7655 / How is the amount of amortizable bond premium determined?

Under regulations generally in effect for bonds acquired on or after March 2, 1998, a holder acquires a bond at premium if the holder’s basis in the bond immediately after its acquisition by the holder exceeds the sum of all amounts payable on the bond after the acquisition date (other than payments of qualified stated interest); the excess is bond premium, which a holder amortizes.² Bond premium is allocable to an accrual period based on a constant yield that is used to conform the treatment of bond premium to the treatment of original issue discount (see Q 7650).³ Under a transition rule, the use of a constant yield to amortize premium does not apply to a bond issued before September 28, 1985.⁴ See Q 7654 for an explanation of the effective date of the regulations.

In general, the holder’s basis in the bond is the holder’s basis for purposes of determining loss on the sale or exchange of the bond. This determination of basis applies only for purposes of amortizing premium; a holder’s basis in the bond for purposes of amortizing premium may differ from the holder’s basis for purposes of determining gain or loss on the sale or exchange of the bond.⁵

For purposes of determining the amount amortizable, if the bond is acquired in an exchange for other property and the bond’s basis is determined (in whole or in part) by the basis of the property, the basis of the bond is not more than its fair market value immediately after the exchange.⁶ This rule applies to exchanges occurring after May 6, 1986.⁷ A special rule applies to a bond acquired in a bond-for-bond exchange in a corporate reorganization.⁸

If the bond is transferred basis property and the transferor had acquired the bond at a premium, the holder’s basis in the bond is the holder’s basis for determining loss on the sale or exchange of the bond reduced by any amounts that the transferor could not have amortized (under the basis rules or because of an election to amortize in a subsequent taxable year), except to the extent that the holder’s basis already reflects a reduction attributable to the nonamortizable amounts.⁹ Transferred basis property is property having a basis determined in whole or in part by the basis of the transferor.¹⁰

For a detailed explanation of the effective dates for the regulations under IRC Section 171, see Q 7654.

Calculation of Annual Deduction or Offset

Bonds Issued After September 27, 1985

Except as provided in regulations (see below), the determination of the amount of the deduction or offset in any year is computed on the basis of the taxpayer’s yield to maturity by using the taxpayer’s basis in the bond (for purposes of determining loss) and by compounding at the close of each accrual period. Generally, an accrual period is the same as used in determining original issue discount (see Q 7650). If the amount payable on a call date that is earlier than maturity is used for purposes of determining the yield to maturity, the bond is treated as maturing on the call date and then as reissued on that call date for the amount payable on the call date.¹¹ If a taxpayer had an election to amortize bond premium in effect on October 22, 1986, the election applies to bonds issued after September 27, 1985, only if the taxpayer so chooses (as may be prescribed in regulations).¹²

Under regulations generally in effect for bonds acquired on or after March 2, 1998, a holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to the accrual period (see Q 7656). This offset occurs when the holder takes the qualified stated interest into account under the holder’s regular method of accounting.¹³ The accrual period to which qualified stated interest is allocable is determined under the regulations to IRC Section 446 (relating to the general rule for methods of accounting).¹⁴ For a detailed explanation of the effective date of the regulations, see Q 7654.

Bonds Issued On or Before September 27, 1985

The amount of the deduction or offset each year may be determined under any reasonable method of amortization, but once an individual has used a method, the individual must consistently use the same method. (The Service has approved use of the “yield” method of amortizing bond premium.)¹⁵ Instead of any other method, he or she may use the straight line method set forth in regulations (in effect for bonds acquired before March 2, 1998, or held before a taxable year containing March 2, 1998). Under that method, the amount of premium that is deductible or offset each year is an amount that bears the same ratio to the bond premium as the number of months in the tax year the bond was held by the individual bears to the number of months from the beginning of the tax year (or, if the bond was acquired in the tax year, from the date of acquisition) to the date of maturity or to an earlier call date if appropriate. A fractional part of a month is counted only if it is more than one-half of a month and then it is counted as a month.¹⁶ The additional regulations, amended December 30, 1997, do not include the above rules.

Under regulations in effect for bonds acquired before March 2, 1998 (or held before a taxable year containing March 2, 1998), if the premium is solely a result of capitalized expenses (such as buying commissions), an individual using the straight line method provided in the regulations may amortize the capital expenses. If such expenses are a part of a larger premium, the individual must treat them as part of the premium if he or she uses the straight line method.¹⁷ The regulations, as amended December 30, 1997, do not include the above rule.