When you buy a bond, you expect to receive interest payments and a return of the bond’s face value when it matures. The bond issuer states the interest payments and face value in the contract that must accompany the issuance of a bond. If you buy a taxable bond selling at a premium, (i.e., for more than face value, or par) you have a couple of options on how to report the taxes on the bonds. However, if you buy a bond premium on a tax-exempt bond, you must amortize it using the constant-yield method.
Owning Tax-Free Municipal Bonds
Municipal bonds are issued by state and local governmental agencies, usually to finance projects for the improvement of the community. You must report on your federal return the tax-free interest you receive from municipal bonds, even though the interest isn’t taxable. Premium municipal bonds offer several advantages, including:
- Tax-free income: Municipal bonds are typically exempt from federal, state and local income tax.
- Increased cash flow: Because premium bonds pay above-market coupon interest, holders receive an increased cash flow relative to bonds paying the prevailing market interest rate or less. You purchase a premium bond’s increased cash flow by paying an above-par price. The higher coupon you receive might offset the initial premium you pay.
- Avoiding market discount costs: Buying a bond at a market discount (that is, at a price below the face-value plus any accrued interest) can result in additional ordinary or capital gains tax. Purchasing a bond at premium offers protection from these additional taxes.
Like all bonds, municipals are subject to the risk of default.
Understanding Bond Cash Flows
The typical bond pays periodic interest, and it returns its face value to the bondholder on the maturity date. The interest paid by the bond is called the coupon. For example, if a bond with a $1,000 face value has a 5 percent annual coupon paid semiannually, the bondholder receives a payment of $25 (i.e., .05 x $1000 / 2) every six months plus a redemption of $1,000 when the bond matures. For a five-year bond, the total cash flow of the bond would be 5 years x 2 coupons per year x $25 per coupon + $1,000 redemption, or $1,250. This is the cash flow you would receive if you bought the bond five years before maturity. The total return, or yield-to-maturity, on the bond depends on how much you pay for it.
Understanding Bond Prices
The example five-year bond pays an annual coupon rate of 5 percent. If the prevailing market rate on similar debt happens to be 5 percent, the bond would likely sell for par, which is equal to the face value ($1,000 in the example), and the yield-to-maturity would be 5 percent. However, if the prevailing market rate is lower, say, 3.676 percent, the bond’s price would bid up because of its relatively generous coupon.
Using a bond price calculator, you’d find that the market price would be $1,060, a $60 premium above face value. In other words, you’d pay $60 more than the redemption amount for the privilege of receiving a 5-percent annual interest rate, when the prevailing rate is only 3.676 percent. Your cost basis for the bond is the purchase price, in this case $1,060. The loss of $60 when the bond is redeemed is partially or fully compensated by the above-market coupon rate.
Understanding Bond Premium Amortization
If the example bond was taxable, you’d have to pay tax on coupon interest of $50/year. However, because you paid a premium to buy the bond, your effective interest income is reduced by your loss of $60 over the five-year bond term.
One way to handle the loss of the premium amount is to amortize it. This is an accounting procedure where you annually reduce the cost basis of the bond by a portion of original premium amount. If the bond interest is taxable, you would subtract the annual amortized amount from your bond interest, thereby reducing your taxable income. If the bond is a tax-exempt municipal, you report the loss of premium value and subtract the loss from the cost basis of the bond, but you don’t subtract it from your taxable income. Tax-exempt bonds purchased for a price above par must be amortized.
Amortizing a Bond
You could try to amortize the bond by dividing the total loss of premium by the number of years until maturity. In the example bond, this is $60 / 5 years, or $12 per year. However, the Internal Revenue Service requires you to use the constant yield method to figure the annual amortized amount, which creates different amounts each year. You deduct the annual amortized amount from your bond’s cost basis. For example, if the original cost basis is $1,060 and the first year amortization is $19, the new cost basis is $1,041. Since the bond is a tax-free municipal, you don’t get to deduct the $19 loss of premium.
Using the Constant Yield Method
To figure the annual amortization amount on a tax-free municipal bond, perform the following steps:
- Find the yield-to-maturity on the bond. You can get this via an Excel spreadsheet function or an online calculator, although it is usually reported by your broker on your transaction confirmation. In the example bond, the yield-to-maturity is 3.676 percent per year, or 1.838 percent semi-annual.
- Calculate the amortization amount for the coupon period by multiplying the current cost basis by the yield-to-maturity, adjusted for the length of the coupon period. For the example bond, the first-period amortization amount is (.01838 x $1,060), or $19.48.
- Subtract the amortization amount from the bond’s current cost basis. In the example, the new cost basis at the start of the second coupon period is ($1,060 - $19.48), or $1,040.52.
- Repeat the process for each coupon period until the bond matures.
If you sell the bond before maturity, you need to prorate the last amortization amount by the number of days since the start of the current coupon period. You might have to report a capital gain or loss on the sale of the bond if you receive more than or less than the bond’s cost basis, respectively.
Reporting Premium Municipal Bond Taxes
You will receive a copy of IRS Form 1099-INT, Interest Income, for each bond you held that paid interest during the year. For tax-free municipal bonds, the interest is reported separately in a box labeled “Tax-exempt interest.” For each premium municipal bond, subtract the amortized premium from the year’s tax-exempt interest and tally the result. Include the tally (along with tax-free interest from other sources, such as par and discount municipal bonds and tax-free bond mutual funds) in the total tax-exempt interest that you report on Form 1040.
Tax-Exempt Original Issue Discount
Original issue discount (OID) refers to the discount on bonds issued at a price below par. For example, if a corporation issues a $1,000-face-value bond at a price of $900, the OID amount is $100. OID is interest, and you must include it when you report taxable and tax-exempt interest income on Form 1040. Taxable OID, tax-exempt OID and bond premium are reported on Form 1099-OID. It is possible to acquire an OID bond in the secondary market at a premium. That is, a bond issued at a discount might be trading at a premium price (above par) on the bond exchange. The premium must be amortized and subtracted from the OID interest reported as either taxable or tax-exempt interest on Form 1040.
- The requirement to amortize the premium paid on a municipal bonds prevents you from claiming the premium as a capital loss when the bond matures at the face value.
- Calculate in advance the premium amortization for every year until the bond matures. Then each year for your taxes just look up the amortization and plug the amount into your tax return calculations.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.