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.)
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.
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.
This is easy to account for, but it can hurt you on your state 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:
Your cost basis at the date of sale is determined by the yield to maturity method. 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, use our handy amortization tools.
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Information provided is intended solely for U.S. individual cash-basis taxpayers and is believed to be accurate for most cases. Always consult your personal tax advisor about your own situation. Suggestions are most welcome. Please e-mail webmaster @ costbasis.com or write to us at P O Box 11022, Chicago IL 60611 with your comments.