Series 7: 4.9.1 Premium Bonds

4.9.1  Premium Bonds

A corporate bond can be bought at either a premium or discount to its par value, and each has different consequences for the bondholder. If the bond is purchased at a premium, the bondholder can choose one of two alternatives at tax time. If the bond is sold for less than it was bought for, the bondholder can take a loss on his taxes in the year of the sale. The loss is the difference between the purchase price and the sale price. A loss can also be taken if the bondholder holds the bond to maturity. In this case, the loss is the difference between what the bondholder paid for the bond and the face value of the bond—also called the premium.

Example: Jeffery purchases a $5,000 10-year bond on the secondary market for $5,700. The bond is redeemable in seven years. At maturity, he redeems the bond and takes a $700 loss on his taxes. He uses this loss to offset taxable earned income from other investments.

An alternative method of dealing with the tax consequences is to amortize the premium over the life of the bond. The amortized amount is determined by dividing the premium by the number of years to maturity when the bond is purchased. When a bond is amortized, its annual amortization reduces the adjusted cost basis of the bond until, at maturity, the adjusted cost basis will equal the bond’s redemption value. If the investor holds the bond until maturity, she will have no capital losses. The amount of the premium that is amortized each year is reported to the IRS and applied to the investor’s annual tax statement. It can be use