Tax treatment of bonds requires the investor to analyze each individual bond holding by purpose, credit type and price. Tax treatment of bonds includes analyzing the income stream plus analysis of the cost of the bond's difference from par or 100. Premium bonds are bonds purchased above par or a price of 100. Par bond purchases are the most common type of purchases. Discount bonds are bonds purchased below par.
Determinining the Premium
At the time of purchase the broker's confirmation will list the par amount ( the value at maturity of bonds purchased ), the price per bond, the call feature, if any, and the maturity date of the bond. Shown elsewhere is the yield to maturity and the yield to the call (if any). All of these data points come into play when computing tax features for bonds.
Computing the Premium
Subtract the bond price from both the call price and the maturity. If you paid 106 for a bond, the call feature is 102, and the bond redeemed at 100 the premium to be reduced would be 106 minus 100, or 6 points. However, premium bonds are priced to the call, so the proper premium is 4 points (106 -102) and then from the call to maturity is 2 points (102-100).
Compute Yearly Premiums
Understand that these premiums are simply recognizing that that you paid more than par for the bonds and at maturity you will only receive par. Therefore, you incur a capital loss as the bonds decline to par. This is called amortizing the premium to maturity and results in a slight reduction in your taxes each year. The yearly amortization can be offset against other gains when filing taxes.
Computing the Annual Amoritization
Using the example above, if the time from purchase to the call is four years then the amortization of the 4 points premium is 4 divided by 4, or 1. If the time from the call to maturity is one year, then the amortization for the last year is 2 divided by 1, or 2. At maturity the bond will be fully amortized at par.
Technical Differences in Bonds
Note that while a loss is sustained through amortization income is still received from the coupon payments you receive. Note also that the amortized cost of the bond becomes your new cost basis for the bond if you sell it in that tax year.This income is taxable as investment income. Investment income will be reported by your broker on a 1099 form sent to you and the federal government.
Municipal Bonds Have Different Concerns
Note that with municipal tax exempt bonds the income is free from federal taxes. Thus there is no offsetting loss from premium amortization. Amortization is still necessary if the premium bond is sold that tax year. Furthermore, not all municipal bonds are tax free from state income tax in which case amortization must be employed for state income tax purposes.
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