Subject: Bonds - Amortizing Premium

Last-Revised: 26 Dec 2007
Contributed-By: Chris Lott (contact me)

The IRS requires investors who purchase certain bonds at a premium (i.e., above par, which means above face value) to amortize that premium over the life of the bond. The reason is fairly straightforward. If you bought a bond at 101 and were redeemed at 100, that sounds like a capital loss -- but of course it really isn't, since it's a bond (not a stock). So the IRS prevents you from buying lots and lots of bonds above par, taking the interest and a phony loss that could offset other income.

Here's a bit more discussion, excerpted from a page at the IRS. If you pay a premium to buy a bond, the premium is part of your cost basis in the bond. If the bond yields taxable interest, you can choose to amortize the premium. This generally means that each year, over the life of the bond, you use a part of the premium that you paid to reduce the amount of interest that counts as income. If you make this choice, you must reduce your basis in the bond by the amortization for the year. If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond by the amortization for the year.

To compute one year's worth of amortization for a bond issued after 27 September 1985 (don't you just love the IRS?), you must amortize the premium using a constant yield method. This takes into account the basis of the bond's yield to maturity, determined by using the bond's basis and compounding at the close of each accrual period. Note that your broker's computer system just might do this for you automatically.

IRS publication 550 states that a bond holder can choose to begin amortizing the bond at any time. However, if the bond holder wishes to stop amortizing the bond, the IRS must be notified. This choice does not affect the acquisition price to use, which is the price adjusted as if amortization began in the first year of ownership.

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