What Is an Amortizable Bond Premium?
The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis.
Key Takeaways
- A tax term, the amortizable bond premium refers to the excess price (the premium) paid for a bond, over and above its face value.
- The premium paid for a bond represents part of the cost basis of the bond, and so can be tax-deductible, at a rate spread out (amortized) over the bond's lifespan.
- Amortizing the premium can be advantageous, since the tax deduction can offset any interest income the bond generates, thus reducing an investor's taxable income overall.
- The IRS requires that the constant yield method be used to calculate the amortizable bond premium every year.
Understanding an Amortizable Bond Premium
A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.
The difference between the bond's current price (or carrying value) and the bond's face value is the premium of the bond. For example, a bond that has a face value of $1,000 but is sold for $1,050 has a $50 premium. Over time, as the bond premium approaches maturity, the value of the bond falls until it is at par on the maturity date. The gradual decrease in the value of the bond is called amortization.
Cost Basis
For a bond investor, the premium paid for a bond represents part of the cost basis of the bond, which is important for tax purposes. If the bond pays taxable interest, the bondholder can choose to amortize the premium—that is, use a part of the premium to reduce the amount of interest income included for taxes.
Those who invest in taxable premium bonds typically benefit from amortizing the premium, because the amount amortized can be used to offset the interest income from the bond. This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well. The cost basis of the taxable bond is reduced by the amount of premium amortized each year.
In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year. The IRS requires that the constant yield method be used to amortize a bond premium every year.
Amortizing Bond Premium With the Constant Yield Method
The constant yield method is used to determine the bond premium amortization for each accrual period. It amortizes a bond premium by multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Or in formula form:
- Accrual = Purchase Basis x (YTM /Accrual periods per year) - Coupon Interest
The first step in calculating the premium amortization is to determine the yield to maturity (YTM), which is the discount rate that equates the present value of all remaining payments to be made on the bond to the basis in the bond.
For example, consider an investor that purchased a bond for $10,150. The bond has a five-year maturity date and a par value of $10,000. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. Let’s calculate the amortization for the first period and second period.
The First Period
Since this bond makes semi-annual payments, the first period is the first six months after which the first coupon payment is made; the second period is the next six months, after which the investor receives the second coupon payment, and so on. Since we’re assuming a six-month accrual period, the yield and coupon rate will be divided by 2.
Following our example, the yield used to amortize the bond premium is 3.5%/2 = 1.75%, and the coupon payment per period is 5% / 2 x $10,000 = $250. The amortization for period 1 is as follows:
- Accrualperiod1 = ($10,150 x 1.75%) - $250
- Accrualperiod1 = $177.63 - $250
- Accrualperiod1 = -$72.38
The Second Period
The bond’s basis for the second period is the purchase price plus the accrual in the first period—that is, $10,150 - $72.38 = $10,077.62:
- Accrualperiod2 = ($10,077.62 x 1.75%) - $250
- Accrualperiod2 = $176.36 - $250
- Accrualperiod2 = -$73.64
For the remaining eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), use the same structure presented above to calculate the amortizable bond premium.
Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes.
FAQs
The primary advantage of premium bond amortization is that it is a tax deduction in the current tax year. Suppose the interest paid on the bond is taxable. In that case, the premium paid on the bond can be amortized, or in other words, a part of the premium can be utilized towards reducing the amount of taxable income.
Do I have to amortize bond premium? ›
Premium on taxable bonds may be amortized, and premium on tax-exempt bonds must be amortized (IRC § 171 ). See Explanation: §171, Amortizable Bond Premium . A taxpayer elects to amortize bond premium by claiming an offset to taxable interest income on the tax return for the first year in which the election is to apply.
What does it mean to amortize a premium? ›
Definition of Amortize Premium, Discount, and Issue Costs
With regards to bonds payable, the term amortize means to systematically allocate the discount on bonds payable, the premium on bonds payable, and bond issue costs to Interest Expense over the remaining life of the bonds.
What happens when you amortize a bond? ›
An amortized bond is one in which the principal (face value) on the debt is paid down regularly, along with its interest expense over the life of the bond. A fixed-rate residential mortgage is one common example because the monthly payment remains constant over its life of, say, 30 years.
How do you amortize a bond? ›
An amortized bond is a bond with the principal amount – otherwise known as face value –regularly paid down over the life of the bond. The bond's principal is divided up according to the security's amortization schedule and paid off incrementally (often in one-month increments).
How do I report amortizable bond premium? ›
If you are required to report the amount of bond premium amortization allocable to an interest payment, you may report either (1) a net amount of interest that reflects the offset of the interest payment by the amount of bond premium amortization allocable to the interest payment, or (2) a gross amount for both the ...
What is the effective interest method to amortize the bond premium? ›
The effective interest method is an accounting practice used to discount a bond. This method is used for bonds sold at a discount or premium; the amount of the bond discount or premium is amortized to interest expense over the bond's life.
How do you report bond premium amortization? ›
Report the bond's interest on Schedule B (Form 1040A or 1040), line 1. Under your last entry on line 1, put a subtotal of all interest listed on line 1. Below this subtotal, print “ABP Adjustment,” and the total interest you received. Subtract this amount from the subtotal, and enter the result on line 2.
What are the two methods to amortize the bond premium and discount? ›
The two methods of amortizing discounts and premiums on bonds payable include the effective-interest method and the straight-line method.
Is amortization a good thing? ›
Why Is Amortization Important? Amortization is important because it helps businesses and investors understand and forecast their costs over time. In the context of loan repayment, amortization schedules provide clarity into what portion of a loan payment consists of interest versus principal.
Amortization of bond costs is a process of adjusting the nominal interest expense of a bond to the actual interest expense.
Do you have to declare Premium bonds on a tax return? ›
Tax and you do not need to declare it on your tax return. Anybody over the age of 16 can buy Premium Bonds, and you can also buy them on behalf of your child or grandchild.
Where does bond premium amortization Go on tax return? ›
However, if you acquired a tax-exempt bond at a premium, only report the net amount of tax-exempt interest on line 2a of your Form 1040 or 1040-SR (that is, the excess of the tax-exempt interest received during the year over the amortized bond premium for the year).
How does bond premium amortization work? ›
2 It amortizes a bond premium by multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Or in formula form: Accrual = Purchase Basis x (YTM /Accrual periods per year) - Coupon Interest.
Why is there a need to amortize discount or premium? ›
Therefore, bond discounts or premiums have the effect of increasing or decreasing the interest expense on the bonds over their life. Under these conditions,it is necessary to amortize the discount or premium over the life of the bonds by using either the straight-line method or the effective interest method.
What is the point of amortization? ›
Knowing the real value and useful life of our assets, and the amount we owe on, and the term of, our loans, are key to managing our finances better. Amortization is a way of finding out that information whenever we want.
How does amortization of bond premium affect cost basis? ›
Note that the adjusted acquisition price at the beginning of the first accrual period is the same as the cost basis. After the initial amortization calculation, cost basis is decreased by the amount of bond premium previously amortized.
How do you get unamortized bond premium? ›
Example: Unamortized Bond Premium Calculation
- Multiplying the selling price of the bond by the YTM yields $1,090 x 4% = $43.60.
- This value when subtracted from the coupon amount (5% coupon rate x $1,000 par value = $50) results in $50 - $43.60 = $6.40, which is the amortizable amount.
Divide the total discount or premium by the number of remaining periods in order to determine the amount to amortize in the current period. Multiply the face value of the bond by its stated interest rate to arrive at the interest payment to be made on the bond in the period.
What is the difference between bond premium and discount amortization? ›
A premium bond has a coupon rate higher than the prevailing interest rate for that bond maturity and credit quality. A discount bond, in contrast, has a coupon rate lower than the prevailing interest rate for that bond maturity and credit quality. An example may clarify this distinction.
If the company uses the amortized cost approach to measure a long-term debt, it can use two methods to amortize the discount and the premium:
- the effective interest rate method, or.
- the straight-line method (allowed only under U.S. GAAP).
By amortizing, the investor is able to reduce the amount of taxable interest for each year he or she owns the bond. This is because the amortized premium offsets the ordinary income of the coupon payment. As long as the bond is held to maturity, there Page 2 will be no capital loss to report.
What is the disadvantage of amortization? ›
Disadvantages of Amortization
For borrowers, the biggest disadvantage is that amortization can make it difficult to pay off a loan early. Amortized loans are carefully calculated to balance the amounts paid towards the loan's interest and principal over a long term — meaning most amortized loans carry long loan terms.
What does amortization mean for dummies? ›
Amortization is an accounting method for spreading out the costs for the use of a long-term asset over the expected period the long-term asset will provide value. Amortization expenses account for the cost of long-term assets (like computers and vehicles) over the lifetime of their use.
What are the pros and cons of amortization? ›
Direct amortization has the advantage of being a feel-good option, as the burden of mortgage interest and the amount of debt is gradually reduced, and the property can be used as an investment option with an object yield. The disadvantages are the rising taxes and a possible lack of retirement savings.
