# Taxation of bond discounts and premiums.

With the recent increase in interest rates by the Federal Reserve, along with the fluctuating stock markets, individual investors are tempted to switch their portfolios from equity to debt securities. In the dynamic environment of buying and selling securities, tax professionals and individual investors should be aware of the tax ramifications associated with the purchase of taxable and tax-exempt bonds. This item provides a summary of how to handle one of the most common issues that arise when purchasing or selling bonds--discount and premium amortization.

Bond Discounts---General Rules

A discount arises when a taxable or tax-exempt bond's stated interest rate is lower than rates on similar bonds in the marketplace. A discount can either be an original issue discount (OID) or a market discount. Although it may be impossible for an individual to determine the rate the market is paying at any given time, the fact that a bond is being offered for less than its face value indicates that it is being issued at a discount. In effect, the return on the taxpayer's investment will equal the market rate of return, after taking into account the purchase of the bond at a price lower than its face value. The following facts illustrate this situation. A bond with a face value of \$250,000 and a stated rate of 12% rate is offered for \$247,125. This is an indication that the market rate is more than 12% for this particular bond. Generally, bonds pay interest twice a year based on their face value and stated rate. This bond would pay a semiannual payment of \$15,000 (\$250,000 x 6%). Note: Receipt of cash does not always represent all of the interest income to be reported for Federal and state income tax purposes; amortization of bond discount is also included.

The annual amount of bond discount amortization is computed using either an effective-interest (constant) method or the straight-line (or ratable) method. The straight-line method of amortization is computed simply by dividing the discount by the number of months until maturity and multiplying by the number of months the bond was held during the year. The calculation for the effective-interest method is more complex. The annual amortization under the constant-interest method is calculated by deriving the yield to maturity (YTM) on the investment, multiplying it by the adjusted principle amount and comparing it to the amount of cash received .based on the stated interest rate. The difference between this calculated amount and the cash received is the amount of annual amortization under the constant-interest method. If the taxpayer makes a formal election to amortize a market discount on an annual basis, the straight-line or constant-interest method may be used to determine the annual amount of amortization to include in income. If a bond is issued with OID, the amortization must be done using the constant interest method.

Bonds Purchased with OID

OID arises when the purchaser of a bond (in effect, the lender of funds) agrees to pay an amount less than face value on the bond's original issue date. The OID on both taxable and tax-exempt bonds must be amortized on an accrual basis.

The issuer of a taxable bond with OID is required to issue Form 1099-OID to report the discount to be included as ordinary income on the taxpayer's current-year income tax return. The issuers of tax-exempt bonds are not required to issue Forms 1099-OID. Therefore, the responsibility of reporting OID amortization falls on the taxpayer, his income tax preparer or his broker. The annual amortization of OID on to tax-exempt bonds gives rise to tax-exempt income.

The amount of OID amortized each year for both taxable and tax-exempt bonds increases the taxpayer's basis in the bonds. The result of this inclusion is a reduction of the gain (or an increase in the loss) on the disposition of the OID bond.

Bonds Purchased with Market Discount

The market discount that arises from the purchase of a taxable bond issued prior to July 18, 1984 and purchased prior to May 1, 1993 is not required to be amortized by the bond holder (Omnibus Budget Reconciliation Act of 1993, Section 13206). The bondholder does not have to amortize the market discount that arises from all tax-exempt bonds purchased prior to May 1, 1993. Note: The bond issue date is not important when dealing with tax-exempt bonds. The difference between the redemption price (or the disposition price) and the purchase price is simply a capital gain to the taxpayer for both taxable and tax-exempt bonds.

For taxable bonds issued after July 18, 1984 and/or purchased after April 30, 1993 (and for tax-exempt bonds purchased after April 30, 1993), the taxpayer may elect whether to amortize the market discount on an annual basis (under Sec. 1278(b)). This election must be carefully considered, as there are significant tax ramifications either way. The amortization of market discount associated with a taxable bond gives rise to the taxpayer's basis in that bond. The amortization of market discount on tax-exempt bonds, however, does not increase the taxpayer's basis in the bond.

If the taxpayer elects to include the amortization of the discount as current-year income, Sec. 1276 provides for the computation of the amortization of the market discount using the straight-line method. The taxpayer may elect on an annual basis to compute the amortization using the constant-yield method. In addition, the taxpayer must decide to which bonds, purchased during the year, the election applies. Because the method of computing the amount of bond amortization is also irrevocable, due care should be exercised when considering the election.

If the taxpayer does not elect to amortize the market discount on an annual basis, the discount that would have been amortized under the straight-line method from the bond purchase date until the earlier of its disposition or maturity date is ordinary income when the bond is disposed of by the taxpayer. This is true both for taxable or tax-exempt bonds. The recognition of ordinary income increases the taxpayer's basis in the bond, and the difference between the redemption or sale price and the bond's basis is a capital gain or loss.

Note: The annual income inclusion for taxable and tax-exempt bonds differs if the taxpayer makes the election. The amortization of the market discount that arises from the purchase of a taxable bond will result in an annual inclusion of ordinary income and an annual increase in the bond's basis. The annual amortization of a tax-exempt market discount does not result in an annual inclusion of income and the exempt bond's basis is not increased annually.

The election applies to all taxable and tax-exempt bonds acquired in the current and future years and is irrevocable without IRS permission.

Planning Tips

The calculation of bond discount amortization, in itself, is not a complicated issue, although it potentially requires meticulous record-keeping. The question of whether to elect to amortize bond discounts should be evaluated on a taxpayer-by-taxpayer basis. Because the election is irrevocable and applies to all taxable and tax-exempt bonds acquired after the formal election is made, a taxpayer's entire portfolio must be analyzed before making the election.

The election to amortize a market discount affects the timing of taxable income for taxable bonds. To illustrate, assume a taxpayer purchases a taxable bond issued at a market discount in the current year. The taxpayer formally elects to amortize the discount and properly includes the annual amortization as additional ordinary income. The annual increase in basis due to amortization of the discount will lower the gain or increase the loss on disposition.

If a taxpayer did not elect to amortize the market discount, the amount that would have been amortized under the straight-line method is included as ordinary income in the year of bond disposition. The ordinary income inclusion in the year of disposition results in an increase in the basis of the bond in the year of disposition. Therefore, the effect of making the election, with respect to taxable bonds, is a timing difference for ordinary income recognition. An election to amortize will accelerate the recognition of ordinary income, while not electing will cause a deferral of ordinary income recognition until disposition.

The election to amortize a market discount on a tax-exempt bond has an effect on the character of gain (ordinary vs. capital) on disposition of the bond. If the taxpayer does not formally elect to amortize a market discount on a tax-exempt bond, ordinary income must be recognized in the year of disposition, to the extent of amortization that would have been taken under the straight-line method. However, if the taxpayer makes a formal election, the amortization of the market discount does not result in either an annual income inclusion or an increase in basis. Consequently, the taxpayer will have a capital gain or loss on disposition. The net effect of electing to amortize the market discount for tax-exempt bonds is that the taxpayer can treat the entire gain as a capital transaction (as opposed to a mixture of capital gain or loss and ordinary income).

The composition of a taxpayer's portfolio between taxable and tax-exempt bonds must be carefully analyzed before making a formal election to amortize market discounts on an annual basis. Rev. Proc. 92-67 outlines the process of electing to amortize market discounts and method of amortization.

Bonds that offer a higher stated rate than the prevailing market rate will sell at a premium on the market. Similar to discounts, premiums are an attempt to equalize the return on the investment to market rate of return. A bond with a face value of \$250,000 and a stated rate of 12% is now being offered at 101.2 or \$253,000. This premium is due to the fact that the bond is paying a higher interest rate than the stated rate for similar bonds.

Note: The bond premium on a tax-exempt bond is required to be amortized on an annual basis. Prior to Sept. 25, 1986, tax-exempt and taxable bond premium could have been computed using "any reasonable" method (the straight-line method was the most commonly used). For tax-exempt bonds acquired on or after Sept. 25, 1986, the annual premium amortization is required to be computed using the effective-interest method. To contrast with market discounts on tax-exempt bonds, the amortization of the premium will lower the taxpayer's basis in the bond. The premium associated with taxable bonds acquired on or after Sept. 25, 1986 is not required to be amortized. If the taxpayer elects to amortize the taxable bond's premium, the annual amortization will be an offset against current interest payments (or to the extent of prior-year interest payments) and a reduction to basis (under Sec. 171(c)). This election is also irrevocable and applies to all taxable bonds acquired thereafter. As a general rule, taxpayers should elect to amortize premiums on taxable bonds and reduce ordinary interest income, as opposed to using the premium as an offset against proceeds in the year of disposition.

Exhibit 1 summarizes the options for elections to amortize premiums and discounts.

[Exhibit 1 ILLUSTRATION OMITTED]

FROM IGNACIO MENDEZ, CPA, AND JORDAN WERBLOW, CPA, KLAYMAN & KORMAN, LLC, CHICAGO, IL

Editor: Anthony Bakale, CPA, MT Cohen & Company, CPAs Summit International Associates, Inc. Cleveland, OH
COPYRIGHT 2000 American Institute of CPA's
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