- Taxable bonds: The amount of the amortizable bond premium for the taxable year is permitted as a deduction.
- Tax-exempt bonds: The amount of the amortizable bond premium for the taxable year is not permitted as a deduction.
See I.R.C. 171(a). In other words, a bondholder may deduct amortizable bond premium for taxable bonds but not for tax-exempt bonds.
The adjustment to basis in the bond resulting from the amortizable bond premium is addressed in I.R.C. 1016(a). An adjustment to basis is made in the case of tax-exempt bonds to the extent of the amortizable bond premium disallowed as a deduction (as described above). An adjustment to basis is also made in the case of taxable bonds to the extent of the deductions allowable as described above. See I.R.C. 1016(a)(5).
In other words, for a tax-exempt bond, as premium is amortized, the amount of the amortization offsets a corresponding amount of interest for the period, and the purchaser’s basis in the bond is reduced by a corresponding amount resulting in an increase in the gain (or decrease in the loss) to be recognized for federal income tax purposes upon a sale or disposition of the bond prior to its maturity. Even though the purchaser’s basis may be reduced, no federal income tax deduction is allowed. (Unlike in the case for taxable bonds absent an election under I.R.C. 171(c).)
For a taxable bond, the amount of bond premium is determined with reference to the amount of basis in the bond and either (1) the amount payable on maturity or (2) the amount payable on an earlier call date, whichever leads to a smaller bond premium. (The effect of this rule is to minimize the amount of deductions from amortization.) For tax-exempt bonds, however, one only looks to the basis and the amount payable on maturity (regardless of what the premium would be by looking to the earlier call date). See I.R.C. 171(b).
There is a special election available for taxable bonds (it does not apply to tax-exempt bonds).
The concept of bond premium was established for book/financial accounting purposes many years before federal income tax law on bond premium existed. In 1942, Congress enacted specific tax legislation mandating the amortization of bond premium for tax-exempt municipal bonds and permitting taxpayers to elect to amortize bond premium on taxable bonds. Section 125 of the 1939 code, added by section 126(b) of the Revenue Act of 1942.
See I.R.C. 75 regarding adjustment for bond premium for dealers in tax-exempt securities.
See Stevie D. Conlon, “Wash Sales Assymmetrically Affect Premium and Discount for Debt,” Tax Notes, April 21, 2014, at 339.