7656 / How is the bond premium allocable to an accrual period calculated if the bond was issued on or after September 28, 1985?

Step one: Determine the holder’s yield. The holder’s yield is the discount rate that, when used in computing the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to the holder’s basis in the bond. The remaining payments include only payments to be made after the date the holder acquires the bond. The yield calculated as of the date the holder acquires the bond must be constant over the term of the bond, and must be calculated to at least two decimal places when expressed as a percentage.¹

Step two: Determine the accrual periods. An accrual period is an interval of time over which the accrual of bond premium is measured. Accrual periods may be of any length over the term of the debt instrument, provided that each accrual period is no longer than one year and each scheduled payment occurs on the final day of an accrual period or on the first day of an accrual period.²

Step three: Determine the bond premium allocable to the accrual period. The bond premium allocable to an accrual period is the excess of the qualified stated interest allocable to the accrual period over the product of the holder’s adjusted acquisition price at the beginning of the accrual period and the holder’s yield. In performing this calculation, the yield must be stated appropriately taking into account the length of the particular accrual period.³ The adjusted acquisition price of a bond at the beginning of the first accrual period is the holder’s basis (see below). Thereafter, the adjusted acquisition price is the holder’s basis in the bond decreased by (1) the amount of bond premium previously allocable (as calculated above), and (2) the amount of any payment previously made on the bond other than the payment of qualified stated interest.

If the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is treated by the holder as a bond premium deduction for the accrual period. However, the amount treated as a bond premium deduction is limited to the amount by which the holder’s total interest inclusions on the bond in prior accrual periods exceeds the total amount treated by the holder as a bond premium deduction on the bond in prior accrual periods. A deduction determined under this rule is not subject to the 2 percent floor on miscellaneous itemized deductions (although these deductions were suspended for 2018-2025).⁴ If the bond premium allocable to an accrual period exceeds the sum of the qualified stated interest allocable to the accrual period and the amount treated as a deduction for the accrual period, the excess is carried forward to the next accrual period and is treated as bond premium allocable to that period.⁵

For bonds acquired on or after January 1, 2013, if there is such a bond premium carryforward as of the end of the holder’s accrual period in which the bond is sold, retired, or otherwise disposed of, the holder treats the amount of the carryforward as a bond premium deduction under Section 171(a)(1) for the year in which such disposition occurs.⁶

Additional rules apply to determine the amortization of bond premium on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules, and a bond that provides for remote or incidental contingencies.⁷

The regulations are generally effective for bonds acquired after March 2, 1998, but certain transition rules may have applied (see Q 7654).