A premium bond is a bond purchased for more than the face value of the bond. The amount paid above the face amount is called the premium. An investor can then amortize the premium over the remaining life of the bond to reduce the amount of taxable interest earned.
Amortizing a bond premium entails writing off a portion of the bond premium each year using the formula required by the Internal Revenue Service. Owners of taxable bonds can choose whether to amortize or take a capital loss of the premium when the bond matures. Amortizing allows the investor to write off a portion of the premium each year. Once an investor has selected amortization, she must use the method for every bond in her investment portfolio. Premium municipal, tax-free bonds must have the premium amortized, which provides no tax benefit.
Holding a Bond to Maturity
If a premium bond is held to maturity and the premium is amortized, there is no tax write-off when the bond matures and pays a lower amount than the price paid for the bond. For example, an investor buys a premium bond for $110,000 and receives the $100,000 face amount when the bond matures. If the premium is amortized, the full $10,000 of premium will be written down by the amortization when the bond matures and there will be no tax-deductible loss.
Losing Money on a Bond Sale
If interest rates increase or a bond's credit rating is downgraded, the market price of the bond will decline. If an investor sells a bond that has decreased in value, the loss is a deductible capital loss for tax purposes. The amount of a bond's premium that has already been amortized reduces the investor's cost basis in the bond, which will result in a smaller capital loss. If enough of the premium has been amortized and the bond is sold for less than the purchase price but above the face amount, there may not be a deductible loss.
Premium Bond Example
As an example, an investor buys a $100,000 premium bond for $108,000 and elects to amortize the premium. Two years later, interest rates have risen and the investor sells the bond for $101,000, $7,000 less than the purchase price. However, over the two years $1,500 of the premium has been amortized, leaving $6,500 in un-amortized premium. The investor's capital loss will be $106,500 minus $101,000, or $5,500. This amount can be claimed as a capital loss on the investor's tax return.