What Is a Bond Premium? Definition, Amortization, and Tax Rules

A bond premium is the amount you pay above a bond’s face value when you buy it. If you pay $10,500 for a bond that will pay back $10,000 at maturity, the $500 difference is the premium. Premiums show up because the bond’s fixed coupon rate is higher than what newer bonds of similar quality are paying, so buyers bid the price up. On your tax return, that extra $500 is not simply lost money: for a taxable bond you can elect to write it off against interest income year by year, and for a tax-exempt bond you must write it off against your basis whether you get a deduction or not.

Why a Bond Sells Above Face Value

The main driver is falling interest rates. When market rates drop below the coupon rate on an existing bond, that older bond pays more than newly issued securities of similar credit quality, and demand pushes its price above par. A bond with a 5% coupon becomes attractive when new bonds are only paying 3%, and the premium is what closes the gap. An investor paying a premium accepts a lower effective yield than the stated coupon, because part of each interest payment is really a return of the extra money paid up front.

How to Calculate the Premium

Subtract the face value from your purchase price. Pay $10,500 for a $10,000 bond, and the premium is $500. Municipal bonds are typically sold in minimum denominations of $5,000, while many other bonds use a $1,000 par value, but the arithmetic is the same.¹ To carry the calculation into your taxes, you also need the coupon rate and the time remaining until maturity, both of which appear on your trade confirmation.

Amortizing the Premium

Amortization spreads the premium over the bond’s remaining life, gradually reducing your cost basis until it equals face value at maturity. Without it, you would report the full coupon each year as interest income and then recognize a capital loss at maturity when the issuer pays back only face value. Amortization moves that adjustment forward and spreads it out.

Federal tax law requires the constant yield method. It uses the bond’s yield to maturity and its adjusted basis at the start of each accrual period to determine how much premium belongs to that period, so the amount shifts slightly year to year rather than staying flat.² Each year you amortize, your basis drops by that year’s amount.³ Keeping a running tally of adjusted basis matters, because that number determines your gain or loss if you sell before maturity.

Taxable Bonds: The Amortization Election

For taxable bonds, which include corporate bonds and most Treasury securities, amortization is an election you make on your return. The election lets you use each year’s amortized amount to reduce the interest income you report from that bond.²

Say the bond pays you $500 in interest during the year and your amortized premium for that period is $75. You report $425 as interest income, and your basis in the bond drops by $75.

If you skip the election, you report the full coupon each year and take a capital loss at maturity when the issuer pays only face value. That loss can offset capital gains, but capital losses are subject to tighter deduction limits than an annual reduction in ordinary income, so for most taxpayers the election is the better choice.

Tax-Exempt Bonds: Amortization Is Mandatory

The rules for tax-exempt bonds, mainly municipals, work differently. Amortization is required, not optional. You must reduce your basis each year by the amortized amount.² But because the interest is already excluded from your gross income, you get no deduction or offset for the premium you write down.³

The practical effect is a steadily shrinking basis. Ignore the required amortization, sell the bond before maturity, and you can miscalculate the gain or loss and end up with an unexpected tax bill.

Making the Election

You make the election by offsetting interest income with bond premium on a timely filed return for the first year you want it to apply, and by attaching a statement to that return indicating you are making the election under Section 171.⁴

Two features of the election deserve thought before you file. First, it is not bond-by-bond. It covers every taxable bond you hold at the start of the election year and every taxable bond you acquire afterward.² Second, it is binding on future years. You cannot revoke it without permission from the IRS Commissioner, and because revocation is treated as a change in accounting method, approval takes a formal request.⁴

One practical note. If your broker holds the bond as a covered security, the broker will usually report amortized premium on your Form 1099-INT automatically unless you tell them you are not making the election.⁵

Callable and Convertible Bonds

Two features complicate the amortization schedule.

For callable bonds, you have to build the schedule around an assumption about whether the issuer will exercise the call. For taxable bonds, the issuer is assumed to call in the manner that maximizes your yield. For tax-exempt bonds, the issuer is assumed to call in the manner that minimizes your yield.⁶ In practice, that often means a tax-exempt premium bond is amortized to the earliest call date, producing a faster write-down, while a taxable premium bond may be amortized to the later maturity date. If the issuer later calls on a different date than assumed, the remaining premium has to be recalculated.

For convertible bonds, you strip out the value of the conversion feature before you calculate the premium. Only the portion of the price above face value attributable to the interest rate advantage is amortizable; the portion reflecting the right to convert into stock is not.² Separating the two pieces can require a professional valuation.

Selling Before Maturity

Sell early, and gain or loss is measured against your adjusted basis, not your original purchase price.³ Suppose you paid $10,500 for a taxable bond with a $10,000 face value and elected to amortize. After three years of amortization totaling $300, your adjusted basis is $10,200. Sell the bond for $10,400 and you have a $200 capital gain, not a $100 loss against the original price.

When a sale falls partway through an accrual period, the amortization for that partial period is allocated to your final year of ownership and offsets the interest you received during it.⁷ The gain or loss on the sale itself is generally a capital gain or loss if you held the bond as an investment.

Reporting on Your Tax Return

Bond premium shows up on Form 1099-INT in three boxes: Box 11 for general bond premium, Box 12 for premium on Treasury obligations, and Box 13 for premium on tax-exempt bonds.⁵ If your broker has already netted the premium against interest, you need no further adjustment.

If the broker reported gross interest without netting, you make the reduction yourself on Schedule B of Form 1040. List the full interest from the 1099-INT, then subtract a line labeled “ABP Adjustment” for the amortized premium.⁸ The net figure carries through as your taxable interest. For tax-exempt bonds, there is no deduction line, because the interest is already outside your income, but you still need to track the basis reduction for the day you sell or the bond is redeemed.

1
MSRB. How Are Municipal Bonds Priced?
2
Office of the Law Revision Counsel. 26 USC 171 Amortizable Bond Premium
3
Office of the Law Revision Counsel. 26 US Code 1016 – Adjustments to Basis
4
eCFR. 26 CFR 1.171-4 Election to Amortize Bond Premium on Taxable Bonds
5
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
6
eCFR. 26 CFR 1.171-3 Special Rules for Certain Bonds
7
eCFR. 26 CFR 1.171-2 Amortization of Bond Premium
8
Internal Revenue Service. Instructions for Schedule B (Form 1040)