I have already reviewed the IRS publication 550 section on “Limit on interest deduction for market discount bonds” but wanted to review the relevant IRC section (1277) for further clarification:
https://www.law.cornell.edu/uscode/text/26/1277
Section 1277 defines the “net direct interest expense” as the excess (if any) of the amount of margin interest paid over the aggregate amount of bond interest includible in gross income. It further states that the “net direct interest expense with respect to any market discount bond shall be allowed as a deduction for the taxable year only to the extent that such expense exceeds the portion of the market discount allocable to the days during the taxable year on which such bond was held by the taxpayer”.
Section 1277a states that the annual deduction is limited to the excess of the “net direct interest expense” over the allocable portion of market discount. Section 1277 also defines “disallowed interest expense” as the aggregate amount [of net direct interest expense] not previously allowed, and states that the “disallowed interest expense” will be allowed in the year the bond is disposed of.
The way this section is worded is confusing to me because “disallowed interest expense” is defined as the portion of “net direct interest expense” which has been disallowed. But assuming that the margin interest rate paid to purchase/carry the market discount bond is less than the bond’s coupon rate, the “net direct interest expense” will be 0 in the first place (since it is defined above as the excess, if any) and therefore the annual deductions and the “disallowed interest expense” at disposition will also be 0.
