If you purchase a bond that is paying out interest rates higher than the markets interest rate a bond premium will be included in the purchase price. The market uses the bond premium to adjust the price of a bond that has too high of an interest rate.
Bond premiums can cause record keeping to be too complex. You can amortize the amount of the premium over the lifetime of the bond. This allows you to allocate the bond premium over time to show the bond is paying interest this will result in a reduced bond interest. When adjusting the bonds interest rate use an effective interest rate to allow the annual interest of the bond to equal the yield at the bonds maturity.
To earn higher profits and to avoid complex record keeping you can simply ignore the bond premium. When ignoring bond premiums you are able to overstate the interest that was earned over the life of bond and show you are paying higher income tax on the bonds interest over that period. Once the bond matures it will show a capital loss that should be equal to the bonds premium amount that you have but never recorded.
By ignoring the bond premiums until their maturity and simply recording the premium as a loss or even a final year adjustment on the bonds interest will ease the pain of record keeping throughout the year.
It is true: the IRS allows U.S. taxpayers to engage in this strategy of ignoring bond premiums for years end calculations. You are simply overstating the interest amount earned with your bond investment.
A bond that pays a smaller interest rate than the markets interest rate will allow you to use the bond discount. A bond discount is handled in a very similar way as the bond premium.
When you have purchased a bond discount you are required to allocate that discount over the years of the bonds lifetime with it being treated as additional interest. A good example is if you purchased a $500 bond with a $600 return upon its maturity you would earn a $100 profit that is counted as the interest amount. This is a similar method to the zero coupon bond.
All accrued interest is required to be recorded for a bond discount. The accrued interest sum should match the bond discount sum that was allocated for the year. Bond discounts accrued interest is the amortization.
The IRS does dictate that every U.S. tax payer amortizes their bond discounts, unless you know about the loop hole. If you use this strategy to your advantage you will save record keeping time and money. If a bond discount has a very small adjustment in the effective interest rate that was paid generally you can omit the record keeping on amortization for the bond discount. Speak to a tax advisor if you are uncertain about what records should be kept and what strategies will earn you the most.
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