A bond retires at maturity. On the maturity date, the bond pays back its face value and any accrued interest. It then stops accruing interest and is no longer traded. An issuer can retire a bond before maturity by calling it or buying it in the open market. The amount you receive from a bond that is retired early might be different than the face value. Your gain or loss depends on what you paid for the bond and the discount or premium you amortized.
Bond Discounts and Premiums
Discount bonds sell for less than their face values. Conversely, a premium bond sells for more than face value. If you pay face value for a bond, you've bought it at par. You don’t report a gain or loss when a bond you bought at par matures. You must amortize bonds that the issuer sold at a discount. This is original issue discount, or OID. Any discount the bond develops after issuance is market discount, and amortization is not required. It’s also not required for premium bonds. Amortization, or the lack of it, affects how you calculate the gain or loss on retired bonds.
Amortizing Discount Bonds
When you amortize a bond discount, you recognize part of the discount each year as income. Figure this amount using either the straight-line or constant yield method, which the Internal Revenue Service describes in Publication 550. Add the amortized amount to your bond’s cost basis. Also add it to your taxable income, unless the bond is a tax-free municipal. A fully amortized bond has an adjusted cost basis of par at maturity, so no gain or loss results. If you decline to amortize a market discount bond that retires normally, you must report the difference between the original cost basis and par as ordinary gain. If the bond is retired early, treat the gain as ordinary up to the bond’s accrued market discount. Treat the remainder as a capital gain.
Amortizing Premium Bonds
You have the option of amortizing a premium bond. The advantage of doing so is that you subtract the annual amortized amount from the year’s interest income, thereby reducing your taxable income. If you take this option, you must use the constant yield method to figure your annual amortization. Subtract the amortized amount from your bond’s cost basis. If you amortize the premium on a normally retired bond, you have no gain or loss. The loss on an unamortized premium bond at maturity is a capital loss.
An issuer can retire a callable bond on or after the call date. The call price is usually a little higher than par. A company can retire bonds at any time by repurchasing them in the open market. The price of repurchased bonds might be below, at or above par, but is normally just above the current market price. If a bond that you've been amortizing is retired early, recalculate your cost basis by applying any accrued amortization up to the retire date. Calculate your gain or loss as the difference between the price you receive at early retirement and your cost basis.
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