This article will discuss the meaning of bond quotation prices on the exchange, determining initial basis, amortization of premium and discount, determining the adjusted basis, and the gain or loss on the sale before maturity. It will also discuss convertible, callable, and zero coupon bonds.
Price of a Bond
The price of a bond is the present value of future interest payments (an annuity), plus the present value of the maturity (face) value using the yield rate. There is an inverse relationship between the yield rate and selling price. The higher the yield rate, the lower the present value (selling price); the lower the yield rate, the higher the present value (selling price).
Bond Quotation Prices
Bonds are quoted as a percent of face (maturity) value. To find the dollar amount, convert the percent to a decimal and multiply by the face value of the bond.
A $1,000 face value bond is quoted at 95. The price will be $950 (95% x $1,000 or .95 x $1,000).
A $1,000 face value bond is quoted at 90 1/4. The price will be $902.50 (90.25% x $1,000 or .9025 x $1,000).
A $1,000 face value bond is quoted at 101. The price will be $1,010 (101% x $1,000 or 1.01 x 1,000)
A $1,000 face value bond is quoted at 105 1/8. The price will be $1,051.25 (105.125% x $1,000) or 1.05125 x 1,000). [1/8 = .125].
Initial Tax Basis
The total amount paid for a bond is the selling price plus purchase fees and accrued interest since the previous interest payment date. When the next interest payment date arrives, the holder of the bond will receive the interest for the full interest payment period. However, the tax basis does NOT include accrued interest.
On April 1, 2016, Joe purchased $10,000 face value bonds for 105, plus a $300 sales commission. The bonds pay interest of 5%, payable semiannually on July 31 and December 31. Accrued interest at purchase date is $125 (.05 x $10,000 x 3/12). The total amount paid is $11,567 [(1.05 x $10,000) + $300 + $125]. The cost (adjusted basis) is $10,800 ($10,500 purchase price plus $300 commission). On July 31 and December 31, he will receive $250 interest. For 2016, the taxable interest income is $350 ($500 received – $125 paid at purchase date) reported on Form 1040, Schedule B. The premium must be amortized over the life of the bonds which reduces the adjusted basis. See discussion and examples below.
Amortization of Discount or Premium
If bonds are purchased at a discount (less than face value) or a premium (more than face value), the taxpayer can elect to amortize the discount or premium over the remaining life (number of months to maturity) of the bond (see examples below).
The amortization is an adjustment of the contract interest received and the adjusted basis (see examples below). Discount amortization increases the contract interest reported on Schedule B and the adjusted basis. Premium amortization decreases the contract interest and the adjusted basis (see example below). Previous adjusted basis, plus discount amortization or minus premium amortization, becomes the new adjusted basis. If the amortized premium exceeds the contract interest, the excess is taken as a miscellaneous itemized deduction on line 28 of form 1040 Schedule A. It is not reduced by 2% of AGI.
If the taxpayer elects to amortize the discount or premium, one of two methods applies depending on purchase date. For bonds purchased prior to 9/27/85, discount or premium is amortized ratably over the life of the bond (straight-line method). For bonds purchased after 9/27/85, the constant (effective) yield method must be used. If an election is made to amortize the premium or discount, ALL SIMILAR bonds purchased thereafter must be amortized. The election to amortize cannot be revoked without IRS approval (this is considered a change in an accounting method). If you file your return and fail to amortize the bonds in the first year the bonds are purchased, you cannot change your mind and make the election to amortize the discount or premium for that year by filing an amended return. The amortization is reported on a separate line on form 1040, Schedule B, and is labeled “ABP Adjustment”.
Example – Straight-line Amortization
On January 1, 2016, Jerry purchases 6%, 35 year $150,000 face value (maturity value) bonds for $140,000, plus $4,500 in fees and $750 accrued interest (150,000 x .06 x 1/12). Interest is payable semiannually on June 30 and December 31. The initial basis is $144,500 (140,000 + 4,500) and the discount is $5,500 (150,000 – 144,500). Discount amortization for 2016 will be $157 (5,500 x 1/35). The taxable interest income for 2016 will be $8,407 [$9,000, contract interest (.06 x 150,000, minus $750 paid at purchase), plus $157 discount amortization]. The adjusted basis at the end of 2016 will be $144, 5657 (144,500 + 157).
Effective Yield Amortization
Under the effective yield method, the amortization will be the adjusted basis multiplied by the yield rate, minus the contract interest (prorated for the number of months interest is received)
Example – Effective Yield Amortization, Purchased at a Discount
On August 1, 2016, Jim buys $100,000 of face value bonds for $85,500 plus a $4,500 sales fee and accrued interest. The bonds pay 5% contract interest per year, payable semi-annually July 1 and December 31. The yield rate is 6 ½ %. The initial basis is $90,000 (85,500 + 4,500). Accrued interest of $416 ($100,000 x .05 x 1/12) is not part of the initial basis, but an adjustment of the interest received. On December 31, he receives $2,500 semiannual interest. Discount amortization for 2016 is $4,522 [$2,437 effective interest ($90,000 x .065 x 5/12) + $1,800 contract interest (100,000 x .05 x 5/12) – 208 paid at purchase]. Interest income reported will be $6,397 ($1,785 contract interest, plus $4,522 discount amortization). The adjusted basis of the bonds at 12-31-16 will be $90,522 ($90,000 initial basis, plus $4,522 amortization.
Example – Effective Yield Amortization, Purchased for a Premium
On July 1, 2016, $75,000 of face value, 20 year bonds are purchased for $90,500, plus $4,500 in fees and pay 5% interest, payable semiannually on July 1 and December 31. Since the bonds were purchased on the interest payment date, there is no accrued interest. The bonds have a 4% yield rate. The initial basis is $95,000 (90,500 + 4,500). Premium amortization for 2016 will be $25 [(95,000 x .04 x 6/12) – (75,000 x .05 x 6/12)]. Interest income reported for 2016 will be $1,850 ($1,875 contract interest minus $25 premium amortization). The adjusted basis of the bonds at December 31 will be $94,375 (95,000 initial basis, minus $25 premium amortization).
If a taxpayer does not elect to amortize the discount, the unamortized discount is reported as interest income at maturity or sale date). If purchased for a premium, the unamortized amount is reported as a capital loss.
Sale of bonds before maturity date
If bonds are sold before maturity date, the gain or loss is the difference between the adjusted basis (you must adjust the previous year-end adjusted basis by any discount or premium amortization from the beginning of the year to the date of sale) and net sales price, excluding accrued interest received.
On July 1, 2010, Claire purchased $20,000 of GM’s 6%, 10 year bonds for $15,000, excluding accrued interest. Interest is payable on June 30 and December 31. On January 1, 2016, the adjusted basis (original purchase price, plus discount amortization) was $17,500. On April 1, 2016, she sold $10,000 of these bonds for $9,500, plus accrued interest, less a $500 sales fee ($9,000 net sale price). Discount amortization for January 1-March 31, on $10,000 of bonds, is $65. The adjusted basis at date of sale for the bonds sold is $ 8,815 [(½ x 17,500) + 65)]. Accrued interest for the bonds sold is $150 (10,000 x .06 x 3/12). The long-term capital gain on the sale is $185 (9,000 – 8,815). NOTE: Accrued interest does NOT affect the gain or loss on the sale.
Convertible bonds are bonds that are convertible into common stock of the company that issued the bonds. Any conversion premium is not amortized. When the bonds are converted into common stock, no gain or loss is recognized. The basis of the stock is the adjusted basis of the bonds. The holding period of the stock starts with the bonds acquisition date.
Example – Direct Exchange, No Cash Payment
On July 1, 2010, Joe purchased $30,000 (each bond has a face value of $1,000) of PepsiCo’s 6%, 10 year convertible bonds for $32,500 (the $2,500 conversion premium is not amortized). Each bond is convertible into 5 shares of PepsiCo’s common stock, beginning on January 1, 2015. On September 1, 2016, Joe converts all of the bonds into common stock and receives 150 shares (30, $1,000 bonds x 5). The $32,500 basis of the bonds becomes the basis of the stock ($217 per share). No gain or loss is recognized on the exchange. The holding period of the common stock begins on July 2, 2010, the day after the purchase date of the bonds.
If you make partial cash payment on the exchange, there will be a dual basis for the stock received-the basis of the bonds exchanged and the cash paid. The holding period for the stock received for the bonds begins on the day after the bonds were purchased and the holding period for the stock relative to the cash payment begins on the day after the cash was paid.
Example – Cash Payment for Conversion
Assume the sane fact as above except Joe also paid $2,500 cash when he converted the bonds. No gain or loss is recognized on the exchange or for the cash paid. The basis of the stock received will be two amounts: (1) $32,500 for the bonds and (2) $1,500 for the cash payment. The holding period for the stock received for the bonds begins on July 2, 2010. The holding period for the stock relative the $1,500 cash payment begins on September 2, 2016.
Regardless of issue date, the amortization time period is based on earlier of the maturity or call date. If the bond is called before maturity, the unamortized premium is taken as an ordinary loss in the year the bonds are called.
On April 1, 2010, Barb purchased 10 year (120 months) $10,000 face value bonds for $8,500, plus a $500 commission (a discount of $1,000), plus accrued interest. The annual interest rate is 6% payable semiannually on June 30 and December 31. The corporation has the option to call them at 105, on July 1, 2016. Since the earliest of the call or maturity date is July 1, 2016, the amortization period will be 60 months (April 1, 2010 to July 1, 2016). The bonds are called on July 1, 2016. The adjusted basis of the bonds on July 1, 2016, is $10,000 because the bonds were amortized over 60 months. Barb will receive $10,500 (10,000 x 1.05) for the bonds. The long-term gain on the retirement will be $500 (10,500 – 10,000)).
Zero Coupon Bonds
A zero coupon bond does not pay interest and is sold at a discount. The discount must be amortized each year and reported as interest income even though no interest is received from the bond issuer. The amortization increases the adjusted basis of the bonds.
On September 1, 2009, Claire purchased a $25,000 zero coupon bond for $18,500 plus a $1,500 sales fee. The bonds mature September 1, 2019. The discount is $5,000 [25,000 – (18,500 + 1,500)] which will be amortized over 120 months and added to the cost of the bond and reported as interest income. The annual amortization will be $500. On July 1, 2016, Claire sells the bond for $26,000, less a $1,300 sales fee. She held the bonds for 70 months. The adjusted basis on July 1, 2016 will be $22,900 [(20,000) + (5,000 x 70/120)]. The long-term gain on the sale will be $1,800 [(26,000 – 1,300) – 22,900].