Monday, March 12, 2007

Muni Bonds: Tax Reporting For Premium Bonds


How To Determine Reportable Tax-Free Income For The Investor

The amount of reportable tax-free income that an investor receives from their municipal bonds may be dependent on the investor’s cost basis in the individual security and the coupon structure of the bond. Many investors mistakenly believe that the coupon received from a muni bond represents their reportable tax-free income to be filed on line 8b of their 1040 tax form. However, this is only the case for all muni bonds purchased at par.

An individual muni bond may be purchased at par ($100), a premium (greater than $100), or at a discount (less than $100). Each of these coupon structures may be treated differently for tax purposes.

Par Bonds

Par bonds are the simplest for tax reporting. All of the coupon income earned during a tax year is reported as tax-exempt income. No adjustments need to be made. This amount is entered on form 1040 as tax-free income on line 8b.

Premium Bonds

Each individual security has an original cost basis. It is important to identify and remember the original purchase yield for a bond bought at a premium. This yield will be less than the coupon of the bond and needs to be calculated to at least 2 decimal places. The premium paid for the bond is amortized down each year, which reduces the basis for the bond by the amount of the amortization. This amortization is deducted from the coupon income earned and the difference is tax-exempt income earned and is entered on the 1040 line 8b. The new amortized cost basis is also used for determining capital gains and losses if the security is sold.

The logic for amortization of premium bonds:

When a bond is purchased at a premium, the coupon rate must be greater than the yield of the bond. Therefore, only part of the money the investor receives is tax-free income, and the rest is considered to be a return of his principal in the form of a coupon payment.

Amortization Calculation

Most premium bonds are amortized using a constant yield method. There are some exceptions for bonds issued before September 27, 1985. We will not discuss these exceptions in this article.

IRS Publication 550 shows how to calculate the amortization of the bond premium.

The amount of the amortization is subtracted from the coupon income which was received during the tax period. The remainder is the amount of tax-exempt interest that is reported on the Federal 1040 Return line 8b.

Example

Purchase on 1/1/05 $100,000 Salt River Project, AZ 5% coupon bonds that mature on 1/1/09 at a yield of 3.00% for a price of $107.485

Let’s calculate the tax-free interest and amortization for the first 1 year period ending 12/31/05.

The bonds mature at par so the total premium paid is $7,485 ($107,485-$100,000. To determine the bond premium amortization we multiply the acquisition cost times the purchase yield ($107,485)*(.0300) to get $3,225. We then subtract this amount from $5,000 which is the amount of coupon earned for 1 year. The result is $1,775. This is our amortization for the year.

For tax reporting purposes we would take the interest earned for the period less the amortization and report this amount as tax-exempt interest earned on line 8b of our 1040 form. This amount would be $5,000-$1,775=$3,225 for tax-exempt interest earned.
Our new cost basis would be $107,485-$1,775=$105,710.
This process would be repeated every period until the bonds mature at 100 on 1/1/09.





IRS Publication 550 (page 35)

Investment Income and Expenses

Bond Premium Amortization

If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year.

How To Figure Amortization

For bonds issued after September 27,1985, you must amortize bond premium using a constant yield method on the basis of the bond’s yield to maturity, determined by using the bond’s basis and compounding at the close of each accrual period.

Step 1:determine your yield. Your yield is the discount rate that , when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage.
Step 2: determine the accrual periods. You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.
Step 3: determine the bond premium for the accrual period. To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result from the qualified stated interest for the period.
Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.



The Problem: Overpaying State Income Tax

Most investors receive a year-end statement from their broker which shows how much interest was earned during the last year. The investor gives this statement to his CPA and the amount is entered on line 8b as tax-exempt interest. This can, under certain circumstances, lead to the overpayment of state income taxes. If the investor owns premium coupon bonds that are not state tax-exempt, and he has not amortized his premium, he will be overpaying his state income tax.

An Example

The investor is an Arizona resident. He owns a municipal bond portfolio that consists primarily of bonds that are premium coupon bonds. Let’s assume that 50% of these bonds are issued by municipalities in the State of Arizona, and that the other 50% are issued by municipalities that are in other states. The interest on the Arizona bonds is exempt from state taxes. The interest on the out of state securities is subject to the state tax in Arizona. Let’s also assume that the investor owns 5% coupons that he/she purchased at an average yield of 3.00%. If the investor does not amortize his coupons he will be paying interest as if he had earned a yield of 5.00%. However, if these premiums are amortized, he will pay tax on 3.00% interest. The table below shows that the investor in this case has reduced his overall yield by .05% by not properly amortizing the premiums of the out-of-state securities.







Calculating Gains/Losses

To continue with our example, let’s assume that at the end of the first year interest rates have risen 1.00% to 4.00%. We decide to take a tax loss and sell the bonds at 4.00%. What is the capital loss that we report on Form 1040 and on Schedule D?

First, we would calculate the dollar price we receive from our sale at 4.00%. The dollar price is $102.80. Thus, we receive $102,800 from our sale. We subtract this amount from our new basis which we calculated above ($105,710)-($102,800) and we get a loss of ($2,910). This is the amount we report on Form 1040 line 13 and on Schedule D.


Conclusion

It is important to remember to amortize the premiums on all holdings of municipal bonds in order to report the proper amount of tax-free interest earned, and to be able to have a proper cost-basis to calculate gains/losses on any sales of the securities. Why not then include this information as part of the year-end report for the client by including an Income Report, and Realized Gains/Losses Report that include these calculations? This will be most helpful for the client’s CPA when he does the tax return next year!



2 comments:

kenkirs said...

The brokerage firm sends me a 1099-INT stating I was paid $5,000 in tax-exempt interest. This amount is also reported to the IRS. Yet I report on Line 8b a value of $3,225. Why won't the IRS question this discrepancy? Or, how do I report the $1,775 adjustment to the IRS? It doesn't go on Sched B because Sched B is for taxable interest.

Len Templeton said...

We create an income report for our clients which shows this adjustment. This report can then be used as backup documentation if questioned by the IRS, or could be included when filing the return.