Amortizable Bond Premium

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What Is an Amortizable Bond Premium?

The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis. https://76ca5f3599a16f088511b2836d7a39d7.safeframe.googlesyndication.com/safeframe/1-0-37/html/container.html

Key Takeaways

  • A tax term, the amortizable bond premium refers to the excess price (the premium) paid for a bond, over and above its face value.
  • The premium paid for a bond represents part of the cost basis of the bond, and so can be tax-deductible, at a rate spread out (amortized) over the bond’s lifespan.
  • Amortizing the premium can be advantageous, since the tax deduction can offset any interest income the bond generates, thus reducing an investor’s taxable income overall.
  • The IRS requires that the constant yield method be used to calculate the amortizable bond premium every year.

Understanding an Amortizable Bond Premium

A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.

The difference between the bond’s current price (or carrying value) and the bond’s face value is the premium of the bond. For example, a bond that has a face value of $1,000 but is sold for $1,050 has a $50 premium. Over time, as the bond premium approaches maturity, the value of the bond falls until it is at par on the maturity date. The gradual decrease in the value of the bond is called amortization.

Cost Basis

For a bond investor, the premium paid for a bond represents part of the cost basis of the bond, which is important for tax purposes. If the bond pays taxable interest, the bondholder can choose to amortize the premium—that is, use a part of the premium to reduce the amount of interest income included for taxes.

Those who invest in taxable premium bonds typically benefit from amortizing the premium, because the amount amortized can be used to offset the interest income from the bond. This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well. The cost basis of the taxable bond is reduced by the amount of premium amortized each year.

In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce his or her basis in the bond by the amortization for the year. The IRS requires that the constant yield method be used to amortize a