Original issue discount (OID) is a form of interest. It usually occurs when institutions issue bonds at a price less than their redemption value at maturity. The difference between these 2 amounts is the OID.
For bonds issued after 1984, the OID is treated as interest. It's 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.

Ex: 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 report the $125 OID as income over the 10-year term of the bond ($12.50 per year). You do this even though you don't receive the interest until the bond matures. Your basis in the bond will also increase by $12.50 each year over the 10-year period.

If the bond was issued before 1985, special rules apply:

• Bonds issued after May 27, 1969, but before 1985 -- If the underlying instrument is a capital asset, add OID to the basis as it accrues each year.
• Bonds issued before May 28, 1969 -- No addition to basis is allowed for OID

The bond issuer will send you a Form 1099-OID. This form shows the amount of OID (box 1) to include in your income. Sometimes you might need to recalculate the OID. Ex: You might need to recalculate the OID if you purchased the bond after the date it was originally issued and you paid a premium for it. Or, you might have gotten a market discount.

To learn more, see IRS Publication 1212: Guide to Original Issue Discount (OID) Instruments.