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Bond premium amortization reporting: federal and state tax issues.

One of the challenges facing CPAs is how to handle bond premium amortization in light of the new favored New York State tax treatment. This article reviews the treatment of bond premiums at the federal level, and then delves into considerations at the state level.

The past few years have seen a number of changes to Form 1099 reporting as a result of the Emergency Economic Stabilization Act of 2008. One of those changes, seen on the 2014 Form 1099-INT, is the introduction of line 11, "bond premium": this lists the annual bond premium amortization for covered securities purchased after January 1, 2014.

The problem lies whenever a taxpayer has covered and noncovered securities (bonds purchased prior to 2014), so simply looking at line 11 of Form 1099-INT would not be sufficient for tax reporting. CPAs should always look at the detail and supplementary information provided, in order to gather all of the information regarding amortizable bond premiums for the respective tax year.

Treatment of Bond Premiums

When taxpayers purchase a bond above its face/par value, they are said to have purchased the bond at a premium. An example would be purchasing a $1,000 par value bond (i.e., a bond that will pay $1,000 at maturity) with a 5% coupon rate paid semiannually (i.e., paying $25 semiannually) for $1,100. This additional $100 represents the premium charged because, under the current market conditions at the time of purchase, few other bonds were offering similar interest rates that high. Because the coupon interest rate is fixed, the issuer's only way to adjust for differences between varying market interest rates is to adjust the issuing price of the bond itself. In this example, the issuer can sell their bonds at a premium because they offer a higher coupon rate when compared to prevailing lower market interest rates.

Taxpayers will generally experience two forms of income tax while holding such a bond. First, they will have interest income to report throughout the life of the bond: the $50 paid annually, taxed at ordinary income tax rates. Second, there will also be a future capital gain or loss at maturity: specifically, a $100 capital loss (assuming no election to amortize), because the bond was bought for $1,100, but the taxpayer will receive only $1,000 when the bond matures.

It is important to note that brokers will assume the election is made [see Treasury Regulations section 1.6045-1(n)(5)(i)] and will report the cost basis taking into account this bond premium amortization. Taxpayers can (in writing, of course) notify their broker that they do not want to have the broker take into account the election to amortize the bond premium under Treasury Regulations section 1.6045-1(n)(5)(ii)(A).

Taxpayers that make the election to amortize the bond premium will attach the election with their return. Taxpayers do not need IRS consent to make this election [Treasury Regulations section 1.171 -5(c)(1)]. The election will be in effect for the current tax year, and all future years, unless the IRS revokes it. The election to amortize under IRC section 171(a)(1) is done under a constant yield method, based upon the bond's yield to maturity. Generally, this is provided by the broker, done with software, or calculated by an accountant's spreadsheet.

It is generally advantageous for taxpayers to elect to amortize the bond premium, because an interest income offset is more beneficial than a future capital loss.

When a considerable amount of bonds is involved, that loss will be limited to $3,000 per year; assuming there are no other capital gains to offset this, this further reinforces the benefit of taking the deduction annually. When the election is made, the taxpayer will report interest income from the bond, along with a corresponding line item reflecting a deduction for the amortizable bond premium, similar to interest received as a nominee.

The amortization taken annually will bring the cost basis down; if the bond is held to maturity, it will result in no capital loss. In the example above, the cost basis will be reduced from $1,100 to $1,000. The adjusted cost basis will equal the proceeds received when the bond is redeemed.

CPAs frequently find that investors are holding more tax-exempt bonds than taxable bonds. Tax-exempt bonds are barred a deduction for amortizable bond premiums under IRC section 171(a)(2). Conceptually, this makes sense, because the income is not taxable and therefore no deduction should be allowed. But even though no deduction is allowed, tax-exempt bonds still must amortize the premium on the books under IRC section 1016(a)(5).

Once again, it is important to note that brokers will assume the election to amortize is made and report basis accordingly unless the taxpayer has specifically directed them in writing to reflect basis assuming no amortization.

State Considerations

At the federal level, no deduction is allowed for bond premium amortization on tax-exempt bonds because the income is not taxable at the federal level. But what about at the state level? A bond whose interest income is subject to New York income tax but exempt from federal tax can be included as a New York itemized deduction under section 612(c)(10) of the New York State tax law. It is included on line 11 of Form IT-201-D as an addition to New York itemized deductions.

The New York State Department of Taxation and Finance (DTF) has become increasingly effective in recent years at sending notices acknowledging the amount of interest income not being reported from state and local bonds that is from outof-state bonds. As a result, it is even more important to take bond premium amortization into account. The notices from the DTF are simply requesting that taxes be paid on interest income from out-ofstate bonds and do not take into consideration the bond premium amortization deduction. It is important for tax professionals to understand this, and not miss a potential deduction for their clients.

The Big Picture

While this article has addressed just one new line item on the Form 1099-INT, taxpayers and their advisors need to be aware of all that one line item entails.

David M. Barral, CPA/PFS, CFP, is a supervisor at MBAF CPAs LLC, New York, N.Y.
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Title Annotation:Taxation: federal taxation
Author:Barral, David M.
Publication:The CPA Journal
Date:Oct 1, 2015
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