Amortization of bond premium is the writing off of the extra amount paid for a bond above what the bond will actually repay, spread across the periods until it matures rather than taken all at once. In the hands of an investor the tax rules do it by netting: a holder amortizes bond premium by offsetting the interest allocable to an accrual period with the premium allocable to that period, and the premium is allocated to periods based on a constant yield (26 CFR 1.171-1).
The netting is the part that surprises people. Amortized premium is not normally a deduction, it is a reduction of the interest the holder reports.
Two Different Amortizations Share the Name
The phrase describes two separate exercises on opposite sides of the same bond, and mixing them up is the most common error with this term.
On the issuer’s books, premium is the excess of what an issue raised over the face amount, and it is amortized to interest expense across the life of the bonds so that the carrying amount reaches face at maturity. That treatment, the interest method behind it and a worked schedule are in bonds payable. The tax rules for an issuer’s bond issuance premium sit elsewhere again, at 26 CFR 1.163-13, and are not the rules described here (26 CFR 1.171-1).
Everything below is the holder’s side: an investor who paid more for a bond than it will return, working out what that costs and when.
Elective on a Taxable Bond, Required on a Tax-Exempt One
The two cases run opposite ways, which is the single most useful thing to know about this term.
A holder may elect to amortize bond premium on a taxable bond (26 CFR 1.171-1). It is a choice, and a holder who does not make it simply reports the full stated interest and carries the premium in basis instead.
A holder must amortize bond premium on a bond that is a tax-exempt obligation (26 CFR 1.171-1). There is no election there, and no benefit either, since the interest being offset was not taxable to begin with. The amortization still reduces basis, which is why a tax-exempt holder who ignores it overstates basis and understates gain on a later sale. The basis adjustments themselves are governed by 26 CFR 1.1016-5 (26 CFR 1.171-1).
How a Period’s Premium Is Worked Out
The mechanism is netting against interest, and the timing follows the holder’s own accounting. A holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to that period, and the offset occurs when the holder takes the qualified stated interest into account under the holder’s regular method of accounting (26 CFR 1.171-2).
Finding the amount for a period runs in three steps (26 CFR 1.171-2).
First, determine the holder’s yield: the discount rate that, applied to all remaining payments on the bond including qualified stated interest, produces an amount equal to the holder’s basis in the bond. Only payments falling after the acquisition date count. The yield is calculated as of the date the holder acquires the bond, must be constant over the term, and must be calculated to at least two decimal places when expressed as a percentage.
Second, determine the accrual periods for the bond.
Third, the bond premium allocable to an accrual period is the excess of the qualified stated interest allocable to that period over the product of the holder’s adjusted acquisition price at the beginning of the period and the holder’s yield, with the yield stated appropriately for the length of the period.
Within an accrual period the premium accrues ratably (26 CFR 1.171-2). The constant yield approach is deliberate: it is intended to generally conform the treatment of bond premium to the treatment of original issue discount (26 CFR 1.171-1), so the two sit on the same arithmetic rather than on different conventions.
When the Premium Runs Past the Interest
Netting only works while there is interest to net against. Where the premium allocable to an accrual period exceeds the qualified stated interest allocable to it, a taxable bond holder treats the excess as a bond premium deduction for that period, and that deduction is limited to the amount by which the holder’s total interest inclusions on the bond in prior accrual periods exceed the total already treated as a bond premium deduction on it (26 CFR 1.171-2).
So the deduction is capped by history rather than by the current year. A holder cannot deduct more premium than the bond has previously produced in reportable interest, which stops the premium turning into a loss ahead of time.
Which Bonds the Rules Do Not Reach
The regime has a defined scope, and several common holdings sit outside it. The rules do not apply to a regular interest in a REMIC or similar debt instruments with payments subject to acceleration, to contingent payment debt instruments, to a bond held by a holder that has made a section 1.1272-3 election with respect to the bond, to a bond that is stock in trade or inventory or held primarily for sale to customers in the ordinary course of the holder’s business, or to a bond issued before September 28, 1985 unless it bears interest and was issued by a corporation or by a government or political subdivision (26 CFR 1.171-1).
The dealer exclusion is the one most likely to matter on a business return. A bond held as inventory is not amortized under these rules at all.
Where a Firm Meets It
On an investor’s return, usually arriving as a number on a broker statement rather than as a decision. Three checks are worth making before the figure is accepted.
Establish whether the bond is taxable or tax-exempt, because that decides whether amortization is a choice or an obligation. Confirm that basis has been reduced by the amortization actually taken, since the offset against interest and the reduction of basis are two effects of one event and reporting only the first inflates the eventual gain. And on a tax-exempt holding, check that amortization is happening at all, because there is no current tax benefit to prompt anyone to notice it.
Common Questions
As an offset to interest rather than as an expense, in the accrual period the interest is taken into account under the holder’s regular method of accounting (26 CFR 1.171-2). Only where a period’s premium exceeds that period’s qualified stated interest does any part of it become a deduction, and then only within the limit set by prior interest inclusions (26 CFR 1.171-2).
For a holder there is no single closed formula, because the amount is a residual from the yield calculation: the period’s qualified stated interest, less the adjusted acquisition price at the start of the period multiplied by the holder’s constant yield (26 CFR 1.171-2). On the issuer’s side the arithmetic is the interest method applied to the carrying amount, which is worked with figures in bonds payable.
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