Revenue Code 171: Tax Rules for Bond Premiums
Understand the tax treatment when you pay more than a bond's face value. This guide explains how your tax reporting choices affect your investment returns.
When an investor purchases a bond, the price paid can be more than the bond’s principal or face value. This excess payment is known as a bond premium, and it has specific tax implications. The rules governing this area allow investors to make certain decisions that affect how their bond investments are taxed over time.
Understanding Bond Premium
A bond premium occurs when an investor pays a price higher than a bond’s stated face value, which is the amount the issuer will pay back at maturity. For instance, if a bond with a $1,000 face value is purchased on the secondary market for $1,050, the $50 difference is the bond premium. This situation arises when the bond’s fixed interest rate, or coupon rate, is higher than current market interest rates for similar new bonds.
Investors are willing to pay this premium because the bond’s interest payments are more attractive than what they could get from other available investments. The premium effectively compensates the seller for the above-market interest payments the new owner will receive. This extra cost is not lost money but is treated as part of the investment’s basis, reflecting interest rate movements since the bond was first issued.
The Amortization Election
For owners of taxable bonds, Internal Revenue Code Section 171 provides a choice regarding the tax treatment of the premium. An investor can elect to amortize the bond premium over the life of the bond. This election is made by claiming the amortization on the tax return for the first year the choice applies and attaching a statement. Once made, this election is binding for all taxable bonds the investor owns and any acquired in the future, and revoking it requires IRS permission.
This choice contrasts with the rules for tax-exempt bonds. For bonds where the interest income is not subject to federal tax, amortization of the premium is mandatory. This means investors holding tax-exempt bonds must reduce their basis in the bond each year by the allocable premium amount.
Tax Treatment of Amortized Premium
When an investor elects to amortize the premium on a taxable bond, the amortized amount for the year is used to reduce the total taxable interest income reported from that bond. For example, if a bond pays $60 in interest and the amortizable premium for the year is $5, the investor reports only $55 of interest income. This process spreads the tax benefit of the premium over the bond’s life.
Simultaneously, the bond’s cost basis is reduced each year by the amount of the amortized premium. This adjustment is necessary to prevent a double tax benefit, ensuring the investor cannot also claim a capital loss for the premium amount when the bond is sold or matures. For instance, a bond purchased for $1,050 with a $50 premium will have its basis reduced to $1,000 over its life, resulting in no gain or loss if held to maturity.
Brokerage firms often simplify this process for investors by reporting the net interest income and the amount of bond premium amortization on Form 1099-INT. The amortized amount may appear in Box 11, which directly reduces the taxable interest reported in Box 1. This reporting streamlines the tax preparation process.