Market discount is the opposite to bond premium amortization. It's only an issue if you own individual TIPS in a taxable account. It's not an issue if you own individual TIPS in a tax deferred or tax free account. It's also not an issue if you own TIPS mutual funds or ETFs in a taxable account.

Market discount arises when you buy a bond with a coupon rate below the market yield. The bond pays less interest than you actually earn. When the bond matures, you get a bump in the principal repayment.

The good thing about market discount is that you don't have to account for it every year. Although the IRS allows you to include a small piece of the discount as current interest income while you hold the bond, there's not a compelling reason for you to do so. You are usually better off deferring the income and the tax.

When you sell the bond or when the bond matures, the market discount is added as interest income, not capital gain.

The IRS publishes rules on market discount bonds in Publication 550 Investment Income and Expenses. I illustrate it with a real world example here.

Facts

Suppose you purchased ten 10-year TIPS (CUSIP 9128274Y5) at auction on Jan. 6, 1999. The interest rate was 3.875%. The yield was 3.898%. You paid 99.811 as the adjusted price on Jan. 15, 1999 (the issue date). The index ratio for this TIPS bond was 1.00000 on the issue date. These numbers are on the auction result announcement.

The bond matured on Jan. 15, 2009. The index ratio was 1.30914 on the maturity date.

Calculation

The cumulative OID you included as interest income from Jan. 15, 1999 to Jan. 15, 2009  was:

$1,000 * (1.30914 - 1.00000) * 10 = $3,091.40

The ten bonds paid $13,091.40 but your cost basis was

$99.811 * 10 + $3,091.40 = $13,072.50

Therefore you must add

$13,091.40 - $13,072.50 = $18.90

as interest income in 2009. As you can see, this is the same discount you had when you bought the bond:

(100 - 99.811) / 100 * $1,000 * 10 = $18.90

You don't have to pay tax on this discount until you sell the bond or the bond matures.