Amortization of Municipal Bonds

A premium bond is just a bond that costs more than the face amount. For example, if you paid $105,000 for a $100,000 bond, the extra $5,000 is called a premium. You may wonder why anyone would pay extra for a bond, but there is a very good reason: A premium bond pays more interest -- called the coupon rate -- than the current market yield for similar bonds. The premium on the bond effectively lowers the yield to bring the rate in line with the rest of the municipal bond market. However, with a premium bond you do receive more money in tax-free interest than you would from a bond with a lower price and lower coupon rate.

If you $105,000 for a bond that will pay you $100,000 when it matures, the extra interest you will earn will make up for the premium, but on a cost basis that $5,000 is lost money. With taxable bonds, you would get to claim the loss, either when the bond matures or by amortizing the premium over the life of the bond and using the annual amortization amount to reduce the taxable interest. However, since municipal bond interest not taxed, the writers of the tax rules have decided you cannot use that lost bond premium as a tax loss.

To complicate matters, the tax rules require you to amortize the premium of a municipal bond. Amortization in this case means that you take a portion of the premium each year and use it to lower your cost basis in the bond. By the time the bond matures, your cost basis will be the same as the face amount and you have no tax-deductible loss. The amount to amortize each year is calculated using the "constant yield method." The method accounts for the dates of your purchase and the dates of interest payments. The good news is that your broker will apply the constant yield method for you and provide you with the amortization amounts to use each year.

Even though your municipal bond interest is not taxed and the amortization has no effect on your taxes, you still must include the interest and amount amortized on your annual tax return. If you sell your municipal bond before it matures you may end up with a capital gain or loss based on the cost basis at the time of sale. Your basis will be what your paid for the bond minus the amounts amortized over the years since you bought it.