You can invest your money in many different ways, including buying debt instruments such as bonds. Debt instruments pay you interest and repay their face values at maturity. Amortization is an accounting process you apply to debt that you purchase for an amount other than its face value. This process affects the taxes on the debt instrument.
Premium vs. Discount Debt
If you buy a bond or other debt instrument for more than its face value, the amount above the face value is the premium. Conversely, the discount is the amount by which the face value exceeds the purchase price. Discounts and premiums affect the yield, or total return, of the debt instrument. Premiums reduce your yield, while discounts increase yields. When you amortize discount debt, you turn part of the discount into interest income for each year that you own the instrument. Amortizing a premium creates a tax deduction each year.
Amortizing a Discount
When you buy a debt instrument issued at a discount, the instrument has “original issue discount,” or OID. Each year you own the debt instrument, you’ll receive Form 1099-OID from your broker telling you the amount of OID income you earned the previous year. Include this amount in your taxable interest income. Also, add this amount to the “cost basis” of the instrument, which is the amount you paid for it. In this way, the unamortized part of the debt decreases each year and disappears when the debt matures. Debt can also have market discount, which is discount that develops after the issue date. You can amortize this discount each year, but it’s optional.
Amortizing a Premium
A premium creates a built-in loss amount above the face value of a debt instrument you hold until maturity. You can choose to amortize the premium each year and take the annual loss as a tax deduction. You do this by subtracting the amortized premium from the debt’s interest income that you report on Schedule B of Form 1040. If your amortized premium exceeds your interest income, deduct the excess on Schedule A. Also subtract the amortized amount from your cost basis. Your remaining cost basis is the unamortized value of the debt instrument.
Selling the Debt Instrument
If you sell a bond or other debt instrument before it matures, you might have a capital gain or loss. The gain or loss is based on the difference between the sale price and the unamortized value of the debt. Amortizing the instrument results in a lower tax bill on a gain, because amortization reduces the unamortized amount. If you sell market discount debt that you didn't amortize, you must calculate the amount you could have amortized -- this is the accrued market discount. You pay ordinary tax rates on any gain up to the accrued market discount and use capital gains tax rates for any remaining gain. You pay only capital gains rates on profit from the sale of OID or premium debt.
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