An unamortized bond premium is the part of the price you paid above a bond’s face value that hasn’t yet been written down on your books. Buy a $1,000 face-value bond for $1,050 and the $50 extra is the premium; whatever piece of that $50 you haven’t amortized yet at any given moment is the unamortized portion. It matters because the issuer will only hand back the face value at maturity, so that extra $50 has to disappear from your cost basis somewhere along the way.
Why Bonds Sell Above Face Value
A bond’s coupon rate is fixed the day it’s issued. When market rates drop afterward, that older coupon looks generous next to what new bonds are paying, and buyers bid the price up. A bond with a 6% coupon in a 4% market throws off more cash than newly issued paper, so it trades above par. The premium buyers pay is what pulls their actual yield down toward the current market rate.
That gap between what you paid and what you’ll get back at maturity is the amount that needs to be amortized over the bond’s remaining life.
How the Premium Gets Written Down
Amortization chips away at the premium period by period until it reaches zero at maturity. Each period, part of the cash coupon you receive is treated as true interest income and the rest is treated as a return of the premium you paid, reducing your basis in the bond.
A quick example. You pay $10,500 for a bond with a $10,000 face value and a 6% coupon; the market yield when you buy is 5%. In year one, you collect $600 in cash. Effective interest is $10,500 × 5% = $525, which is what counts as interest income. The other $75 is premium amortization, and it lowers your carrying value to $10,425. Repeat each year with the new carrying value, and by maturity the carrying value has drifted down to the $10,000 face value the issuer repays. The unamortized premium at any point is simply whatever’s left of the original $500.
Don’t confuse carrying value with market price. Carrying value follows a fixed schedule regardless of what the bond trades for on any given day. The two only have to line up at maturity.
Effective Interest Method or Straight-Line
Under GAAP, the effective interest method is required. You multiply the current carrying value by the market yield at the time of purchase; the difference between that figure and the actual coupon is the period’s amortization. Because the carrying value declines each period, the amortization slice grows slightly each period and the interest slice shrinks.
The straight-line method divides the total premium evenly across every period. It’s only acceptable when the result isn’t materially different from what the effective interest method would produce. Short-term bonds and small premiums are usually fine; long bonds with large premiums are not.
For federal tax purposes on bonds issued after September 27, 1985, the constant yield method applies, which works the same way as the effective interest method: your yield to maturity is calculated from your purchase price, then used to split each coupon between interest and amortization.1Internal Revenue Service. IRS Publication 550 – Investment Income and Expenses
Tax Treatment for Taxable Bonds
For a taxable bond, amortizing the premium is optional. You have to affirmatively elect it under IRC Section 171, and once you make the election it applies to every taxable bond you own or later acquire, and stays in effect for future years unless the IRS lets you revoke it.2Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium
If you elect to amortize, each year’s amortization offsets the interest income the bond throws off, reducing your taxable interest. Your cost basis in the bond drops by the same amount.1Internal Revenue Service. IRS Publication 550 – Investment Income and Expenses
If you don’t elect, you report the full coupon as taxable interest every year, and when the bond matures you take a capital loss equal to the premium, because you paid more than you got back. For most investors, the annual offset against ordinary interest income is worth more than a capital loss later on, but it depends on the situation.
Brokers report the amortization on Form 1099-INT. Box 11 covers taxable covered securities, Box 12 covers U.S. Treasury obligations, and Box 13 covers tax-exempt securities. If you’ve elected to amortize, your broker may already report the net interest (coupon minus amortization); check the numbers before you file.3Internal Revenue Service. Form 1099-INT – Interest Income
Tax Treatment for Tax-Exempt Bonds
Tax-exempt bonds are stricter. There is no election. If you bought a tax-exempt bond at a premium, you must amortize the premium.1Internal Revenue Service. IRS Publication 550 – Investment Income and Expenses
Because the interest is already excluded from federal tax, the amortization doesn’t produce a deduction. It can’t offset other income. What it does instead is reduce your cost basis each year, as required by IRC Section 1016.4Office of the Law Revision Counsel. 26 U.S. Code 1016 – Adjustments to Basis
The mandatory basis reduction blocks a tax move that would otherwise be available. Without it, you could pay $10,500 for a tax-exempt bond, collect tax-free interest for years, and then claim a $500 capital loss at maturity when only $10,000 came back. The forced basis reduction converges your basis to the face value over time and shuts that down.2Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium
Callable Bonds
A callable bond lets the issuer buy it back early at a set price on preset dates. When a callable bond is held at a premium, the premium is amortized to the earliest call date instead of to maturity. If the issuer can pay you back sooner, stretching the amortization over the full term would overstate what’s really left of the premium.
The tax rule under IRC Section 171 lines up with the same logic. The premium is calculated with reference to the amount payable at maturity, or the earlier call date if that produces a smaller premium for the period before the call. If the call date passes without the issuer exercising the option, the yield is recalculated using the remaining payment terms.
Selling Before Maturity
Sell early and your unamortized premium runs straight into the gain-or-loss calculation. Your adjusted basis is the original purchase price minus all the amortization you’ve taken. The capital gain or loss is the sale price minus that adjusted basis, not minus what you originally paid.
Back to the $10,500 bond. After two years the carrying value is roughly $10,346. Sell for $10,600 and you have a capital gain of about $254, not $100. Sell for $10,200 and you have a capital loss of about $146, not $300. The amortization already flowed through your interest income over those two years, so the basis is lower by the time you sell. The economics balance either way; amortization only changes when and how the numbers show up on your return.