How to Amortize a Taxable Bond Premium

When an investor purchases a bond, the price paid might be different from the bond’s principal amount, also known as its face or par value. A bond premium occurs when the purchase price is higher than this face value. This situation often arises when the interest rate stated on the bond, the coupon rate, is higher than the prevailing market interest rates for similar securities.

The process of accounting for this premium over the bond’s life is called amortization. Amortization allows for the gradual reduction of the premium over the remaining term of the bond. Conceptually, it treats the premium paid as an adjustment to the interest income received, spreading its financial impact over time rather than absorbing it all at once upon maturity or sale.

The Election to Amortize Taxable Bond Premium

For individuals holding taxable bonds, the decision to amortize the premium is elective. The primary result of making this election is that the amortized portion of the premium for a given year reduces the amount of interest income from the bond that is subject to tax. This effectively lowers the bondholder’s taxable income for each year the bond is held.

Once a taxpayer makes the election to amortize, it is binding for all taxable bonds they currently own and any they acquire in the future. This is not a choice that can be made on a bond-by-bond basis. Revoking this election requires formal permission from the Internal Revenue Service (IRS). The election is made by attaching a statement to a timely filed federal income tax return for the first year it applies, indicating the choice is being made under Internal Revenue Code Section 171.

In contrast, for tax-exempt bonds, amortization of the premium is mandatory. While the premium must be amortized each year, the amortized amount is not deductible because the interest itself is not taxable at the federal level. The purpose of mandatory amortization for tax-exempt bonds is to adjust the bond’s cost basis.

Information Required for Amortization

To calculate the amortization amount, several pieces of information about the bond are required:

• The bond’s exact purchase price, which is the total amount paid to acquire the security, including any commissions paid to a broker. This is typically found on the trade confirmation statement.
• The bond’s face value, or par value. This is the amount the issuer will pay the bondholder at maturity and is the principal on which interest payments are calculated.
• The coupon interest rate, which is the fixed annual interest rate paid by the issuer.
• The yield to maturity (YTM) at the time of purchase. The YTM represents the total annualized return an investor can expect if the bond is held until it matures, factoring in both the coupon payments and the premium paid.

Calculating Bond Premium Amortization

The IRS requires the use of the constant yield method for calculating premium amortization on bonds issued after September 27, 1985. This method, also known as the effective interest method, results in a different amount of amortization for each period.

The first step is to determine the interest income for the period. This is done by multiplying the bond’s adjusted basis at the beginning of the period by its yield to maturity. For the very first period, the adjusted basis is the total purchase price. This calculated amount represents the true economic interest earned on the investment for that period.

The second step is to identify the actual cash interest payment received, often called the coupon payment. This is calculated by multiplying the bond’s face value by its stated coupon rate. The difference between the interest income calculated in the first step and the coupon payment received is the amount of bond premium to be amortized for that period.

Finally, the bond’s adjusted basis must be updated for the next accrual period by subtracting the amortization amount. This new, lower adjusted basis is then used to calculate the interest income for the subsequent period, repeating the process until the bond matures.

Reporting Amortization and Adjusting Basis

The amortized premium is not a separate deduction but rather an adjustment that reduces the taxable interest income from the bond. On Schedule B of Form 1040, the taxpayer first lists the total interest received from the bond as reported on Form 1099-INT. Below this, they should write “ABP Adjustment” and show the amortization amount as a negative number, subtracting it from the total interest.

This direct offset ensures the taxpayer receives the benefit of the amortization against ordinary income, which is often taxed at higher rates than capital gains. Amortizing the premium also has a direct impact on the bond’s cost basis. Each year, the cumulative amount of the amortized premium reduces the original purchase price basis of the bond.

This adjustment is necessary for correctly determining the capital gain or loss when the bond is ultimately sold or matures. When the disposition occurs, the gain or loss is calculated on Form 8949 by subtracting the adjusted basis from the sale proceeds. Failure to properly reduce the basis would result in an overstated loss or an understated gain.