How to Amortize Bond Premium for Tax Purposes

To amortize bond premium for tax purposes, you spread the amount you paid above face value across the bond’s remaining life using the constant yield method, reducing both your reported interest income and your cost basis each accrual period. For taxable bonds, this is an election under Internal Revenue Code Section 171. For tax-exempt bonds, the basis reduction is mandatory even though no deduction is available.

What Counts as Bond Premium

You have bond premium when your cost basis in a bond is more than the total of all amounts payable on the bond after you buy it, other than the regular interest payments. Put plainly, if you pay more than face value, the excess is premium. It happens most often when the bond’s coupon rate sits above current market rates, so buyers are willing to pay extra for the larger payments.

Cost basis is the purchase price plus buying costs such as brokerage commissions and transfer fees.¹ A $10,000 face value bond bought for $10,500 with a $50 commission has a basis of $10,550 and a bond premium of $550.

One exclusion to know about: for convertible bonds, you ignore any portion of the premium attributable to the conversion feature. Only the premium tied to the bond’s interest-paying characteristics is amortizable.²

Taxable Bonds vs. Tax-Exempt Bonds

Whether amortization is optional or required depends on the interest.

For taxable bonds (corporate bonds, Treasuries), amortization is elective. If you make the Section 171 election, you reduce your reported interest income each year by the amortized premium, and your basis drops by the same amount.

For tax-exempt bonds (municipal bonds), amortization is mandatory. There’s no deduction, because the interest is already tax-free, but you must still reduce your basis by the premium every year.³ Section 1016(a)(5) requires the basis adjustment for both types.⁴ Skip the tax-exempt basis reduction and you will miscalculate the gain or loss when you sell.

Making the Section 171 Election

For taxable bonds, you make the election by reporting the amortization on a timely filed federal income tax return for the first year you want it to apply. Attach a statement to the return indicating you’re making the election under Section 171.⁵

Two features of the election deserve thought before you file. It applies to every taxable bond you hold at the start of that year and every taxable bond you buy afterward, so you cannot cherry-pick. And it binds you for future years. Revoking it means filing Form 3115 and getting written IRS approval through the formal change-in-accounting-method process.⁵

How the Constant Yield Method Works

For bonds issued after September 27, 1985, the IRS requires the constant yield method. Amortization is tied to the bond’s yield to maturity, so the premium reduction is larger in early periods, when the basis is highest, and shrinks as the basis falls. The regulations align this with how original issue discount works under Sections 1271 through 1275.³

You calculate the amortization once per accrual period. Accrual periods can be any length up to one year, but each scheduled interest payment must fall on either the first or last day of a period.⁵ Most investors match the coupon schedule, so a semi-annual bond gets six-month accrual periods.

A Worked Example

Take a $10,000 face value bond with a 6% annual coupon paid semi-annually ($300 per payment). You pay $10,437.61, giving a yield to maturity of 5% annually, or 2.5% per semi-annual period.

Step 1. Find the yield. Your brokerage statement or a bond calculator will give you the yield to maturity. Here it’s 2.5% per period.

Step 2. Calculate interest income for the period. Multiply your adjusted basis at the start of the period by the period yield: $10,437.61 × 2.5% = $260.94. That’s the interest you actually report.

Step 3. Find the amortization. Subtract calculated interest from the coupon payment: $300.00 − $260.94 = $39.06. That’s the amortizable premium for the period.

Step 4. Reduce your basis. $10,437.61 − $39.06 = $10,398.55. That new basis carries into the next period.

In period two, $10,398.55 × 2.5% = $259.96, so amortization is $40.04, and basis falls to $10,358.51. The amortization amount rises slightly each period because the shrinking basis produces less calculated interest, widening the gap against the fixed coupon. By final maturity, basis will have declined to exactly $10,000, and the entire premium will be gone.

Callable Bonds

Many bonds can be redeemed by the issuer before the stated maturity, and that changes the horizon over which you amortize. For taxable bonds, the statute directs you to use an earlier call date if doing so produces a smaller amortizable premium for the period ending on that call date.² In practice, you compare amortization to maturity against amortization to each possible call date and use whichever gives the smaller premium for the relevant period. The call price for this comparison is the amount stated on the bond, not a side agreement.

When Amortization Exceeds the Interest Payment

In some accrual periods, particularly for bonds bought at a steep premium close to a call date, the amortization allocated to the period can exceed the interest payment.

For taxable bonds, the excess is treated as a separate bond premium deduction, but capped. You can only deduct the excess up to the amount by which your total interest inclusions on the bond in prior periods exceed the premium deductions you’ve already taken. Anything above that cap carries forward to the next accrual period, and any leftover carryforward becomes deductible when you eventually sell or the bond is retired.⁶

For tax-exempt bonds, the excess is a nondeductible loss. You can’t use it to offset other income.

What Happens If You Sell Before Maturity

Because amortization reduces basis each period, it directly affects any gain or loss on sale. Gain or loss is the sale price minus your adjusted basis at the time of sale.

Hold to maturity with the election in place and your basis will have declined to exactly face value by then, so the return of principal produces no capital gain or loss. Skip the election on a taxable bond and your basis stays at the original purchase price, so a maturity payoff at face value produces a capital loss equal to the original premium.

Selling early looks different. If your adjusted basis after amortization is $10,200 and you sell for $10,350, you have a $150 capital gain. Without the election, basis would still be $10,437.61, and the same sale would produce an $87.61 capital loss instead. The election shifts both your annual interest income and the size and character of any gain or loss on disposition.

Reporting on Your Tax Return

How you report depends on what your broker does on Form 1099-INT. The rules turn on whether the bond is a “covered security” — generally, taxable bonds acquired after January 1, 2014.

Reading Your 1099-INT

For covered taxable bonds bought at a premium, the broker must report the amortization unless you notified them in writing that you did not want to amortize. They have two options: net the premium into Box 1, or report gross interest in Box 1 and premium amortization in Box 11.⁷

If Box 11 is blank on a covered premium bond, the broker already netted the adjustment into Box 1. No further action from you.⁸ For noncovered securities, the broker reports only gross interest, and the adjustment falls entirely on you.

Schedule B Adjustment

When you need to make the adjustment yourself, report the full Box 1 interest in Part I of Schedule B (Form 1040). Below your last interest entry, put a subtotal line. Then enter the amortizable premium as a separate line labeled “ABP Adjustment” and subtract it. The net is your taxable interest.⁹

If the payer already netted the premium into Box 1, do not subtract again on Schedule B. Doubling up the adjustment is easy to do if you don’t first check whether Box 11 is blank or populated.⁹

For tax-exempt bonds there is no interest deduction to report, since the income is already excluded. But keep records of the annual basis reduction yourself. The IRS will not remind you, and you’ll need those figures to calculate the correct gain or loss when the bond is sold or matures.

1
Internal Revenue Service. Publication 551 – Basis of Assets
2
Office of the Law Revision Counsel. 26 US Code 171 – Amortizable Bond Premium
3
eCFR. 26 CFR 1.171-1 – Bond Premium
4
Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
5
Internal Revenue Service. Publication 550 – Investment Income and Expenses
6
eCFR. 26 CFR 1.171-2 – Amortization of Bond Premium
7
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
8
Internal Revenue Service. Instructions for Form 1099-INT – Instructions for Recipient
9
Internal Revenue Service. Instructions for Schedule B (Form 1040)