6.4.1.1. Premium Bonds
As we have seen, when a bond is bought at a premium to par, the investor amortizes the premium over the remaining life of the bond. The amortized amount reduces the adjusted cost basis of the bond until, at maturity, the adjusted cost basis will equal the bond’s redemption value. If the investor holds the bond until maturity, she will have no capital losses. In that case, the amount of the premium that has been amortized each year was reported to the IRS and applied to the investor’s annual tax statement. It is now gone.
Example: John purchases a $5,000 10-year bond on the secondary market for $5,700. The bond is redeemable in 7 years. His amortized loss on the bond will be $100 per year ($700 premium / 7 years). Subtracting that amount from his cost basis annually will result in an adjusted cost basis of $5,000 at the bond’s maturity ($5,700 – (7 years x $100)). Thus, if he holds the bond to maturity, John will incur no capital loss.
Another nuance of the premium municipal bond is that the amortized loss is applied to the tax-exempt interest on tax forms over the life of the bond. John’s bond has a 5% coupon rate, so each year he will be paid $250 ($5,000 x 0.05) in interest. His amortized loss, as we have seen, is $10