If you purchased an individual bond over the past couple of years you probably paid a high premium to get any sort of a yield. When a bond comes due it is redeemed at face value, so any premium that you paid for the bond disappears at maturity. How you account for the lost bond premium in your cost basis can be a little more complicated than with a stock, so the purpose of this article is to highlight the cost basis issues associated with bond premiums. (For related reading, see 5 Basic Things To Know About Bonds.)
TUTORIAL: Bond Basics: Introduction

The first thing you need to know about your bond is whether it is taxable or tax exempt. If your bond is taxable then you have options, but if you paid a premium on a tax-exempt bond then you only have one option, amortizing your premium. (This article will explore each of the major categories of bonds. For more, see Taxation Rules For Bond Investors.)

Fortunately for taxable bondholders the simplest option is also the default option. The default option allows the bondholder to use their purchase price as their cost basis. Using this method allows the bondholder to take a loss when the bond comes due for face value or when they sell the bond for less than what they paid for it. This option is not available to tax exempt bondholders as they must amortize their premium.

Bond Premium Amortization
Amortization of the bond premium lets the bond holder carve off a small piece of the premium each year and use it to offset the annual interest from the bond during the same time period. If your bond was purchased after September 27, 1985 then you will probably use the constant yield method to amortize your premium. For in depth examples on how to amortize your premiums you can reference IRS Publication 550, but here are the basic steps:

Step 1: Determine your yield to maturity of the bond. This step should be pretty easy, because this information should be listed in the trade confirmation or quote when you purchase your bond.

Step 2: Determine accrual periods, which can't be longer than 12 months. The accrual period starts when you first buy the bond and it ends when the bond matures or you sell it. The computation is easier when the accrual periods are the same as the intervals between interest payments.

Step 3: Determine the amount of premium to amortize for the given accrual period. To determine this value you need to multiply your adjusted acquisition price at the beginning of the accrual period by your yield to maturity. Then you subtract the amount from the qualified stated interest for the period. Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After the initial amortization calculation is made your basis is decreased by the amount of bond premium that has been previously amortized. The best way to understand how all this works is through an example.

A taxable corporate bond with a face value of $100,000 paying 5.96% interest on 12/31 of each year is purchased after the interest is paid out on 1/1/2011 for $111,000 with four years left until maturity and it has a yield to maturity of 3.00%.

Year 1 Amortization Calculation:

($100,000 x 5.96%) = $5,960 Qualified Stated Interest

-($111,000 x 3.00%) = -$3,330 Your Yield

Year 1 Amortization = $2630

This would be the amortization schedule:

Purchase 1/1/2011 1/1/2012 1/1/2013 1/1/2014 Redemption 1/1/2015
Bond Premium available for amortization $11,000 $8,370 $5,661 $ 2,871 $0
Cost basis at the beginning of the year $111,000 $108,370 $105,661 $102,871 $100,000
Amortized premium available to offset interest payments $2,630 $2,709 $ 2,790 $ 2,871 $11,000
$0 Capital Loss

In exchange for the basis reduction, an individual is allowed to reduce their qualified stated interest from the same period that the basis was amortized. Based on the amortization schedule from the example, the bond holder is allowed to reduce their taxable bond interest by $2,630. For someone with a sizable taxable bond portfolio and a lot of capital losses there is a sizable opportunity that people can take advantage of when they amortize their premiums. (For related reading, see Asset Allocation In A Bond Portfolio.)

For example, if a taxpayer has $50,000 in carryover losses, $60,000 in bond interest payments, and $26,000 available from premium amortization, they can reduce their taxable bond interest from $60,000 down to $34,000. This would be a much better result then taking a capital loss on the premium when the bond matures.

With long term capital gains and income tax rates likely to go higher by the end of 2012, someone can make the case for selling their long term bonds with embedded capital gains now and buying equivalent premium bonds back. This strategy would allow an individual to realize a 15% capital gain on the sale of their bonds, while the purchase of equivalent premium bonds would reduce future ordinary interest income through premium amortization.

The bottom line is that amortization of premiums gives bondholders the ability to arbitrage capital gains with the ordinary interest income they report on Schedule B of their 1040. For an individual with a large portfolio of taxable bonds, the opportunity to optimize for taxes can increase an investor's after tax return. That said, taxable bond investors need to be aware that once you change from the default method to the amortization method, you have to use it for all your taxable bonds and you have to get permission from the IRS to change it back. (For related reading, see How To Appeal Your IRS Audit.)

Additional Complications for Tax-Exempt Bondholders
The interest offset can work wonders for your taxable bond portfolio, but it does nothing for someone with tax exempt bonds. In fact, if your bonds aren't both federal and state income tax exempt, you could end up getting dinged on your state income tax return.

The reason so many bondholders get penalized on their state income tax return is because the year-end 1099 sent out by brokerage firms doesn't factor in the interest reduction bondholders are due for the premium amortization (Treasury Regulation 1.171-2 Example 4). As a result, most people will report the full amount of tax-exempt interest reported on their 1099 directly onto line 8b of their 1040, and in turn, overpay on their state income tax returns.

Some states like Connecticut will filter out the bond amortization on non-Connecticut municipal bonds, but a lot of states are ignorant of the issue and pull whatever is listed on line 8b of your 1040 onto the state return. In general, people living in states with high income tax rates should try to avoid purchasing tax exempt bonds with premiums that are not also tax exempt in their state. Tracking and complying bond amortization issues can be difficult, so it is important that you keep your tax advisor up to speed on the facts of your situation. (For related reading, see The Basics Of Municipal Bonds.)

The Bottom Line
Many bondholders have looked to increase their yield without fully understanding the consequences of purchasing individual bonds with large premiums. Individuals with premium bonds should review their individual bonds to see if there are arbitrage opportunities available and to make sure they are not over paying on state income taxes. If premium amortization makes your head want to explode, you can simply buy a bond mutual fund as they are required to amortize premiums. (For related reading, see Get Acquainted With Bond Price/Yield Duo.)

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