| Bonds Bought at a Premium |
Determining the cost basis of a bond
or note bought at a premium over
par value depends on two factors:
(1) whether it is TAXABLE or
TAX-EXEMPT, and
(2) whether you held it until the
maturity date or sold it prior to
maturity (or it was called.)
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For each combination of factors, the answer is detailed below. Page down until
you see your particular situation:
A. If you bought a TAXABLE bond at a PREMIUM and redeemed it at MATURITY:
Your cost basis is the original purchase price per bond from the trade confirmation.
Do not include the accrued interest that you may have paid at the purchase date.
You should have already deducted this on your Form 1040 Schedule B as a reduction
of interest income.
In the event that the bond was originally issued at a discount to par value, you will
also need to add any OID (original issue discount) interest which has been taxed
to you on Form 1099 each year since you bought the bond. Even bonds issued
with OID may be bought at a premium if interest rates have changed significantly
since the date of issue.
This answer assumes that you did not elect in the year of purchase to amortize
the premium over the life of the bond.
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B. If you bought a TAX-EXEMPT bond
at a PREMIUM and redeemed it at
MATURITY:
Your cost basis is par value. You implicitly
have amortized all of the premium
over the life of the bond even though
it is not deductible.
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Those tax-exempt bonds were put
in so that a town or a state or a
government could sell more bonds
than it ought to.
— Will Rogers
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This is easy to account for, but it can hurt you on your state individual income
tax return because, unless it is a double-exempt bond not subject to tax in your
home state, you will end up paying state income tax on more tax-exempt interest
income than you are actually earning. A portion of each interest payment on a
bond purchased at a premium is really a return of your own principal to you, since
you will only get back par value at maturity. You could make a state income tax
adjustment for this, but who goes to those lengths?
Bottom line: avoid buying tax-exempt bonds at high premiums, especially if you
live in a high-marginal-tax state and the bond is not double-exempt in your state.
C. If you bought a TAXABLE bond at a PREMIUM and sold it PRIOR to maturity:
Your cost basis is the original purchase price of the bond on your trade confirmation.
Do not include the accrued interest that you may have paid at the purchase date.
You should have already deducted this on your Form 1040 Schedule B as a reduction
of interest income.
This answer assumes that you did not elect during the year of purchase to
amortize the premium over the life of the bond.
D. If you bought a TAX-EXEMPT bond at a PREMIUM and sold it PRIOR to maturity
(or it was called):
Your cost basis at the date of sale is determined by the yield to maturity method
(yield to worst for callable bonds.) For a callable bond, the call price becomes
your basis at the call date after amortizing the premium using the yield to call.
Even though the amortized premium is not deductible, you are still required to
adjust your cost basis to calculate the capital gain or loss. For help doing this,
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