Municipal bonds were purchased on 10/2/09 for $111.43. The maturity date was 10/1/18 but they were called on 1/3/14 for $100. What is the amount of the tax loss if $25,000 of par was purchased? The coupon interest was 5%, tax free.
When it was purchased the expectation was that, for the premium price paid of $111.43 the bond would pay the 5% interest per $100 until the maturity date of 10/1/18. Instead, the bond paid the 5% until it was called on 1/3/14. If the bond was priced on the date of sale knowing it would only pay the interest until 1/3/14 the price would presumably be much less than $111.43. It would have been something like $106 because, instead of running for the expected approximately 9 years, it only ran for approximately 5 years, or a little more than 50% of the expected time. Therefore, would not the difference between the price paid and the price that would have been paid knowing the actual remaining life of the bond be a capital loss?
Tax law requires that any premium you pay on the purchase of tax-free munis be amortized over the life of the bond using a constant yield to maturity. Each year's amortized amount reduces the cost basis. If held to maturity there would be no gain or loss. In this instance, the bond was called before maturity. The owner is required to compute the adjusted cost basis before any loss can be computed. The broker from whom the bonds were purchased should be able to make the computation for you.
As an aside, if bonds are not tax-free munis, the owner can use as the basis the amount paid or can make an election (attach a statement to the tax return) for the year purchased to amortize the premium as above. The amortized amount each year would be used to reduce the taxable amount of interest and it reduces the cost basis.
As per above, "Tax law requires that any premium you pay on the purchase of tax-free munis be amortized over the life of the bond using a constant yield to maturity."
But I think that rule is subject to an exception, and a different - i.e. faster - amortization, when the bonds are "callable" before maturity.
I have no knowledge of any exception to the rules that require amortization of the premium using the yield to the maturity date. The basis gets adjusted each year for the amortized amount. If sold or disposed of for any reason prior to maturity the loss is calculated using the adjusted cost basis in the year of sale.
The formula for computing the amortized premium is
Amortized premium = (coupon payments ? (YTM x Adjusted basis)) x days/accrual period
YTM is generally revealed to the buyer at the time of the purchase.
On Thursday, February 19, 2015 at 4:01:36 PM UTC-7, snipped-for-privacy@gmail.com wrote:...snip...
My reading of a much earlier thread ("Municipal Bonds Called, bought at a Premium"
formatting link
$20Bonds$20Called$2C$20bought$20at$20a$20Premium$20|sort:relevance/misc.taxes.moderated/94a7WDS5AQw/xeQv24uShroJ) suggests that while you can amortize a premium on a called muni bond, this action has little or no tax value as the amortized loss can only be applied against the interest which isn't taxable in the first place. Is that thinking still correct?
To make this clearer to all. Tax-free bonds are treated differently than taxable bonds. When you buy a tax-free bond at a premium you need to look at the YTM being offered as that is the amount you can expect at maturity. It includes the amount paid (e.g., 110) vs the amount received (e.g., 100) and the interest. As there is no taxable interest to report, there can be no offset. That is why the amortized premium is used to lower the basis. If held to maturity, there can not be a capital loss. You can only sustain a loss if the bond is disposed of before it matures.
Someone once asked me about state taxes. If my state forces me to add another state's muni interest to my state's income can I treat that bond as a taxable bond for my state? In other words, at the time I buy the bond is the premium part of my state cost basis (this would lead to a difference in state and federal basis) or can I then offset my state taxable interest using the amortized premium or am I just screwed.
My answer was..... ta da.. what does your state tax law say? Seriously... it comes down to the method used by the state to compute taxable income for the state. At the time, I was a CA resident so I looked at CA law. CA conforms to Title 26 of the US Code per a certain date. CA has its own Revenue & Tax Code that makes changes to Title 26. Therefore, there are differences between the two. For example, Congress extended for one year the forgiveness of cancelled mortgage debt till the end of 2014. CA has no extension in its code and it does not conform to the current status of Title 26. Taxpayers must include that cancelled debt in CA income. There is nothing in the CA code that specifically addresses the issue of amortized bond premium. As such, I concluded that for CA purposes, the bond was no different than any other taxable bond and as the premium was being used to reduce my federal and state cost basis I could use that amortized premium to offset state interest income. ____________________ Alan
I'm sure I'm right about amortization being required to the call date of *callable* tax-exempt bonds bought at a premium. I've posted a link in another message, below, to a Wells Fargo resource that explains pretty carefully the amortization of premiums paid for different types of bonds.
Sometimes the call date and sometimes the maturity date. One has to look at the notice given with the bond. Most of the ones I have seen were amortized to the maturity date. If amortized to the call date, then there is no capital loss at teh call date.
I should have added, that I believe this rule is for tax-free bonds at issue. For bonds bought after issue at a premium in the open market, I believe the maturity date is always used.
BeanSmart website is not affiliated with any of the manufacturers or service providers discussed here.
All logos and trade names are the property of their respective owners.