Amortization of Tax Exempt Bond Premium

[RWG1950]

I've posted on this before, so please excuse the redundancy but I still have trouble understanding the concept.
This concerns a zero coupon double tax exempt state bond. Non-covered security.
Brokerage statement shows both non-covered & not reported OID and acquisition premium on this bond.
Have gone over IRS pubs 550 & 1212. As I understand this, the acquisition premium must be amortized but how does how does one go about this?
Does the amortized premium amount simply accrue to basis or somehow get subtracted from current income on schedule "B"
Thanks for comments.

[terryats]

I believe Premiums paid for tax-exempt bonds cannot be amortized. Instead, the premium reduces the basis of the bond ( Code Sec. 1016(a)(5)).

[Maribeth]

Simple Example: $5000 face value bond, 5 year maturity, 5% interest, you paid $5,600 for the bond. Bond premium is $600. First year, you receive $250 in interest. Your interest income is $250, less the bond amortization of $120, taxable amount $130. Bond basis after year one is $5600 - 120 = $5,480.

This will go on for the 5 years. At maturity, the issuer will pay you back the $5000 face value, which is now also your adjusted basis, and there is no gain/loss.

hth

[RWG1950]

Thanks much for responding.

TERRYATS Everything I read on this seems to say that tax exempt bond premiums must be amortized. The part I don't seem to grasp is how to do this.
Was also wondering how an un-amortized premium could reduce the basis of a bond. Isn't the premium paid part of the asset's original cost basis?

MARIBETH Your example seems correct for a taxable bond (if choosing to amortize) but if a bond is a zero coupon paying tax exempt interest, simply reducing
the exempt interest (the OID) by the amortized acquisition premium amount seems a little counterintuitive. Zero's are sold at a big discount to face and the interest
is the internal yearly accrual. Are you saying that the investor simply needs to reduce the yearly tax exempt interest (OID) on the bond by the amortized amount ?
Wouldn't the investor then be reducing cost basis (and have LTCG or ordinary income at sale) just to have tax exempt income along the way?

One of us seems to be in left field on this issue - and I'm pretty sure it's me

[New York Enrolled Agent]

RWG - tax exempt bond - I think it goes like this. IRC 171(a)(2) says the premium is amortized each year but the amount of amortization is not deductible. However, The amortized premium reduces the basis in the bond each year as per IRC 1016(a)(5). The taxpayer keeps track while the bond is held and if the bond is sold then the sale price would be compared to the reduced basis for gain or loss.

[Maribeth]

Thanks much for responding.

MARIBETH Your example seems correct for a taxable bond (if choosing to amortize) but if a bond is a zero coupon paying tax exempt interest, simply reducing
the exempt interest (the OID) by the amortized acquisition premium amount seems a little counterintuitive. Zero's are sold at a big discount to face and the interest
is the internal yearly accrual. Are you saying that the investor simply needs to reduce the yearly tax exempt interest (OID) on the bond by the amortized amount ?
Wouldn't the investor then be reducing cost basis (and have LTCG or ordinary income at sale) just to have tax exempt income along the way?

It's the same procedure for a tax exempt bond. And yes, you reduce the amount of t/e interest that you have received for the year. In effect, you purchased that interest when you bought the bond at a premium. (you paid the original holder for the interest they had not received till then). And the procedure is the same. Your journal entry would be:

Debit - T/E interest income
Credit - Unamortized bond premium.

The amortization reduces the amount of t/e income you have, it's not really a deduction, but you have reduced t/e income for the year for calculations such as taxable social security amount.

[New York Enrolled Agent]

Maribeth - in post #3 your example appears to use a straight-line method to determine the amortization amount for the first year. I don’t believe that for bonds issued after 9/27/85 that method can be used. The taxpayer needs to use the constant yield method. The results won’t be vastly different and I understand you purposely used a simple example but I want to point this out to RWG.

[RWG1950]

New York Enrolled Agent Thanks for your input (as well as Maribeth & Terryats). Think I get the concept now.
The broker has been reporting to the investor yearly, the acquisition premium amount to amortize (in varying amounts) on the 1099 form each year,
so even though it's not a covered security, the brokerage firm must be tracking it & presumably will provide the investor with the reduced cost
basis when the bond matures.

[Snaggletooth]

Its sorta misnomer and misleading to an extent. On a tax-exempt bond, only the interest is tax-exempt.

A premium amortizes over the life of the bond, and the amortization is a non-deductible expense. However in the interim the bond is sold, the accumulated amortization reduces the basis of the bond.

The other scenario is a DISCOUNT (not discussed in this thread). The amortization is TAXABLE, and often is reported to the taxpayer as a 1099-OID. And the reverse is true with the basis - the amortization increases the basis if sold in the interim.