Bond Premium for tax exempt bonds

If tax exempt bonds are purchased at a bond premium (i.e., at a price in excess of the face amount of the bond), whether at original issue or in the secondary market, the tax exempt bond premium is amortized over the remaining term of the tax exempt bond using the same constant yield to maturity method discussed above under "Original Issue Discount, OID." The amount of bond premium for tax exempt bonds amortized each year is not deductible by the tax exempt bond holder but instead reduces the tax exempt bonds holder's tax basis.

Amortizable tax exempt bonds premium can also result if a holder purchases tax exempt bonds that were originally issued at a discount and the purchase price exceeds the issue price of the tax exempt bond plus any accrued OID on the tax exempt bonds.

Redemptions of Bond Premium for tax exempt bonds

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 tax exempt bond by the municipal bond holder. Thus, the tax exempt bonds holder may recognize capital gains or capital loss on such a sale of tax exempt bonds. If the tax exempt bond is redeemed at a price above the state face amount of the tax exempt bond, it is considered to be redeemed at a "premium."

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For instance, assume a tax exempt bonds holder purchased at original issue a ten-year tax exempt bond for $10,000 on January 1, 2003 and that the 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.