month certificate. The certificate is priced to yield 4% (the effective interest rate) with interest compounded annually. No interest is paid until maturity', when Kunto receives $50,000. In your computations:
a. Compute Kunto’s gross income from the certificate for 2018.
b. Compute Kunto’s gross income from the certificate for 2019.
Round any amounts to the nearest dollar.

Answer 1

The difference between the amount due at maturity is actually interest but is referred to as original issue discount. In such an arrangement, the Code requires the original issue discount to be reported when it is earned, regardless of the taxpayer’s accounting method. The interest “earned” is calculated by the effective interest rate method. The original issue discount rules do not apply to U.S. savings bonds or to obligations with a maturity date of one year or less from the date of issue.

Kunto’s gross income from the certificate is $3,772 ($50,000 − $46,228). Kunto’s income earned each year is calculated as follows:

 

a. 

2018: $46,228 × 4% = $1,849.12 rounded to $1,849.

 

b. 

2019: [($46,228 + $1,849) × 4%] = $1,923.08, rounded to $1,923.

a. 2018: $1,849

b. 2019: $1,923