Investing Tax Free

Municipal Bond Premium

What is a municipal bond premium?

The municipal bond premium is the amount in excess of the face value or par value of the municipal bond that the bond investor purchases. When a municipal bond investor purchases a municipal bond at premium, he/she pays a higher price for the municipal bond than the par value or face value. Below are the tax implications and tax treatments of municipal bond premiums.

How to amortize municipal bond premiums?

If tax exempt municipal bonds are purchased at premium (i.e., at a price in excess of the face amount of the bond), whether at original municipal bond offerings or in the secondary market, the municipal bond premiums are amortized over the remaining terms of the municipal bonds using the same constant yield to maturity method discussed under "Original Issue Discount, OID."

Are municipal bond premiums tax deductible?

The amount of bond premium for tax exempt municipal bonds amortized each year is not tax deductible by the bond holder but instead reduces the bonds holder's tax basis.

Amortizable municipal bond premiums can also result if an investor purchases municipal bonds that were originally issued at a discount and the purchase price exceeds the issue price of the municipal bonds plus any accrued OID on them.

Redemptions of Municipal Bonds at Premium

An issuer will sometimes be permitted under the terms of a municipal bond to redeem the tax exempt bond prior to its maturity date at a fixed price. Such a redemption is treated as a sale of the municipal bond by the municipal bond holder. Thus, the municipal bond holder may recognize capital gains or capital loss on such a sale of tax exempt bonds. If the municipal bond is redeemed at a price above the state face amount, it is considered to be redeemed at a "premium."

Example of tax implication of redemption of municipal bonds at premium

For instance, assume a municipal bond holder purchased at original issue a ten-year tax exempt municipal bond for $10,000 on January 1, 2003 and that the municipal issuer was permitted to redeem the tax exempt bond on January 1, 2008 for a payment of $10,300. If the issuer in fact chooses to redeem the tax exempt bond at such time, the additional $300 paid by the issuer to the holder is considered a "premium" and will produce a $300 long-term capital gains to the holder.