4.17 Amortization of Bond Premium
Bond premium is the extra amount paid for a bond in excess of its principal or face amount when the value of the bond has increased due to falling interest rates. The premium is included in your basis in the bond but if the bond pays taxable interest, you may elect to amortize the premium by deducting it over the life of the bond. Amortizing the premium annually is usually advantageous because it gives an annual deduction to offset the interest income from the bond. Basis of the bond is reduced by the amortized premium. If you claim amortization deductions and hold the bond to maturity, basis is reduced by the entire amortized premium and you have neither gain nor loss at redemption.
You may not claim a deduction for a premium paid on a tax-exempt bond. However, you must still reduce your basis in the bond by the annual amortization amount. The amortized amount also reduces the amount of tax-exempt interest that you report on your return (4.24).
Dealers in bonds may not deduct amortization but must include the premium as part of cost.
Planning Reminder
Capital loss alternative to amortizing premium.
If you do not elect to amortize the premium on a taxable bond, you will realize a capital loss when the bond is redeemed at par or you sell it for less than you paid for it. For example, you bought a $1,000 corporate bond for $1,300 and did not amortize the $300 premium; you will realize a $300 capital loss when the bond is redeemed at par: $1,000 proceeds less $1,300 cost basis ($1,000 face value plus $300 premium). You could realize a capital gain if you sell the bond for more than the premium price you paid.
Determining the amortizable amount for the year.
The annual amortizable premium is based on the constant yield method if the bond was issued after September 27, 1985. This method is the same as the optional constant yield method for reporting market discount (4.20). See IRS Publication 1212 or consult a tax professional for making the complex computations.
For taxable bonds subject to a call before maturity, the amortization computation is based on the earlier call date if that results in a smaller amortization deduction.
Amortization election allowed in or after the year you acquire a bond.
An election to amortize premium on a taxable bond does not have to be made in the year you acquire the bond. Attach a statement to the tax return for the first year to which you want the election to apply. If the election is made after the year of acquisition, the premium allocable to the years prior to the year of election is not amortizable; the unamortized amount is included in your cost basis for the bond and will result in a capital loss when the bond is redeemed at par or sold prior to maturity for less than basis.
How to deduct amortized premium on taxable bonds.
The premium amortization for such bonds offsets your interest income from the bonds; see the Filing Tip in this section. Any excess of the allocable premium over interest income may be fully deducted as a miscellaneous deduction (not subject to the 2% floor) on Line 28 of Schedule A (Form 1040). However, the miscellaneous deduction is limited to the excess of total interest inclusions on the bonds in prior years over total bond premium deductions in the prior years.
Filing Tip
Effect of amortization election on other taxable bonds you acquire.
If you elect to amortize the premium for one bond, you must also amortize the premium on all similar bonds owned by you at the beginning of the tax year, and also to all similar bonds acquired thereafter. An election to amortize may not be revoked without IRS permission. If you file your return without claiming the deduction, you may not change your mind and make the election for that year by filing an amended return or refund claim.
Callable bonds.
On taxable bonds, amortization is based either on the maturity or earlier call date, depending on which date gives a smaller yearly deduction. This rule applies regardless of the issue date of the bond. If the bond is called before maturity, you may deduct as an ordinary loss the unamortized bond premium in the year the bond is redeemed.
Convertible bonds.
A premium paid for a convertible bond that is allocated to the conversion feature may not be amortized; the value of the conversion option reduces basis in the bond.
Premium on tax-exempt bonds.
You may not take a deduction for the amortization of a premium paid on a tax-exempt bond. However, you must still figure the amortization for each year and reduce your basis in the bond by the amortized amount. When you dispose of the bond, you amortize the premium for the period you held the bond and reduce the basis of the bond by the amortized amount. If the bond has call dates, the IRS may require the premium to be amortized to the earliest call date.