Bond Premium

Bond premium is the excess of what a holder paid for a bond over what the bond will repay. Publication 550 defines it as "the amount by which your basis in the bond right after you get it is more than the total of all amounts payable on the bond after you get it (other than payments of qualified stated interest)," and gives the plain case: "a bond with a maturity value of $1,000 generally would have a $50 premium if you buy it for $1,050." The statute that governs its treatment is IRC 171, whose title is "Amortizable bond premium" and whose 171(b)(1) is headed "Amount of bond premium." Form 1099-INT uses the same words for boxes 11, 12 and 13.

A bond trades above face value when its coupon is higher than the yield the market now demands, a relationship the coupon rate and yield to maturity pages explain. This page is about what the tax law does with the premium once it exists: a holder who pays $1,050 for a $1,000 bond will receive $50 less at maturity than they paid, and IRC 171 is the set of rules for recognizing that $50 over the bond's life instead of as a loss at the end.

The premium is measured from basis, and sometimes to the call date. IRC 171(b)(1) determines the amount of bond premium "with reference to the amount of the basis (for determining loss on sale or exchange) of such bond" and, for a taxable bond, "with reference to the amount payable on maturity (or if it results in a smaller amortizable bond premium attributable to the period before the call date, with reference to the amount payable on the earlier call date)." So a premium callable bond may have to be amortized to its call date, which spreads the same premium over fewer years. The same subsection excludes the value of a conversion feature: "In no case shall the amount of bond premium on a convertible bond include any amount attributable to the conversion features of the bond." Because premium is measured from basis rather than from the issue price, IRC 171 applies whether the bond was bought at issue or in the secondary market, which is one way it differs from discount, where the tax law splits original issue discount from market discount by when the discount arose.

Taxable bonds: an election that offsets interest. IRC 171(a)(1) allows the amortizable premium on a taxable bond "as a deduction," but 171(c)(1) makes the whole section apply to taxable bonds "only if the taxpayer has so elected," and 171(e) changes the form the deduction takes: "in lieu of any deduction under subsection (a), the amount of any premium so allocated to any interest payment shall be applied against (and operate to reduce) the amount of such interest payment." The premium is therefore an offset against the coupon, not a line on Schedule A. Publication 550 gives the reporting: list the bond's interest on Schedule B, subtotal, then enter the year's amortization labeled "ABP Adjustment" and subtract it. Only where the premium allocable to a period exceeds that period's interest does any part become a deduction, and even then, per Regulation 1.171-2(a)(4), it is limited to the interest previously included on the bond, with the excess carried forward.

The election is one decision for every taxable bond. IRC 171(c)(2) provides that an election "shall also apply to all such bonds held by the taxpayer at the beginning of the first taxable year to which the election applies and to all such bonds thereafter acquired by him and shall be binding for all subsequent taxable years," revocable only with the Secretary's permission. Regulation 1.171-4(b) states it in one sentence: "The election under this section applies to all taxable bonds held during or after the taxable year for which the election is made." The election is made by simply reporting the amortization on a timely return for the first year it is to apply, with a statement attached. A holder who elects late cannot recover amortization that would have applied in earlier years.

Tax-exempt bonds: mandatory, and no deduction. IRC 171(a)(2) provides that for a bond whose interest is excludable from gross income "no deduction shall be allowed for the amortizable bond premium for the taxable year," and yet the premium must still be amortized. Publication 550 explains what that means: "If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year, you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on your tax return) by the amortization for the year." The logic is that the premium is the price of receiving above-market exempt interest, so it is recovered by shrinking the exempt interest, and a holder cannot instead carry the full basis to maturity and claim a capital loss.

Basis falls as premium is amortized. IRC 171(a)(3) points to 1016(a)(5), which reduces basis by the premium amortized on a taxable bond (or applied to reduce interest under 171(e)) and by the premium disallowed as a deduction on a tax-exempt bond. At maturity, a fully amortized bond has a basis equal to its face value, and repayment produces no gain or loss.

The method is a constant yield. IRC 171(b)(3) requires the amortization to be computed "on the basis of the taxpayer's yield to maturity," using the holder's basis and compounding at the close of each accrual period as defined for original issue discount. Regulation 1.171-2 spells out the three steps: find the yield that discounts the remaining payments to the purchase price, fix the accrual periods, and treat as premium for each period the excess of the period's interest over the adjusted acquisition price multiplied by the yield. Early periods therefore amortize less premium and later periods more, because the base shrinks.

The broker statement assumes you elected. The Instructions for Form 1099-INT direct a payer to report the year's premium amortization in box 11 (taxable bonds), box 12 (Treasury obligations) or box 13 (tax-exempt bonds) for a covered security acquired at a premium, and for the taxable boxes to do so "unless you were notified in writing that the holder did not want to amortize bond premium under section 171." A holder of taxable bonds who has not made the election and does not want to therefore has to tell the broker in writing; otherwise the statement shows an amortization figure the holder's return will not match. A related but different concept, acquisition premium, arises when a buyer pays more than the adjusted issue price of a bond that still has original issue discount; it reduces the OID reported rather than the coupon, and the original issue discount page covers it.

The holder's basis, usually the purchase price, is compared with the total of the payments the bond will make other than its regular interest. The excess is the premium. The yield that equates the purchase price with all remaining payments is computed, and in each accrual period the premium allocated to that period is the interest received less the yield applied to the adjusted acquisition price. On a taxable bond that allocation reduces the interest reported if the holder has elected; on a tax-exempt bond it reduces the exempt interest reported whether or not the holder wants it to. Basis falls by the same amount each year.

A hypothetical example, simplified to a single accrual period. Lorraine buys a taxable corporate bond with a $10,000 face value and a 5 percent coupon exactly one year before maturity, when the bond will pay its final $500 coupon and repay the $10,000. She pays $10,200. The remaining payments total $10,500, of which $500 is regular interest, so her bond premium is $10,200 − $10,000 = $200.

Her yield is the rate that turns $10,200 into $10,500 over the year: $10,500 ÷ $10,200 − 1 = 2.9412 percent. The premium allocable to the year is the coupon less the yield applied to her cost: $500 − ($10,200 × 0.029412) = $500 − $300.00 = $200, the whole premium, as it must be with one period left.

If she has elected to amortize, she reports $500 − $200 = $300 of interest income for the year, her basis falls from $10,200 to $10,000, and the repayment of $10,000 at maturity produces no gain or loss. Her broker's Form 1099-INT will show $500 in box 1 and $200 in box 11, unless she has told the broker in writing not to amortize.

If she has not elected, she reports the full $500 of interest, her basis stays at $10,200, and at maturity she has a $200 capital loss ($10,000 received against $10,200 basis). The same $200 shows up either way; the election decides whether it reduces ordinary interest income now or produces a capital loss at the end.

If the bond were tax-exempt, amortization would be mandatory. Lorraine would report $300 of tax-exempt interest rather than $500, her basis would fall to $10,000, and there would be no deduction and no loss at maturity.

Pros

• Electing to amortize on a taxable bond turns what would be a capital loss at maturity into a yearly reduction of ordinary interest income, which is usually the more valuable treatment.
• The offset is taken on Schedule B against the coupon, so it does not depend on itemizing deductions.
• Basis tracks the amortization, so the premium is recovered exactly once and the maturity repayment is clean.
• Brokers compute and report the figure for covered securities, so the holder who has elected can generally take the box 11 through 13 amounts as reported.

Cons

• The taxable-bond election is all-or-nothing across every taxable bond the holder owns or later buys, and revoking it requires IRS consent.
• A holder who does not want to amortize must tell the broker in writing, or the Form 1099-INT will report an amortization the return does not use.
• On a tax-exempt bond the amortization is compulsory and yields no deduction, so the premium paid for high exempt coupons cannot be recovered as a loss.
• A callable premium bond may have to be amortized to the call date, and a convertible's conversion value is excluded from the premium, so the amount amortized can be smaller than the premium paid.