Call of Muni Bond

[Kram BergGold]

A $15,000 bond is inherited with a value of $15,600. When it is called $15,150 is received. Is the premium amortized down to $15,150 for no gain or loss or amortized down to $15,000 for a $150 gain?

[Gary2]

Normally the amortization is based, in part, on the yield, which requires knowing total remaining payments. So if it were just sold on the open market and wasn't callable, there would be no way to answer the question without knowing the maturity date of the bond. But callable bonds have special rules that I've never bothered reading. Pub. 550 contains a reference to Reg. 1.171-3, so I suggest starting there.

[Roberts]

A $15,000 bond is inherited with a value of $15,600. When it is called $15,150 is received. Is the premium amortized down to $15,150 for no gain or loss or amortized down to $15,000 for a $150 gain?

If it's an individual bond, no gain / no loss.

[Roland Slugg]

There is taxable gain or loss on the sale or redemption of T/F municipal bonds just like any other capital asset. Based on the values given there is a LTCL of $450 ... $15,150 selling price less $15.600 basis. This is true for corporate bonds, US Government bonds and T/F municipal bonds.

[Burke]

I agree with Roland. The FMV is what it is valued using stepped-up basis at death. Called at $15,150 = $450 LT cap loss.

[Roberts]

Pub 550 page 34 or 35 says:
"If the bond yields tax exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income."

No capital losses allowed on tax free muni bonds. IF it's a packaged product that buys tax free muni bonds, a capital loss is allowed i.e. Mutual funds, UITs, ETFs, CEFs.

Let's think about it. Currently you can get tax free bonds with current yields of 4% that have a massive capital loss bringing the yield to maturity down to 3%. They aren't going to allow you 4% tax free income AND allow you to deduct the loss.

NOTE: not all muni bonds pay tax exempt interest. Some pay taxable interest payments.

[Gary2]

Pub 550 page 34 or 35 says:
"If the bond yields tax exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income."

No capital losses allowed on tax free muni bonds. IF it's a packaged product that buys tax free muni bonds, a capital loss is allowed i.e. Mutual funds, UITs, ETFs, CEFs.

Let's think about it. Currently you can get tax free bonds with current yields of 4% that have a massive capital loss bringing the yield to maturity down to 3%. They aren't going to allow you 4% tax free income AND allow you to deduct the loss.

NOTE: not all muni bonds pay tax exempt interest. Some pay taxable interest payments.

I agree, more or less. I still haven't digested the special rules for callable bonds, but I think they're designed to have the same effect as the ordinary rules for munis, i.e., no loss allowed if held to maturity, the only difference being that a callable bond is treated has having multiple potential maturity dates.

The one nit (and it's just a nit), is that a loss is allowed if sold on the open market prior to maturity/call. The amortization is spread over the life of the bond, so if you sell it before maturity, you need to calculate the adjusted basis depending on how much amortization has already accrued, and there can be a capital loss allowed in such cases.

[Roberts]

The one nit (and it's just a nit), is that a loss is allowed if sold on the open market prior to maturity/call. The amortization is spread over the life of the bond, so if you sell it before maturity, you need to calculate the adjusted basis depending on how much amortization has already accrued, and there can be a capital loss allowed in such cases.

No, it isn't. If a loss was allowed on a sale, why would anyone in their right mind hold a bond to maturity? They'd sell it 2 days before maturity to generate a capital loss deduction. Since you can't reduce income with amortization, the IRS doesn't care how much amortization you take in any year.

[Gary2]

No, it isn't. If a loss was allowed on a sale, why would anyone in their right mind hold a bond to maturity? They'd sell it 2 days before maturity to generate a capital loss deduction. Since you can't reduce income with amortization, the IRS doesn't care how much amortization you take in any year.

No, because 2 days before maturity the adjusted basis will be essentially the same as the redemption price (which will be essentially the same as the market price), so there won't be any gain or loss.

The rule isn't literally that you can't take a loss. The rule is that amortization of bond premium on a tax-free bond is mandatory. It's a corollary that if you hold the bond till maturity, than the effect of the amortization is to make the basis the same as the maturity price, creating 0 gain or loss. But if it's a ten year bond, bought at a premium, and sold after only five years, you've only amortized half the premium. The market price may be more or less than the adjusted basis at that point.

[Burke]

The rule isn't literally that you can't take a loss. The rule is that amortization of bond premium on a tax-free bond is mandatory. But if it's a ten year bond, bought at a premium, and sold after only five years, you've only amortized half the premium. The market price may be more or less than the adjusted basis at that point.

And hence, my response regarding the inherited bond. No time frame was given. However, the FMV at death was apparently $15,600 and it was later called at $15,150. Now, there was no indication that the bond was originally bought at a premium or that any partial amortization had taken place prior to the death of the owner. The question arises: must the estate/trust amortize this phantom "premium" (excess over face value) each year it continues to be held?

[Jiggers]

Interesting reading. The client brings in a 1099DIV/INT/B combination.

Shows total DIV, INT, including tax-exempt INT, and B transactions.

How are we to know what the bonds that are being sold are? We get no detail information on the bond.

[Burke]

How are we to know what the bonds that are being sold are? We get no detail information on the bond.

Virtually all the 1099-B's I receive for bond sales or redemptions are from the big brokerage houses' statements, and the individual sales of bonds are described so that you know which are which (taxable vs tax-frees). In fact, most of the 1099-INT's I see indicate the accrued interest on those (if any) as well. Note Roberts comment above regarding bond funds or mut funds containing bonds.

Although it does not directly answer the OP re: an inherited bond, a very readable article concerning muni/tax exempt bonds, including whether you can take a gain or loss, and the treatment of premiums/discounts, etc. is shown at the link below:

http://www.investinginbonds.com/lear...=8&subcatid=60.

After some extensive research, I am going to rely on certain statements from the IRS regarding inherited property to wit:

1. Bond has FMV in the estate of $15,600.

2. Since IRS instructions say you must amortize the "premium" on a bond based on its value "immediately after you get it," I am going to infer that the estate must do the same for a tax-exempt. Amortized from date of receipt to maturity date, and basis reduced over that period, annually.

3. If called prior to maturity date, sale proceeds are $15,150 and basis is FMV reduced by any prior amortized amt. Therefore, if it was called in the first year of the estate, no amortization would have been taken, and it would have a $450 LTCL.

[Gary2]

After some extensive research, I am going to rely on certain statements from the IRS regarding inherited property to wit:

1. Bond has FMV in the estate of $15,600.

2. Since IRS instructions say you must amortize the "premium" on a bond based on its value "immediately after you get it," I am going to infer that the estate must do the same for a tax-exempt. Amortized from date of receipt to maturity date, and basis reduced over that period, annually.

3. If called prior to maturity date, sale proceeds are $15,150 and basis is FMV reduced by any prior amortized amt. Therefore, if it was called in the first year of the estate, no amortization would have been taken, and it would have a $450 LTCL.

I believe the essential theory here is correct.

However, keep in mind that the amortization is based on accrual periods, and each interest payment triggers such a period. Thus the only way there would be no amortization in the first year would be if it's a short year with no interest paid in the time frame, or if called before the next payment is due. However, it it's callable at $15,150 prior to or at the next interest payment, then it would not have had a market value of $15,600.

Finally, I'll get back to the special rules for callable bonds. The amortization is not simply based on maturity date. Regulation 1.171-3(c)(4)(ii)(A) says, if I'm reading it correctly, that the amortization for a tax-exempt bond is determined by assuming it will be called in a manner that minimizes yield, which has the effect of maximizing the amortization. We don't have enough information to determine that in this case. I wouldn't be surprised if callable muni bonds are, as a matter of industry practice, set up so that the answer is either always "final maturity date" or always "first callable date", but I don't know. If I had to guess, I'd guess the latter, since otherwise why would an issuer ever call a bond if doing so resulted in a higher effective yield? But there could be other reasons, such as managing municipal debt limits.

[taxxcpa]

Muni bond premium amortization

See page 6-5 of The Tax Book:
Bonds yielding tax-exempt interest. If the bond yields taxexempt
interest, the taxpayer must amortize the premium. The
amount is used to reduce the amount of tax-exempt interest reported
on line 8b, Form 1040, and also reduces the taxpayer’s basis
in the bond.

The basis for gain or loss would be the original stepped-up basis minus any amortization actually
allowed or allowable.

[Gary2]

For what it's worth, I located this article on Premium Pricing of Munis: http://www.munibondadvisor.com/PremiumPricing.htm . The article is actually addressed to municipal finance people, but the second paragraph points out "... callable premium bonds must be priced to the date resulting in the worst (lowest) yield for the investor. Generally this means that the bonds are priced to the first call date." Although this is talking about the way the bond price is set, it seems to confirm that amortization will generally zero out at each and every call date, since the IRS requires the amortization to match the worst yield. (If it's not obvious, the call prices will decline over time until reaching the face value at full maturity.)