The Tax Treatment of an Acquisition Premium
When a bond with OID is purchased above its adjusted issue price, the resulting acquisition premium has specific tax rules that can lower your reported income.
When an investor purchases a bond, the price paid can differ from its face value, creating specific tax considerations. This is particularly true when the bond was originally issued at a discount. An acquisition premium occurs when a bond with original issue discount (OID) is bought for a price higher than its adjusted value at the time of purchase, but less than its face value at maturity.
The tax rules for an acquisition premium allow the bondholder to reduce the amount of OID they report as taxable interest income each year. This process, known as amortization, spreads the tax benefit of the premium over the remaining life of the bond.
Identifying and Calculating the Acquisition Premium
An acquisition premium occurs when a taxpayer buys a debt instrument with OID for a price greater than its adjusted issue price at the time of purchase. The adjusted issue price is the bond’s original issue price plus the accumulated OID up to the purchase date. The purchase price must also be less than the bond’s stated redemption price at maturity, which is its face value.
An acquisition premium should be distinguished from a market premium, which occurs when a bond is purchased for more than its stated redemption price at maturity. An acquisition premium exists only for OID bonds and applies when the purchase price is between the bond’s adjusted issue price and its face value. The tax treatments for market premium and acquisition premium are different.
To calculate the acquisition premium, first determine the amount paid above the bond’s adjusted issue price. This amount is then compared to the total remaining OID. The acquisition premium is the lesser of these two figures, ensuring the amortized premium does not exceed the total OID left on the bond.
For example, consider a corporate bond with a $1,000 face value and a $900 original issue price, resulting in a total OID of $100. An investor later buys the bond for $970 when its adjusted issue price has increased to $950 due to accrued OID. The acquisition premium is the purchase price ($970) minus the adjusted issue price ($950), which equals an amortizable premium of $20.
Amortization Methods and Tax Impact
Once calculated, the acquisition premium is amortized over the remaining life of the bond, which reduces the OID income the bondholder must report annually. The Internal Revenue Service (IRS) provides two amortization methods: the ratable accrual method and the constant yield method.
The default amortization method is the ratable accrual method. This approach involves dividing the total acquisition premium by the number of days from the purchase date to the bond’s maturity date. This daily amount is multiplied by the number of days the bond was held during the tax year to find the annual amortization, providing a consistent reduction of OID income.
In the previous example, the bond had a $20 acquisition premium. If 1,000 days remain until maturity, the daily amortization is $0.02 ($20 / 1,000 days). If the investor holds the bond for a full 365-day year, the total amortization for that year is $7.30, which is subtracted from the reported OID income.
Alternatively, a bondholder can elect to use the constant yield method, which ties the premium’s amortization to the bond’s yield to maturity. While more complex, this method can provide a more economically accurate measure of income. To calculate it, the bond’s adjusted acquisition price is multiplied by its yield to maturity, and the result is reduced by any qualified stated interest. The amortization amount is the difference between the OID calculated with and without the premium.
The election to use the constant yield method must be made for the first tax year the taxpayer acquires a bond with an acquisition premium. Once made, this election applies to all taxable bonds with an acquisition premium acquired in that year and all future years. The election cannot be revoked without IRS consent.
Adjusting Bond Basis and Reporting
Amortizing the acquisition premium affects the bond’s basis. For each dollar of premium used to reduce reportable OID income, the taxpayer must also increase their basis in the bond by the same amount. This upward adjustment ensures the correct calculation of capital gain or loss when the bond is sold or matures, preventing the same amount from being taxed twice.
From the previous example, the investor amortized $7.30 of the premium in the first year. This amount is added to the bond’s basis. If the initial basis was $970, the adjusted basis at year-end would be $977.30. This process continues each year the bond is held.
Acquisition premium amortization is reported on Schedule B of Form 1040. A broker reports the gross OID amount on Form 1099-OID, which the taxpayer then lists on Schedule B. On a separate line, the taxpayer subtracts the amortized acquisition premium as an “OID Adjustment” to arrive at the net taxable OID income.
Some brokers may report the net OID amount on Form 1099-OID after factoring in the amortization. In this case, Box 6 of the form (acquisition premium) will be blank, and the taxpayer should report the net amount directly on Schedule B without further adjustment. For detailed guidance, refer to IRS Publication 550 and Publication 1212.