Many people wonder how the cost basis and amortization rules apply to bonds that are inherited. Basically, the rules work the
same way as they do for inherited stocks.
The fair market value on the date of death
(or the alternate valuation date if so elected by the executor) becomes the new beginning cost basis.
The fair market value for estate tax purposes is defined as the average of the high and low trading prices for the day the death occurred. Since many bonds do not have daily trading, the average of the previous day's closing price and the closing price on the date of death can be used as the fair market value. If the death occurs on a weekend, the average of the Friday and Monday average trading prices becomes the fair market value for estate tax purposes.
This is where a relationship with a good full-service brokerage firm can really come in handy. They have bond pricing services to value bonds at historical points in time and can provide an estate evaluation.
Obtaining the date of death fair market value is only the first step, however. Based on the estate value market price, you then must determine the new yield to maturity and amortize the premium or discount over the remaining term of the bond.
Sadly, the excellent Yield Calculator at Ficalc.com is no longer available. To obtain the new yield to maturity or yield(s) to call for inherited bonds, you will need to call your broker and ask the bond desk to calculate the yield using the date of death as the settlement date and the estate fair market value as the purchase price. They have special bond calculators to do this.
If it is a callable bond, determine both the yield to maturity and the yield to the various call dates and pick the least (worst) yield.
If the yield to maturity is used, amortize the bond from the date of death estate value to the maturity date par value using the new yield to maturity calculated on the estate fair market value.
If the yield to call is used, amortize the bond from the date of death estate value to the call date and call price.
An inherited OID bond works exactly the same way. Obtain the new yield to maturity and amortize from the estate fair market value at the date of death to par value at the maturity date.
The acquisition date is the date of death, but for capital gains purposes an inherited asset is always long-term even if it was purchased by the decedent less than a year before the date of death.