Amortizing a premium is a process by which an investor can redistribute and potentially reduce the taxable interest on a bond over its lifetime. The Internal Revenue Service requires investors who purchase certain bonds above their face value to amortize the extra premium they paid over the bond's life. Face value is also called par value. The face value of a bond is in very simple terms the market value or the price it logically should fetch given the current market at the time it is purchased. A premium in this context is the excess cost taken on by the buyer in choosing to buy above par or above face value. The rules compiled by the IRS are put in place to prevent investors from reporting false losses on bonds that could negate other taxable income.
Buying Bonds at a Premium
Investors buying bonds at a premium are required to amortize that premium for the entire time they own that bond. This is a failsafe to prevent investors from hiding or trying to cancel out taxable income elsewhere by reporting losses on bonds, which do not affect us financially in the same way as do losses on stocks. If a bond holder chooses to voluntarily pay a premium in order to purchase a bond (i.e. buy a bond above its market value), that premium becomes a part of the investor's cost basis in the bond. If the bond happens to yield taxable interest for the bond holder, that bond holder has the option of amortizing the premium, which many do choose to do.
How Bond Amortization Works
Amortizing a premium on a bond purchase works something like this: over the life of a bond, the bond holder uses a part of the premium (that original amount paid above par) to reduce the amount of interest counting as income. In other words, this method works to cut down on the amount of interest earned that bond holders have to count as income. But if you make this choice, you must reduce your basis in the bond by the amount of the amortization for the year. If the interest yielded is tax exempt, any premium must be amortized, and this amortized portion is not tax deductible. Anyone choosing this option for tax exempt bonds still must reduce their basis in the bonds by that year's amortization.
How to Compute Bond Amortization
There is a fairly straightforward method for computing a year's worth of amortization on a bond issued after these IRS rules went into effect. Investors working to calculate their amortization must do so using a constant yield method. Doing so takes into account the maturity of the bond and the basis of the bond's yield all the way to maturity. This is done by using the bond's basis and compounding it at the end of each accrual period. In many cases, financial advisors have computer software that can do this for you as an investor automatically without any extra work on your part.
According to the rules set up by the IRS regarding bond amortization, an investor can make the decision to begin amortizing any time they want to after purchasing a bond and it is not necessary to do so right from the outset. However, if as a bond holder you make the choice to stop amortizing, you must inform the IRS of this change for tax collecting purposes. This decision does not change the way acquisition price is used; the price is adjusted to match what it would have been had you amortized from the beginning.