Background

A bond investor generally recognizes two characters of income during the bond’s term: interest income from the coupon payments, and a capital gain/loss when the bond matures (or is disposed of). During the bond’s term, they may have to address any Amortizable Bond Premium (ABP) for income tax purposes. ABP is equal to the excess of the purchase price over the face/par value, and is typically incurred when the interest rate on the bond is paying more than the prevailing interest rates on bonds. 

Example: On October 15, 2021, Janice purchases for $1,030 a taxable bond maturing on April 15, 2024, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $40, payable on April 15 of each year. Janice uses the cash receipts and disbursements method of accounting and the calendar year as her taxable year. She has made an election to amortize the premium. The bond premium paid is $30, which is the additional $30 paid over the face value ($1,000).

Although the interest rate is generally fixed by the issuer, bonds traded on the market will be bought and sold both above face value (i.e., at a premium for its favorable terms, generating ABP) and below face value (i.e., at a discount generating “original issue discount” – a topic for another day). Importantly, clients’ bond premiums create additional reporting considerations for tax professionals. Most, if not all, clients will elect to amortize the premium over the life of their taxable bonds, because it acts as a direct offset of the taxable interest income for that year. The 1099-INT and its supplemental information should provide the taxpayer’s amount of ABP allocable to the interest payments. Treasury Regulation § 1.171-4 discusses how to make an election to amortize bond premium on taxable bonds.

Taxable Bonds

In the example above, if Janice did not elect to amortize the premium, then at maturity there would be a $30 long-term capital loss (sales proceeds of $1,000 less $1,030 paid for the bond). For simplicity, let’s assume that the annual amortization is $10 every year. The $40 (4% coupon on $1,000 par value bond) of interest income could be reduced by $10 each year.

ABC Bank (Acct 1234)                                                                $40

Less: ABP Adjustment – ABC Bank (Acct 1234)*                       ($10)

Taxable Interest                                                                         $30

*See 2020 Instructions for Schedule B (Form 1040), page 2

For each year that the premium is amortized, Janice’s cost basis (the $1,030) is reduced by the annual $10 amortization under IRC § 1016(a)(5) and reflected by the broker as well under Treas. Reg. §1.6045-1(n)(7)(ii)(A).

Note that unless her tax situation is very unusual, Janice is better off electing to amortize the premium rather than keep her $1,030 basis and take a loss when the bond matures. That is because a direct offset to her ordinary income is much better than a future capital loss. Not only is the rate of tax saved likely to be higher, but the fact that it is a current benefit means that its real value need not be discounted for inflation and uncertainty. (It’s like choosing two birds in the hand over one in the bush, to invert the adage.) Thus, the federal rules create a default presumption of bond premium amortization under which brokers must report information as if the customer has made the election to amortize [see Treas. Reg. § 1.6045-1(n)(5)(i)]. Nevertheless, customers who do not elect to amortize may notify the broker, in writing, that they do not want to amortize the bond premium, allowing the broker to report the bond’s basis without adjustment [see Treas. Reg. §1.6045-1(n)(5)(ii)(A)].

Sometimes a bond may pay a variable rate of interest or provide an interest-free period, and the ABP could exceed the interest income. If this occurs, the taxpayer may deduct the excess premium as a miscellaneous itemized deduction not subject to the 2% floor [see IRC § 67(b)(11)].

As a practical aside, tax practitioners will likely have to consider the election to amortize bond premium only for their very wealthy clients (with exceptions for clients who are liability matching), because many individuals tend to invest in taxable bonds through a bond fund rather than purchasing individual bonds, as they may be better able to diversify the portfolio for credit and duration. However, high-net-worth individuals who can afford both to pay for personalized investment management and buy larger lots at favorable prices tend to hold their tax-exempt bonds individually through a separately managed account rather than through a bond fund.

Tax-Exempt Bonds

For federal income tax purposes, IRC § 171(a)(2) disallows a deduction for tax-exempt bonds. Notwithstanding the deduction disallowance, the basis must be reduced annually, in accordance with the ABP under IRC § 1016(a)(5). Therefore, a tax-exempt bond purchased at a premium and held to maturity may result in no capital loss at maturity, because the basis will have been adjusted down to the bond’s face value.

New York

Under N.Y. Tax Law § 612(b)(1), modifications increasing federal adjusted gross income include interest income on obligations of any state other than New York. Tax-exempt bonds from states other than New York are additions on the Form IT-201. Interest income from states other than New York are not directly offset by the amount of premium amortization directly allocable to the interest payments. Instead, New York provides a modification increasing the state itemized deductions for the amortizable bond premium on any bond the interest on which is subject to New York state tax but exempt from federal income tax [see N.Y. Tax Law § 615(d)(3)(ii)]. This addition adjustment is reflected on line 44 of the Form IT-196 (see Instructions: IT-196-I). The few taxpayers who incur ABP as part of their trade or business – rather than investment – may subtract the ABP for the year, without the need to itemize their New York deductions [see N.Y. Tax Law § 612(c)(10)(ii)].

New Jersey

Unfortunately, the New Jersey Gross Income Tax (GIT) statute does not explicitly mention amortizable bond premium. However, when the bond matures or is disposed of, New Jersey will use the federal adjusted basis as provided in N.J.S.A. 54A:5-1(c). Recall that the bond’s basis will have been reduced by the bond premium amortization adjustments mandated by federal tax law. In the absence of both statutory and regulatory guidance to the contrary, it seems reasonable to assume that New Jersey would not whipsaw the taxpayer with a statute that makes basis disappear for purposes of calculating gain or loss upon disposition, while also having a rule that prohibits using ABP to offset taxable interest.[1]

Connecticut

The Connecticut income tax begins with one’s federal adjusted gross income, which would mean starting with taxable bond interest net of ABP, and then making various state adjustments. Just like non-itemizers in New York, a typical investor does not get a deduction for ABP incurred when purchasing bonds that are federally tax-exempt but which are subject to Connecticut tax (i.e., out-of-state municipal bonds). Thus, if the federal adjusted gross income was reduced by ABP for out-of-state municipal bonds, the ABP deduction is added back as a Connecticut addition under CGS § 12-701(20)(A). However, a subtraction adjustment may then be available under CGS § 12-701(20)(B) if the ABP was not deductible in determining federal adjusted gross income and was attributable to a trade or business of that individual (e.g., a bond trader).

Conclusion

Lastly, it is important to keep in mind that the Federal Form 1099-INT provides the bond premium for “covered securities,” which tend to be securities purchased in the past several years [see Treas. Reg. 1.6045-1(a)(15)]. Tax professionals must look elsewhere in the 1099’s supplemental information for the total bond premium (covered and noncovered) to take ABP into consideration.

David M. Barral, CPA/PFS, CFP®, MS (taxation), is a Vice President and Wealth Advisor in Northern Trust’s New York City office. In this role, he serves as a financial planner to Northern Trust clients. David regularly works toward getting clients better organized. This frequently involves building out financial plans and projections for clients. The results allow him and the Northern Trust team to evaluate the current situation and provide their perspective for other strategies and alternatives that clients may want to consider. David also works with clients to help articulate and implement these strategies with their outside advisors (e.g., attorneys, accountants, life insurance professionals). He can be reached at dmb21@ntrs.com.

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel.