Each state handles income and deductions differently. An investor also has the option to not accrue market discount for the period s/he held the bond. In this case, if the bond is held to maturity, the difference between the redemption price and the cost basis is added to the bondholder’s income. If the bond is sold before it matures, any gain made from the accretion in bond value is treated as interest income. To put another way, the gain realized on the disposition of a market discount bond must be recognized as interest income to the extent of the accrued market discount, and any remaining gain will be capital if the bond is a capital asset in the hands of the holder.
Accrued market discount from a US Treasury obligation is not deductible on your state return because the effective paid interest there was coming from a private party, not the US treasury. If you buy the bond from the government, you can subtract the interest. If you buy the bond from a 3rd party, the interest is not deductible.
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