26 U.S.C. § 1277 — Deferral of interest deduction allocable to accrued market discount

(a) Unless this section provides otherwise, a taxpayer may deduct net direct interest expense for a market discount bond in a taxable year only to the extent the expense is greater than the part of the market discount assigned to the days in that year when the taxpayer held the bond. The assignment is made under section 1276(b). (b) (1)(A) If a taxable year has net interest income from a market discount bond and the taxpayer elects under this subparagraph for that bond, disallowed interest expense for the bond is treated as interest paid or accrued by the taxpayer in that year, but only up to the amount of that net interest income. (B) The disallowed amount is measured at the end of the preceding taxable year and does not include amounts already used under subparagraph (A). (C) “Net interest income” is the excess of the amount under subsection (c)(2) over the amount under subsection (c)(1). (2)(A) Unless this paragraph provides otherwise, all remaining disallowed interest expense for a bond is treated as interest paid or accrued in the taxable year when the bond is disposed of. (B) In a nonrecognition transaction, it is treated as interest in the disposition year only up to the gain recognized. The remaining amount is treated as disallowed interest expense: (I) for the transferee’s transferred-basis property in a transaction under section 1276(c)(1); or (II) for the exchanged-basis property in a transaction under section 1276(c)(2). (C) The amount excludes anything already used under paragraph (1). (3) “Disallowed interest expense” means the total amount disallowed under subsection (a) for the bond. (c) “Net direct interest expense” means, for a market discount bond, the excess, if any, of (1) interest paid or accrued during the taxable year on debt incurred or continued to buy or carry the bond over (2) all interest, including original issue discount, included in gross income for that year from the bond. For a bank financial institution defined in section 585(a)(2), whether interest falls under paragraph (1) is decided under principles similar to section 291(e)(1)(B)(ii). Under rules similar to section 265(a)(5), short-sale expenses count as interest when net direct interest expense is determined.