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

Except as otherwise provided in this section, 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 (as determined under the rules of section 1276(b)). there is net interest income for any taxable year with respect to any market discount bond, and the taxpayer makes an election under this subparagraph with respect to such bond, shall be determined as of the close of the preceding taxable year, and shall not include any amount previously taken into account under subparagraph (A). For purposes of this paragraph, the term “net interest income” means the excess of the amount determined under paragraph (2) of subsection (c) over the amount determined under paragraph (1) of subsection (c). Except as otherwise provided in this paragraph, the amount of the disallowed interest expense with respect to any market discount bond shall be treated as interest paid or accrued by the taxpayer in the taxable year in which such bond is disposed of. the disallowed interest expense with respect to such bond shall be treated as interest paid or accrued in the year of disposition only to the extent of the amount of gain recognized on such disposition, and in the case of a transaction described in section 1276(c)(1), of the transferee with respect to the transferred basis property, or in the case of a transaction described in section 1276(c)(2), with respect to the exchanged basis property. For purposes of this paragraph, the amount of the disallowed interest expense shall not include any amount previously taken into account under paragraph (1). For purposes of this subsection, the term “disallowed interest expense” means the aggregate amount disallowed under subsection (a) with respect to the market discount bond. the amount of interest paid or accrued during the taxable year on indebtedness which is incurred or continued to purchase or carry such bond, over the aggregate amount of interest (including original issue discount) includible in gross income for the taxable year with respect to such bond.