If you buy a bond at a premium -- meaning you pay more than the face amount -- you incur a loss of the amount of premium paid when the bond matures at par value. If the bond pays taxable interest, you can use the loss represented by the premium paid as a tax write-off. The tax rules give you two choices of how and when to use this tax loss deduction.
Included in Your Cost Basis
If you buy a premium bond, one option is to just include the premium in your cost basis to calculate a capital gain or loss when your sell the bond or when it matures. At maturity the premium becomes a capital loss. For example, you paid $105,000 for a bond that has a par value of $100,000. When the bond matures, you can claim the $5,000 premium paid as a capital loss on your income tax return.
Amortize the Premium
Another option for the use of a bond premium is to amortize the premium over the remaining life of the bond. Each year you amortize a portion of the premium using the constant yield method -- your broker can do the actual calculation -- and then apply the amount of amortization to reduce the taxable interest earned from the bond. The amount of premium amortization calculated each year reduces both the taxable income from the bond and the cost basis. When the bond matures at the par value, the initial premium will have been amortized away.
You can choose to start amortizing a bond premium for any tax year. You must include a letter to the IRS that you have elected to amortize your bond premium. The choice to amortize applies to all taxable premium bonds that you own. Once you elect to amortize your bond premiums you must continue to do so unless you receive written approval from the IRS to stop annual amortization. To request the change you must send in a Form 3115, Application for Change in Accounting Method. The IRS requires your reason for requesting the revocation of bond premium amortization.
Tax-free Municipal Bonds
The tax rules require you to use the amortization method on the premium of tax-free municipal bonds. Since the interest from municipal bonds is already tax-free, taking an amortization credit against the interest does not further reduce your income taxes. The requirement to amortize municipal bond premiums prevents you from using the premium as a capital loss when a bond matures at par.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.