How to Amortize Bond Premium for Tax Purposes

To amortize bond premium for tax purposes, you elect the treatment under Internal Revenue Code Section 171 (or, for tax-exempt bonds, follow the mandatory rules), then use the constant yield method to spread the premium across each accrual period, reducing your reported interest income and your basis by the same amount each period. The election is made by reporting the amortization on a timely filed return for the first year you want it to apply, with a statement attached indicating you are electing under Section 171.¹

What Counts as Bond Premium

You have bond premium when your cost basis in the bond exceeds the total of all amounts payable on it after you buy it, other than regular interest payments. Put plainly: if you paid more than face value, the excess is premium. It typically appears when the coupon rate sits above current market rates, so buyers pay extra for the richer interest stream.

Cost basis is the purchase price plus the costs of acquiring the bond, such as brokerage commissions.² One carve-out matters for convertibles: ignore any portion of the premium attributable to the conversion feature. Only the premium tied to the bond’s interest-paying characteristics is amortizable.³

Taxable Bonds Versus Tax-Exempt Bonds

The treatment splits by whether the interest is taxable.

Taxable bonds (corporate issues, Treasuries): amortization is elective. If you elect, you reduce reported interest income each year by the amortized amount, and your basis drops by the same figure.
Tax-exempt bonds (municipals): amortization is mandatory. There is no deduction, because the interest is already tax-free, but you still must reduce basis by the premium amount each year.⁴

The mandatory basis reduction on munis catches people off guard. Skip it, and your gain or loss on a later sale will be wrong. Section 1016(a)(5) requires the basis adjustment for both types of bonds.⁵

Making the Section 171 Election

For taxable bonds, you make the election by reporting the amortization on a timely filed federal return for the first year you want it to apply and attaching a statement that identifies the election under Section 171.¹

Two features of the election deserve thought before you file. First, it applies to every taxable bond you hold at the start of that year and every taxable bond you buy later. You cannot pick which bonds it covers. Second, it binds all future years. Revoking it means filing Form 3115 and getting written IRS approval through the change-in-accounting-method process.¹

Using the Constant Yield Method

For bonds issued after September 27, 1985, the IRS requires the constant yield method. The amortization is tied to the bond’s yield to maturity, so more premium comes off in the early periods, when the basis is highest, and less in later periods. The regulations align this with how original issue discount accrues under Sections 1271 through 1275.⁴

You repeat the calculation each accrual period. Accrual periods can be any length up to one year, but each scheduled interest payment must land on the first or last day of a period.¹ Most investors just use the coupon schedule, so a semi-annual bond gets six-month periods.

A Worked Example

Take a $10,000 face value bond with a 6% coupon paid semi-annually ($300 per payment). You pay $10,437.61, which gives a yield to maturity of 5% annually, or 2.5% per semi-annual period. You don’t need to derive the yield yourself; a brokerage statement or bond calculator provides it.

For the first period, multiply your beginning basis by the semi-annual yield: $10,437.61 × 2.5% = $260.94. That is the interest income you actually report. Subtract it from the $300 coupon to get the amortization: $300.00 − $260.94 = $39.06. Reduce your basis by that amount: $10,437.61 − $39.06 = $10,398.55. The new basis carries into the next period.

For the second period, $10,398.55 × 2.5% = $259.96. Amortization is $300.00 − $259.96 = $40.04, and basis falls to $10,358.51. The amortization amount creeps up each period because the shrinking basis produces less calculated interest, widening the gap against the fixed coupon. By the final period, basis has worked its way down to exactly $10,000 and the full premium is gone.

Callable Bonds

If the issuer can redeem the bond before stated maturity, you may need to amortize to the call date instead. For taxable bonds, Section 171 says to use the earlier call date if doing so produces a smaller amortizable bond premium for the period ending on that call date.³ You compare the amortization figured to maturity against the figures to each call date and use whichever is smaller for the relevant period. The call price for this comparison is the amount stated on the bond itself.

When the Period’s Premium Exceeds the Interest

Sometimes the premium allocated to a period runs larger than the interest payment itself. This shows up most often on bonds bought at a steep premium near a call date.

On taxable bonds, the excess is a separate bond premium deduction, but it is capped. You can deduct the excess only up to the amount by which your total interest inclusions on the bond in prior periods exceed the premium deductions you have already taken. Anything beyond that cap carries forward to the next accrual period, and any remaining carryforward becomes deductible in the year you sell or retire the bond.⁶ On tax-exempt bonds, the excess is a nondeductible loss.

Effect on a Sale or Maturity

Because amortization lowers basis each period, it directly changes the gain or loss you recognize if you sell. Hold to maturity after electing, and basis has reached face value by then, so the return of principal produces no gain or loss. Never elect on a taxable bond, and basis stays at the original purchase price; at maturity you realize a capital loss equal to the full premium.

Sales before maturity shift the math. If your adjusted basis after amortization is $10,200 and you sell for $10,350, you have a $150 capital gain. Without the election, basis would still be $10,437.61 and the same sale would produce an $87.61 capital loss. The election changes both your annual interest and the character of any disposition result.

Reporting on Your Return

How you report depends on what your broker already did on Form 1099-INT. For covered taxable bonds purchased at a premium, the broker must apply the amortization unless you notified them in writing that you did not want it. The broker can either report a net interest figure in Box 1 that already reflects the offset, or report gross interest in Box 1 with the amortization shown separately in Box 11.⁷

If Box 11 is blank on a covered security acquired at a premium, the broker already netted the amortization into Box 1 and no further adjustment is needed.⁸ On noncovered securities, the broker reports only gross interest and the adjustment is yours to make.

Schedule B Mechanics

When you make the adjustment yourself, report the full Box 1 interest in Part I of Schedule B (Form 1040). Add a subtotal line below your last interest entry, then enter the amortizable bond premium as a separate line labeled “ABP Adjustment” and subtract it. The net figure is your taxable interest.⁹

If the payer already netted the premium into Box 1, do not subtract again on Schedule B. Double-counting the adjustment is easy to do if you don’t check whether Box 11 is blank or populated.⁹

For tax-exempt bonds, there is no interest deduction to report, since the income is already excluded. You still need to track the annual basis reduction in your own records, because it drives the gain or loss when you sell or the bond matures. The IRS will not prompt you; the recordkeeping sits with the bondholder.

1
Internal Revenue Service. Publication 550 – Investment Income and Expenses
2
Internal Revenue Service. Publication 551 – Basis of Assets
3
Office of the Law Revision Counsel. 26 US Code 171 – Amortizable Bond Premium
4
eCFR. 26 CFR 1.171-1 – Bond Premium
5
Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
6
eCFR. 26 CFR 1.171-2 – Amortization of Bond Premium
7
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
8
Internal Revenue Service. Instructions for Form 1099-INT – Instructions for Recipient
9
Internal Revenue Service. Instructions for Schedule B (Form 1040)