Amortization of Bond Premium and Discount: Methods and Reporting

Amortization of bond premium and discount is how you spread the gap between what you paid for a bond and its face value across the years you hold it, and it drives both the interest income you report each year and the gain or loss you recognize at sale or maturity. For any bond issued after September 27, 1985, the IRS requires the constant yield method for these calculations, and the tax consequences split sharply between taxable and tax-exempt bonds and between original issue discount and market discount.¹

Premium, Discount, and the Starting Number

You have a premium when you paid more than face value, usually because the bond’s coupon is higher than what newer bonds offer. You have a discount when you paid less, typically because rates have risen since issuance. Amortization allocates that difference across the remaining life of the bond so your tax records track what you’re actually earning.

Start with cost basis: the price you paid plus transaction costs like brokerage commissions and transfer fees.² Do not include accrued interest. If you bought between coupon dates, the amount you paid the seller for interest that had already built up is a separate item; you recover it when the next coupon arrives, and it never becomes part of basis.³

Subtract face value from your correct basis. A positive number is your premium. A negative number is your discount. That total is what you’ll amortize.

The Constant Yield Method

The constant yield method is required for premium amortization on bonds issued after September 27, 1985, and for original issue discount accrual under IRC §1272.¹⁴ It runs in three steps.

First, calculate the yield to maturity: the discount rate that makes the present value of all remaining coupon and principal payments equal to your basis. This yield stays fixed for the life of the bond and must be computed to at least two decimal places.⁵

Second, pick accrual periods. They can be any length up to one year, provided each scheduled coupon falls on the first or last day of a period. Matching them to the coupon schedule keeps the arithmetic straightforward.¹

Third, for each period, multiply your adjusted acquisition price (basis minus premium already amortized, or basis plus OID already accrued) by the yield. The difference between that figure and the actual coupon is the period’s amortization. On a premium bond, the coupon exceeds the yield-based amount and the excess reduces the carrying value. On a discount bond, the yield-based amount exceeds the coupon and the difference increases carrying value. Because the carrying value changes each period, so does the amortization amount, producing a schedule that accelerates gently over time rather than staying flat.

When Straight-Line Still Applies

The straight-line method divides the total premium or discount evenly across each remaining period. For federal tax purposes, it is only available for bonds issued on or before September 27, 1985.¹ Anyone holding bonds bought in the modern market should plan on the constant yield method.

Premium on Taxable Bonds

For a taxable bond, IRC §171(e) requires the amortized premium to offset the bond’s interest rather than take the form of a separate deduction.⁶ Each year’s amortization reduces reported interest income. If the bond pays $500 in coupon interest and this year’s amortization is $80, you report $420.

The election to amortize comes with a lock. Once made, it applies to every taxable bond you own and every one you buy afterward, binds all future tax years, and cannot be revoked without written IRS permission.⁶ Electing usually helps because it lowers current taxable income, but you are stuck with it.

Each year’s amortization also reduces your basis. When you sell or redeem, the adjusted basis, not the price you originally paid, drives the capital gain or loss.

Premium on Tax-Exempt Bonds

The rule is different, and it catches people. For tax-exempt bonds such as municipals, no deduction is allowed for amortizable bond premium.⁶ You still have to amortize the premium and reduce your basis by it. The regulations require the premium to offset qualified stated interest each accrual period, and any excess for a period is treated as a nondeductible loss.⁵

You are writing down basis without any current tax benefit. That reduced basis matters at sale or redemption. If you sell a tax-exempt bond for more than your adjusted basis, the difference is a taxable capital gain, and investors who skip the mandatory basis reduction can understate that gain and draw an IRS adjustment.

Original Issue Discount vs. Market Discount

The tax code splits discounts into two regimes, and treating one like the other is a common reporting error.

Original Issue Discount

Original issue discount (OID) exists when a bond is first issued below face value. Zero-coupon bonds are the classic case, but any bond sold at issuance below par has OID. Under IRC §1272, you include a portion of the OID in gross income every year, whether or not you receive cash, using constant yield accrual. Brokers report the annual amount on Form 1099-OID.⁴ The income is ordinary. Your basis increases by the amount you include each year.

Several instruments are exempt from OID accrual, including tax-exempt obligations, U.S. savings bonds, short-term instruments maturing within one year, and small personal loans of $10,000 or less between individuals.⁴

Market Discount

Market discount arises when you buy an already-issued bond on the secondary market below its current adjusted issue price, usually because rates rose after issuance. IRC §1278 defines it as the excess of the stated redemption price at maturity over your basis right after acquisition.⁷

You generally do not include market discount in income as it accrues, though you can elect to. Otherwise, the tax hits at sale or redemption. Under IRC §1276, gain on the disposition is ordinary income to the extent of accrued market discount.⁸ The ordinary-income slice grows the longer you hold, and by maturity the entire discount is ordinary income. That surprises investors who expected capital gains treatment on bond profits.

The De Minimis Rule

Small discounts drop out. If the market discount is less than one-quarter of one percent (0.25%) of face value multiplied by the number of complete years remaining to maturity when you bought the bond, it is treated as zero.⁷ A $1,000 face-value bond with 12 complete years left has a threshold of $30. Buy it for $975, and the $25 discount falls below and gets capital-gain treatment at maturity. Buy it for $960, and the $40 discount clears the threshold and the full amount is ordinary income under the market discount rules.

Callable Bonds

A callable bond can be redeemed early, which cuts the amortization window short. When you buy a callable bond at a premium, you may have to amortize to the call date rather than the maturity date. For taxable bonds, if amortizing to an earlier call date produces a smaller total premium amount, that call date is the endpoint. For tax-exempt callable bonds, the amortization is based on the amount payable at the earlier call date.

The rule effectively assumes the issuer will call whenever calling would raise your yield, even if a call looks unlikely. If the assumed call date passes without a redemption, you recalculate the yield and the schedule based on the next call opportunity or maturity.

Reporting on Your Return

Brokers do most of the initial reporting. For covered taxable bonds bought at a premium, the amortizable bond premium appears in Box 11 of Form 1099-INT. For U.S. Treasury obligations bought at a premium, it lands in Box 12.⁹ Some brokers reduce Box 1 interest by the amortization themselves, leaving Box 11 blank.

If the broker reported gross interest in Box 1 and put the premium separately in Box 11, adjust on Schedule B of Form 1040. List all interest on line 1, subtotal it, then enter “ABP Adjustment” below the subtotal with the amortization amount subtracted. The result on line 2 is your net taxable interest.³ If Box 1 already netted the premium, do not subtract it again.

OID accrual flows through Form 1099-OID as interest income. If you elected current recognition of market discount and notified your broker, it appears in Box 5 of Form 1099-OID; without the election, the ordinary income shows up when you dispose of the bond, reported on Form 8949 and Schedule D.

Adjust cost basis every year: premium amortization reduces it, OID accrual increases it. At sale or redemption, the adjusted basis determines gain, loss, or break-even. Small annual errors compound over the life of a bond and can flip a modest loss into a taxable gain, or the reverse.²

1
Internal Revenue Service. Publication 550 – Investment Income and Expenses
2
Internal Revenue Service. Publication 551 – Basis of Assets
3
Internal Revenue Service. Instructions for Schedule B (Form 1040)
4
Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
5
eCFR. 26 CFR 1.171-2 – Amortization of Bond Premium
6
Office of the Law Revision Counsel. 26 USC 171 – Amortizable Bond Premium
7
Office of the Law Revision Counsel. 26 USC 1278 – Definitions and Special Rules Relating to Market Discount
8
Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
9
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID