When a bond has an interest rate that's higher than prevailing rates in the bond market, it will typically trade at a price higher than its face value. Such a bond is said to trade at a premium, and the tax laws allow you to amortize the bond's premium between the time you purchase it and its maturity date in order to offset your income. Below, you'll learn more about bond premium amortization and one method of calculating it known as the straight-line method.
How to use the straight-line method
Calculating bond premium amortization using the straight-line method couldn't be simpler. First, calculate the bond premium by subtracting the face value of the bond from what you paid for it. Then, figure out how many months are left before the bond matures and divide the bond premium by the number of months remaining. That tells you how much to amortize on a monthly basis.
For the years in which you own the bond for all 12 months, you simply take amortization of 12 times the monthly amount. For the year of purchase and the year of sale or maturity, you have to account for a partial year, multiplying the monthly amount by the number of months during the year that you actually owned the bond.
One big caveat about the straight-line method
As simple as the straight-line method is, the main problem with it is that the IRS generally doesn't allow you to use it anymore. As IRS Publication 550 states, for bonds issued after Sept. 27, 1985, taxpayers must amortize bond premium using the constant-yield method, which differs from the straight-line method. For older bonds issued before Sept. 27, 1985, the straight-line method is still an option.
The constant-yield method will give you a smaller amortization amount than the straight-line method in early years, with the constant-yield amortization figure growing in later years. That puts it at a overall disadvantage to the straight-line method from the taxpayer's standpoint, which might be one reason why tax laws were changed to have newer bonds use the less favorable method.
Regardless of which method you use, amortizing your bond premium can save you on your taxes throughout the time that you own a bond and prevents you from having to wait until you sell the bond or it matures to get a tax deduction for the extra money you paid up front.
The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us atknowledgecenter@fool.com. Thanks -- and Fool on!
The article How to Amortize a Bond Premium Using the Straight-Line Method originally appeared on Fool.com.
Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
Copyright © 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
