Now that your eyes have thoroughly glazed over, we'll make it worse by trying to explain the "yield to maturity" (YTM) method of accretion of bond discounts or amortization of bond premiums.

This method is also referred to as the "constant yield" or "constant interest" method.

Accretion means gradually increase over time and amortization means gradually decrease over time. People often use the term "amortization" interchangeably for both premiums and discounts.

First look at your original trade confirmation to find the "yield to maturity" interest rate percentage that you got when you bought the bond.

Next multiply the YTM percent by the original purchase price of the bond times the portion of the year that you owned the bond. From the result, deduct the interest you earned based on the stated coupon rate times par value. The difference is the discount accretion or premium amortization for the first year of ownership.

Do this for every year that the bond was owned by multiplying the YTM percent by the sum of the original purchase price plus all previous accumulated discount accretions or accumulated premium amortizations as of the first day of each year. Again, subtract the actual interest coupon payments collected each year to determine each year's accretion to be added to (or amortization to be subtracted from) the cost basis of your bond.

If it is a tax-exempt bond, the premium amortization is not a tax deduction for determining taxable income, but it is a reduction of tax-exempt interest that you report on Form 1040, Line 8b, and it is an adjustment to the cost basis of the bond in order to determine the gain or loss. Reducing tax-exempt income will affect the taxability of social security benefits (and also state income taxes if it is not a double-exempt bond.)

Here are two examples:

EXAMPLE A for DISCOUNT ACCRETION

Assume the following: You bought a $25,000 State of California General Obligation Note 4% due 9/30/2010. Purchase date 6/30/2007. Non-callable. Price $95.00 per $100 of par value. Total price paid for bond $23,750 Interest coupon pays semi-annually on March 31 and Sept 30. Accrued interest at date of purchase $250. Yield to maturity 5.70%

On the first coupon date, 9/30/2007, you received a cash payment of $500 of interest ($25,000.00 par value times 4.00% coupon rate of interest times one- half year for semi-annual interest payments.) This represented a reimbursement of $250 of accrued interest for the period 3/'31/07-6/30/07 that you paid to the previous owner when you purchased the bond on 6/30/07. The remaining $250 is the interest you earned for the period 6/30/07 to 9/30/07.

You subsequently sold the note on 4/30/2009 at a price of $98.00 per $100 of par value for sales proceeds of $24,500 and also received accrued interest of $83.33 for one month's interest since the last coupon payment on 3/31/2009.

Here is the discount accretion table year by year:

Period

Beginning of Period Cost Basis

5.70% YTM on Beginning Cost Basis

4.00% Coupon Interest for Period

Discount Accretion for the Year

End of Period Cost Basis

6/30/07 -12/31/07

23,750.00

676.88^{(a)}

500.00^{(b)}

176.88^{(c)}

23,926.88^{(d)}

1/1/08 - 12/31/08

23,926.88

1,363.83^{(e)}

1,000.00^{(f)}

363.83^{(g)}

24,290.71^{(h)}

1/1/09 - 4/30/09

24,290.71

461.52^{(i)}

333.33^{(j)}

128.19^{(k)}

24,418.90^{(l)}

Discount accretion table calculation notes: (a) $23,750.00 times 5.70% times 1/2 year equals $676.88 (b) $25,000.00 times 4.00% times 1/2 year equals $500.00 (c) $676.88 less $500.00 equals $176.88 (d) $23,750.00 plus $176.88 equals $23,926.88 (e) $23,926.88 times 5.70% equals $1,363.83 (f) $25,000 times 4.00% equals $1,000.00 (g) $1,363.83 less $1,000.00 equals $363.83 (h) $23,926.88 plus $363.83 equals $24,290.71 (i) $24,290.71 times 5.70% times 1/3 year equals $461.52 (j) $25,000 times 4.00% times 1/3 year equals $333.33 (k) $461.52 less $333.33 equals $128.19 (l) $24,290.71 plus $128.19 equals $24,418.90

Your ending adjusted cost basis is $24,418.90. Your capital gain is the sales proceeds of $24,500 less your adjusted cost basis of $24,418.90 for a gain of $81.10 to be reported on your 2009 Form 1040 Schedule D. Since this is a tax-exempt bond, report an additional $128.19 of tax-exempt interest on your 2009 return (Form 1040, line 8b) from the discount accretion in addition to the $500.00 interest you collected on 3/31/09 and the $83.33 of accrued interest you collected on the date of sale, for total tax-exempt interest income of $711.52 in 2009.

If this had been a taxable bond, you would have reported $668.90 of ordinary taxable interest income (in addition to the $583.33 interest collected) on your 2009 Form 1040 Schedule B from the accumulated discount accretions to date (unless you elected in 2007 to report the discount accretion each year.) The $668.90 is an increase to your cost basis and your adjusted basis is $24,418.90 for capital gain purposes.

EXAMPLE B for PREMIUM AMORTIZATION

Assume the following: You bought a $25,000 State of California General Obligation Note 4% due 9/30/2010. Purchase date 6/30/2007. Non-callable. Price $104.00 per $100 of par value. Total price paid for bond $27,500. Interest coupon pays semi-annually on March 31 and Sept 30. Accrued interest at date of purchase $250. Yield to maturity 2.70%

On the first coupon date, 9/30/2007, you received a cash payment of $500 of interest ($25,000.00 par value times 4.00% coupon rate of interest times one- half year for semi-annual interest payments.) This represented a reimbursement of $250 of accrued interest for the period 3/'31/07-6/30/07 that you paid to the previous owner when you purchased the bond on 6/30/07. The remaining $250 is the interest you earned for the period 6/30/07 to 9/30/07.

You subsequently sold the note on 4/30/2009 at a price of $101.00 per $100 of par value for sales proceeds of $25,250.00 and received accrued interest of $83.33 for one month of interest earned since the last interest coupon payment date on 3/31/2009.

Here is the premium amortization table year by year:

Period

Beginning of Period Cost Basis

2.70% YTM on Beginning Cost Basis

4.00% Coupon Interest for Period

Premium Amortization for the Year

End of Period Cost Basis

6/30/07 -12/31/07

26,000.00

351.00^{(a)}

500.00^{(b)}

(149.00)^{(c)}

25,851.00^{(d)}

1/1/08 - 12/31/08

25,851.00

697.98^{(e)}

1,000.00^{(f)}

(302.02)^{(g)}

25,548.98^{(h)}

1/1/09 - 4/30/09

25,548.98

229.94^{(i)}

333.33^{(j)}

(103.39)^{(k)}

25,445.59^{(l)}

Discount accretion table calculation notes: (a) $26,000.00 times 2.70% times 1/2 year equals $351.00 (b) $25,000.00 times 4.00% times 1/2 year equals $500.00 (c) $351.00 less $500.00 equals ($149.00) (d) $26,000.00 plus ($149.00) equals $25,851.00 (e) $25,851.00 times 2.70% equals $697.98 (f) $25,000 times 4.00% equals $1,000.00 (g) $697.98 less $1,000.00 equals ($302.02) (h) $25,851.00 plus ($302.02) equals $25,548.98 (i) $25,548.98 times 2.70% times 1/3 year equals $229.94 (j) $25,000 times 4.00% times 1/3 year equals $333.33 (k) $229.94 less $333.33 equals ($103.39) (l) $25,548.98 plus ($103.39) equals $25,445.59

Your ending adjusted cost basis is $25,445.59. Your capital loss is the sales proceeds of $25,250.00 less your adjusted cost basis of $25,445.59 for a loss of ($195.59) to be reported on your 2009 Form 1040 Schedule D. Since this is a tax-exempt bond, you will actually report a net of $479.94 tax-exempt interest income on your 2009 return based on $500.00 interest collected on the 3/31/09 coupon date plus $83.33 one month's accrued interest collected at the 4/30/09 sale date less $103.39 premium amortization for the year.

If this had been a taxable bond, you could have dispensed with the bond premium amortizations and just declared the $26,000 original purchase price as your cost basis at the date of sale for a capital loss of $750 ($25,250.00 less $26,000). This approach is not as advantageous to you for tax purposes, however, because the bond premium amortization amounts only save tax at the capital gains rate of 15% instead of at the ordinary marginal rate on taxable interest income.

Alternatively, you could elect to amortize the premiums on your taxable bonds by attaching an election statement to your tax return in the year of purchase. You would then report each year's bond premium amortization amount as a reduction of ordinary taxable interest income on your Form 1040 Schedule B. The accumulated bond premium amortizations to the date of sale ($554.41) would be a reduction in your cost basis, resulting in a capital loss of ($195.59) based on the sale price of $25,250 less the adjusted cost basis of $25,445.59. The $554.41 of bond premium amortizations save tax at the ordinary marginal tax rate, and the ($195.59) capital loss saves tax at the capital gains rate.

If you do elect to amortize taxable bond premiums, the choice is binding forall taxable bonds that you own that year and also for all bonds that you acquire later. Furthermore, you cannot change back to the non-amortization method without written approval from the IRS.

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Information provided is intended solely for U.S. individual cash-basis taxpayers and is believed to be accurate for most cases. Always consult your personal tax advisor about your own situation. Suggestions are most welcome. Please e-mail webmaster @ costbasis.com or write to us at P O Box 11022, Chicago IL 60611 with your comments.