Bond Premium Amortization

If you pay a premium to buy a bond, the premium is part of your basis in the bond. If the bond yields taxable interest, you can choose to amortize the premium. This generally means that each year, over the life of the bond, you use a part of the premium to reduce the amount of interest includible in your income. If you make this choice, you must reduce your basis in the bond by the amortization for the year.

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 by the amortization for the year.

Bond premium.   Bond premium is 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). For example, a bond with a maturity value of $1,000 generally would have a $50 premium if you buy it for $1,050.

Basis.   In general, your basis for figuring bond premium amortization is the same as your basis for figuring any loss on the sale of the bond. However, you may need to use a different basis for convertible bonds, bonds you got in a trade, and bonds whose basis has to be determined using the basis of the person who transferred the bond to you. See section 1.171-1(e) of the regulations.

Dealers.   A dealer in taxable bonds (or anyone who holds them mainly for sale to customers in the ordinary course of a trade or business or who would properly include bonds in inventory at the close of the tax year) cannot claim a deduction for amortizable bond premium.

See section 75 of the Internal Revenue Code for the treatment of bond premium by a dealer in tax-exempt bonds.

How To Figure Amortization

For bonds issued after September 27, 1985, you must amortize bond premium using a constant yield method on the basis of the bond's yield to maturity, determined by using the bond's basis and compounding at the close of each accrual period.

Constant yield method.   Figure the bond premium amortization for each accrual period as follows.

Step 1: determine your yield.   Your yield is the discount rate that, when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage.

If you do not know the yield, consult your broker or tax advisor.

Step 2: determine the accrual periods.   You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.

Step 3: determine the bond premium for the accrual period.   To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result 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 that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.

Example.   On February 1, 2001, you bought a taxable bond for $110,000. The bond has a stated principal amount of $100,000, payable at maturity on February 1, 2008, making your premium $10,000 ($110,000 - $100,000). The bond pays qualified stated interest of $10,000 on February 1 of each year. Your yield is 8.0745% compounded annually. You choose to use annual accrual periods ending on February 1 of each year. To find your bond premium amortization for the accrual period ending on February 1, 2002, you multiply the adjusted acquisition price at the beginning of the period ($110,000) by your yield. When you subtract the result ($8,882) from the qualified stated interest for the period ($10,000), you find that your bond premium amortization for the period is $1,118.

Special rules.   For special rules that apply to variable rate bonds, inflation-indexed bonds, and bonds that provide for alternative payment schedules or remote or incidental contingencies, see section 1.171-3 of the regulations.

Bonds Issued Before September 28, 1985

For these bonds, you can amortize bond premium using any reasonable method. Reasonable methods include:

1. The straight-line method, and
2. The Revenue Ruling 82-10 method.

Straight-line method.   Under this method, the amount of your bond premium amortization is the same each month. Divide the number of months you held the bond during the year by the number of months from the beginning of the tax year (or, if later, the date of acquisition) to the date of maturity or earlier call date. Then multiply the result by the bond premium (reduced by any bond premium amortization claimed in earlier years). This gives you your bond premium amortization for the year.

Revenue Ruling 82-10 method.   Under this method, the amount of your bond premium amortization increases each month over the life of the bond. This method is explained in Revenue Ruling 82-10.

Choosing To Amortize

You choose to amortize the premium on taxable bonds by reporting the amortization for the year on your income tax return for the first tax year for which you want the choice to apply. You should attach a statement to your return that you are making this choice under section 171. See How To Report Amortization, next.

This choice is binding for the year you make it and for later tax years. It applies to all taxable bonds you own in the year you make the choice and also to those you acquire in later years.

You can change your decision to amortize bond premium only with the written approval of the IRS. To request approval, use Form 3115, Application for Change in Accounting Method.

How To Report Amortization

Subtract the bond premium amortization from your interest income from these bonds.

Report the bond's interest on line 1 of Schedule B (Form 1040). Several lines above line 2, put a subtotal of all interest listed on line 1. Below this subtotal, print ABP Adjustment, and the amortization amount. Subtract this amount from the subtotal, and enter the result on line 2.

Bond premium amortization more than interest.   If the amount of your bond premium amortization for an accrual period is more than the qualified stated interest for the period, you can deduct the difference as a miscellaneous itemized deduction on line 27 of Schedule A (Form 1040).

But your deduction is limited to the amount by which your total interest inclusions on the bond in prior accrual periods is more than your total bond premium deductions on the bond in prior periods. Any amount you cannot deduct because of this limit can be carried forward to the next accrual period.

Pre-1998 election to amortize bond premium.   Generally, if you first elected to amortize bond premium before 1998, the above treatment of the premium does not apply to bonds you acquired before 1988.

Bonds acquired before October 23, 1986.   The amortization of the premium on these bonds is a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit.

Bonds acquired after October 22, 1986, but before 1988.   The amortization of the premium on these bonds is investment interest expense subject to the investment interest limit, unless you choose to treat it as an offset to interest income on the bond.

Expenses of Producing Income

You deduct investment expenses (other than interest expenses) as miscellaneous itemized deductions on Schedule A (Form 1040). To be deductible, these expenses must be ordinary and necessary expenses paid or incurred:

1. To produce or collect income, or
2. To manage property held for producing income.

The expenses must be directly related to the income or income-producing property, and the income must be taxable to you.

The deduction for most income-producing expenses is subject to a 2% limit that also applies to certain other miscellaneous itemized deductions. The amount deductible is limited to the total of these miscellaneous deductions that is more than 2% of your adjusted gross income.

For information on how to report expenses of producing income, see How To Report Investment Expenses, later.

Attorney or accounting fees.   You can deduct attorney or accounting fees that are necessary to produce or collect taxable income. However, in some cases, attorney or accounting fees are part of the basis of property. See Basis of Investment Property in chapter 4.

Automatic investment service and dividend reinvestment plans.   A bank may offer its checking account customers an automatic investment service so that, for a charge, each customer can choose to invest a part of the checking account each month in common stock. Or, a bank that is a dividend disbursing agent for a number of publicly-owned corporations may set up an automatic dividend reinvestment service. Through that service, cash dividends are reinvested in more shares of stock, after the bank deducts a service charge.

A corporation in which you own stock also may have a dividend reinvestment plan. This plan lets you choose to use your dividends to buy more shares of stock in the corporation instead of receiving the dividends in cash.

You can deduct the monthly service charge you pay to a bank to participate in an automatic investment service. If you participate in a dividend reinvestment plan, you can deduct any service charge subtracted from your cash dividends before the dividends are used to buy more shares of stock. Deduct the charges in the year you pay them.

Clerical help and office rent.   You can deduct office expenses, such as rent and clerical help, that you pay in connection with your investments and collecting the taxable income on them.

Cost of replacing missing securities.   To replace your taxable securities that are mislaid, lost, stolen, or destroyed, you may have to post an indemnity bond. You can deduct the premium you pay to buy the indemnity bond and the related incidental expenses.

You may, however, get a refund of part of the bond premium if the missing securities are recovered within a specified time. Under certain types of insurance policies, you can recover some of the expenses.

If you receive the refund in the tax year you pay the amounts, you can deduct only the difference between the expenses paid and the amount refunded. If the refund is made in a later tax year, you must include the refund in income in the year you received it, but only to the extent that the expenses decreased your tax in the year you deducted them.

Fees to collect income.   You can deduct fees you pay to a broker, bank, trustee, or similar agent to collect investment income, such as your taxable bond or mortgage interest, or your dividends on shares of stock.

Fees to buy or sell.   You cannot deduct a fee you pay to a broker to acquire investment property, such as stocks or bonds. You must add the fee to the cost of the property. See Basis of Investment Property in chapter 4.

You cannot deduct any broker's fees, commissions, or option premiums you pay (or that were netted out) in connection with the sale of investment property. They can be used only to figure gain or loss from the sale. See Reporting Capital Gains and Losses, in chapter 4, for more information about the treatment of these sale expenses.

Investment counsel and advice.   You can deduct fees you pay for counsel and advice about investments that produce taxable income. This includes amounts you pay for investment advisory services.

Safe deposit box rent.   You can deduct rent you pay for a safe deposit box if you use the box to store taxable income-producing stocks, bonds, or other investment-related papers and documents. If you also use the box to store tax-exempt securities or personal items, you can deduct only part of the rent. See Tax-exempt income under Nondeductible Expenses, later, to figure what part you can deduct.

State and local transfer taxes.   You cannot deduct the state and local transfer taxes you pay when you buy or sell securities. If you pay these transfer taxes when you buy securities, you must treat them as part of the cost of the property. If you pay these transfer taxes when you sell securities, you must treat them as a reduction in the amount realized.

Trustee's commissions for revocable trust.   If you set up a revocable trust and have its income distributed to you, you can deduct the commission you pay the trustee for managing the trust to the extent it is to produce or collect taxable income or to manage property. However, you cannot deduct any part of the commission that is for producing or collecting tax-exempt income or for managing property that produces tax-exempt income.

If you are a cash-basis taxpayer and pay the commissions for several years in advance, you must deduct a part of the commission each year. You cannot deduct the entire amount in the year you pay it.

Investment expenses from pass-through entities.   If you hold an interest in a partnership, S corporation, real estate mortgage investment conduit (REMIC), or a nonpublicly offered regulated investment company (mutual fund), you can deduct your share of that entity's investment expenses. A partnership or S corporation will show your share of these expenses on your Schedule K-1. A nonpublicly offered mutual fund will indicate your share of these expenses in box 5 of Form 1099-DIV, or on an equivalent statement. Publicly-offered mutual funds are discussed later.

If you hold an interest in a REMIC, any expenses relating to your residual interest investment will be shown on line 3b of Schedule Q (Form 1066). Any expenses relating to your regular interest investment will appear in box 5 of Form 1099-INT or box 7 of Form 1099-OID.

Report your share of these investment expenses on Schedule A (Form 1040), subject to the 2% limit, in the same manner as your other investment expenses.

Including mutual fund or REMIC expenses in income.   Your share of the investment expenses of a REMIC or a nonpublicly offered mutual fund, as described above, are considered to be indirect deductions through that pass-through entity. You must include in your gross income an amount equal to the amount of the expenses allocated to you, whether or not you are able to claim a deduction for those expenses. If you are a shareholder in a nonpublicly offered mutual fund, you must include on your return the full amount of ordinary dividends or other distributions of stock, as shown in box 1 of Form 1099-DIV or an equivalent statement. If you are a residual interest holder in a REMIC, you must report as ordinary income on Schedule E (Form 1040) the total amounts shown on lines 1b and 3b of Schedule Q (Form 1066). If you are a REMIC regular interest holder, you must include the amount of any expense allocation you received on line 8a of Form 1040.

Publicly-offered mutual funds.   Publicly-offered mutual funds, generally, are funds that are traded on an established securities exchange. These funds do not pass investment expenses through to you. Instead, the dividend income they report to you in box 1 of Form 1099-DIV is already reduced by your share of investment expenses. Therefore, you cannot deduct the expenses on your return.

Include the amount from box 1 of Form 1099-DIV in your income.

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