A premium bond is an investment bond purchased for more than the face value of the bond. A bond will be priced at a premium if the interest rate paid by the bond is higher than the prevailing or market rate for similar corporate bonds. An investor paying a premium for a corporate bonds has two choices on how to handle the premium for tax purposes.
An investor pays more than the face value for a bond to earn the higher rate of interest the bond pays. If interest rates have dropped significantly, a larger portion of available corporate bonds will have premium prices. Paying a premium and holding a bond until maturity will result in a loss for the investor of the amount of premium paid. The extra interest earned from the higher rate paid will more than make up for the loss, but the loss of the premium paid can still be used as a tax write-off.
Tax Loss Alternatives
An investor who buys a premium corporate bond can select one of two methods to write off the premium amount paid. The premium can be used as a capital loss when the bond matures and the face amount is paid back to an investor or if the bond is sold before maturity at a lower price than was paid. Capital losses can be used to offset other capital gains or a limited amount of ordinary income. The other choice is to amortize the premium, writing off a portion of the premium each year the bond is owned. Amortization uses the premium write-off against the interest earned from the bond.
Amortizing the premium amount of a corporate bond calculates an amount of the premium paid to be taken as a credit each year for taxes. The annual amount amortized is used to reduce the amount of taxable interest earned from the bond. The initial annual amortization amount is the premium amount minus the bond yield to maturity rate times the price of the bond. For example, a $100,000 bond is purchased for $110,000 with a yield to maturity of 7 percent. The amount amortized the first year is the $10,000 premium minus $110,000 times 7 percent for an amortization amount of $2,300. The next year, the amortization amount would be calculated on a basis of $107,700.
The amortization of premium choice allows an investor to write down the premium paid on a corporate bond quicker than waiting for the bond to mature and take the capital loss. If an investor chooses the amortization method, it must be used for all premium corporate bonds in the investor's portfolio. If a bond is sold, the basis for the bond will be the price less the amounts taken as tax write-offs. Many brokers will calculate the amortization amount each year to assist investors with their tax filing.