If a bond is purchased at a price higher that the face amount, a premium has been paid. For example, if an investor pays $110,000 for a $100,000 bond, he has paid a premium. An investor buys a premium bond because the bond pays a higher than market rate of interest. Tax rules allow bond investors to amortize a bond premium, using the amortization to reduce the amount of taxable interest earned from corporate or government bonds. Municipal bond premiums must be amortized to prevent using the premium as a capital loss when a bond matures.
1. Determine the initial premium amount paid on the bond and the number of months until the bond matures. For example, if you purchased a $100,000 bond in July for $110,000, you paid a $10,000 premium. If it matures in 10 years and 6 months, there are 126 months until the bond matures.
2. Divide the number of months you owned the bond in the first calender year by the number of months from the purchase date until the date of maturity. In this example, the bond was owned for 6 months, which is divided into the 126 total months for a result of 0.04762.
3. Multiply the result of Step 2 by the initial premium amount. The result is the amortization amount for the first year the bond is owned. In the example, 0.04762 multiplied by $10,000 gives an amortization amount of $476.18. Remaining premium after the first year would be $9,523.81.
4. Divide 12 by the number of months until the bond matures, including the current year, and multiply that figure by the balance remaining on the premium for each subsequent year the bond is owned. For the example bond, in the second year 12 is divided by 120, then multiplied by $9,523.81, giving an amortization amount of $952.38. This will be the amortization amount for each year until the bond is sold or matures.
- For tax purposes, the straight line depreciation method can only be used for bonds issued before September 28, 1985. Bonds issued after that date must use the constant yield method of amortization.
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