Bond Premium Amortization: How It Affects Your Taxes

When an investor purchases a bond, they may pay more than its stated face value, a situation known as buying a bond at a premium. This often occurs when the bond’s stated interest rate is higher than the current market interest rates for similar securities. The excess amount paid over the face value is the bond premium. This premium is not a loss but rather an additional cost that can have tax implications over the life of the bond.

To account for this overpayment, investors can use a method called bond premium amortization. This process involves gradually reducing the bond’s cost basis by the premium amount over the bond’s remaining life. Amortization systematically allocates a portion of the premium to each interest payment period. This accounting treatment changes how an investor reports interest income and calculates their gain or loss when the bond is ultimately sold or matures.

The Amortization Election and Its Tax Impact

For investors holding taxable bonds, such as those issued by corporations or the U.S. Treasury, the decision to amortize the premium is an optional one. An investor makes a formal election to begin amortizing, and once made, this choice applies to all taxable bonds they own at that time and any acquired in the future. This election is binding and can only be revoked with permission from the Internal Revenue Service (IRS).

The tax treatment differs significantly for tax-exempt bonds, like those issued by municipalities. For these securities, amortization is not optional; it is mandatory. Investors must amortize the premium on tax-exempt bonds, even though they cannot deduct the amortized amount from their taxable income. The primary purpose of this mandatory amortization is to accurately adjust the bond’s cost basis for calculating capital gains or losses.

Choosing to amortize a taxable bond premium has two direct effects on an investor’s tax liability. First, the amortized amount for each year is used to reduce the amount of taxable interest income reported from the bond. For example, if a bond pays $500 in interest during the year and the calculated premium amortization is $50, the investor only reports $450 of taxable interest income. This provides an annual tax benefit by lowering taxable income.

The second consequence is the corresponding reduction of the bond’s cost basis. Each time a portion of the premium is amortized and used to offset interest income, the same amount must be subtracted from the original purchase price to establish the bond’s adjusted basis. If the bond is held to maturity, the basis will have been reduced by the full premium amount, resulting in no capital loss. Without amortization, the investor would report the full $500 of interest annually and then realize a capital loss of the full premium amount at maturity.

Information Needed to Calculate Amortization

To calculate the bond premium amortization each year, an investor must gather specific information about the bond.

• The bond’s purchase price, which is the total amount paid including any commissions or fees.
• The bond’s face value, also known as par value, which is the amount the issuer pays the bondholder at maturity.
• The stated interest rate, or coupon rate, which determines the periodic interest payments.
• The interest payment dates, which define the accrual periods for the amortization calculation.
• The bond’s maturity date, which establishes the time frame for amortizing the entire premium.
• The yield to maturity (YTM) at the time of purchase, which is the total expected return if the bond is held to maturity and is required for the IRS calculation method.

Methods for Calculating Premium Amortization

The IRS requires investors to use a specific method for amortizing bond premiums for any bonds issued after September 27, 1985. This required approach is the Constant Yield Method. This method is based on the bond’s yield to maturity at the time of purchase and ensures that the amortized amount accurately reflects the bond’s economic accrual of interest over its life. It treats the bond premium as a reduction in the effective interest earned.

Under the constant yield method, the calculation is performed for each accrual period, which is the period between interest payments. The first step is to multiply the bond’s adjusted basis at the beginning of the period by the constant yield to maturity rate. The result is the total interest income that should be recognized for that period. The difference between this calculated interest income and the actual cash interest payment received is the premium amortization for that period.

For instance, imagine an investor buys a bond with an adjusted basis of $1,050 and a YTM of 4% (or 2% per semiannual period). The actual coupon payment received is $30. The interest income for the period would be the adjusted basis multiplied by the yield ($1,050 2% = $21). The amortized premium for this period is the difference between the coupon payment and the calculated interest ($30 – $21 = $9). This $9 reduces both the taxable interest and the bond’s basis for the next period.

Reporting Amortization on Your Tax Return

After calculating the correct amortization amount, the next step is to report it on your federal income tax return. The process begins with Form 1099-INT, Interest Income. Brokers may report this information in two ways: they might report the net interest income in Box 1, having already subtracted the premium amortization, or they may report the gross interest in Box 1 and show the bond premium amortization amount separately in Box 11.

Regardless of how the broker reports it, the investor must properly account for the amortization on Schedule B (Form 1040), Interest and Ordinary Dividends. If your Form 1099-INT shows the gross interest, you will list the full amount from Box 1 on line 1 of Schedule B. Then, on a separate line below, you will subtract the calculated amortization amount for the year. You should label this subtraction “Amortizable Bond Premium Adjustment” or “ABP Adjustment.”

This subtraction reduces the total interest income that is carried forward to your Form 1040, ensuring you are only taxed on the net amount. It is important to verify the amount in Box 11 of Form 1099-INT against your own calculations, as you are ultimately responsible for the accuracy of the figures on your return.

If it is the first year you are choosing to amortize premiums on taxable bonds, you must formally make the election. This is done by attaching a statement to your tax return for that year. The statement should explicitly state that you are making the election under Internal Revenue Code Section 171. It should also specify the bonds to which the election applies, providing enough detail for the IRS to identify the securities.