7625 / Is an investor who holds a Treasury bill (T-bill) required to include interest in income prior to sale or maturity of the bill?

However, a cash basis investor may elect to include in income, as it accrues prior to sale or redemption, the difference between the stated redemption price at maturity and his or her basis in the obligation (this difference is called “acquisition discount”). Such an election may not be limited to a particular bill, but applies to all short-term taxable obligations acquired on or after the first day of the first taxable year for which the election is made, and it continues to apply until the Service consents to revocation of the election.² (Short-term obligations are those having a fixed maturity date of one year or less after issue.)³ The election affects short-term taxable corporate obligations as well; however, in the case of corporate obligations, original issue discount is included unless the investor chooses to include “acquisition discount” with respect to all of them.⁴ With respect to interest-paying, short-term corporate obligations, elections to include discount as it accrues will also have the effect of requiring the taxpayer to include stated interest payments (not otherwise includable in income until paid) in income as they accrue.⁵ See also Q 7627.

Under the election, acquisition discount is considered to accrue daily on a ratable basis. That is, the amount of discount is divided by the number of days after the day the taxpayer acquired the obligation up to and including the day of its maturity.⁶ The taxpayer must include an amount equal to the sum of the daily portions for each day in the tax year he or she held the obligation.⁷ However, a taxpayer electing to include acquisition discount as it accrues may elect, under regulations, with respect to particular obligations, a constant interest rate (using yield to maturity based on the cost of the bill and daily compounding) and use ratable accrual on other short-term obligations. Once made, this election is irrevocable with respect to the obligations to which it applies.⁸

This election may, under some circumstances, be advantageous where leveraging is used by a cash basis investor to purchase or carry Treasury bills, since deduction of the interest expense up to the amount of discount accruing during the year must be deferred unless discount is currently included (see Q 8045).

While a cash basis investor is not usually required to include discount in income prior to sale or other disposition, certain taxpayers must include acquisition discount in income. The mandatory accrual rules apply to bills (1) held by accrual basis taxpayers, (2) held by a bank, (3) held by a regulated investment company (RIC) or common trust fund, (4) held as inventory, (5) identified⁹ as part of a hedging transaction, or (6) held by a pass-through entity (e.g., a trust, partnership, or S corporation) formed or availed of to avoid the mandatory inclusion rule, or a pass-through entity in any year in which taxpayers who would be subject to the rule own 20 percent or more of the value of the interests in the entity for 90 days or more.¹⁰ A taxpayer subject to these mandatory accrual rules may, under regulations, elect irrevocably to accrue discount with respect to any obligation on a constant rate (compounded daily) instead of ratably.¹¹

The basis of a T-bill is increased by amounts of accrued discount and interest included in income prior to disposition or redemption.¹²