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costbasis.com

Yield to Maturity Method
    
     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)


      Premium Amortization 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 for
all
     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.  

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