Taxation of bond discounts and premiums.

• Author: Bakale, Anthony

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...