Reg. § 1.171-1 Bond premium.
(a) Overview
(1) In general This section and through provide rules for the determination and amortization of bond premium by a holder. In general, a holder amortizes bond premium by offsetting the interest allocable to an accrual period with the premium allocable to that period. Bond premium is allocable to an accrual period based on a constant yield. The use of a constant yield to amortize bond premium is intended to generally conform the treatment of bond premium to the treatment of original issue discount under sections through . Unless otherwise provided, the terms used in this section and through have the same meaning as those terms in sections through and the corresponding regulations. Moreover, unless otherwise provided, the provisions of this section and through apply in a manner consistent with those of sections through and the corresponding regulations. In addition, the anti-abuse rule in applies for purposes of this section and through .
(2) Cross-references For rules dealing with the adjustments to a holder's basis to reflect the amortization of bond premium, see . For rules dealing with the treatment of bond issuance premium by an issuer, see .
(b) Scope
(1) In general Except as provided in of this section and , this section and through apply to any bond that, upon its acquisition by the holder, is held with bond premium. For purposes of this section and through , the term bond has the same meaning as the term debt instrument in .
(2) Exceptions This section and through do not apply to—
(i) A bond described in section (regular interests in a REMIC, qualified mortgages held by a REMIC, and certain other debt instruments, or pools of debt instruments, with payments subject to acceleration);
(ii) A bond to which applies (relating to certain debt instruments that provide for contingent payments);
(iii) A bond held by a holder that has made a election with respect to the bond;
(iv) A bond that is stock in trade of the holder, a bond of a kind that would properly be included in the inventory of the holder if on hand at the close of the taxable year, or a bond held primarily for sale to customers in the ordinary course of the holder's trade or business; or
(v) A bond issued before September 28, 1985, unless the bond bears interest and was issued by a corporation or by a government or political subdivision thereof.
(c) General rule
(1) Tax-exempt obligations A holder must amortize bond premium on a bond that is a tax-exempt obligation. See Example 4.
(2) Taxable bonds A holder may elect to amortize bond premium on a taxable bond. Except as provided in of this section, a taxable bond is any bond other than a tax-exempt obligation. See for rules relating to the election to amortize bond premium on a taxable bond.
(3) Bonds the interest on which is partially excludable For purposes of this section and through , a bond the interest on which is partially excludable from gross income is treated as two instruments, a tax-exempt obligation and a taxable bond. The holder's basis in the bond and each payment on the bond are allocated between the two instruments based on a reasonable method.
(d) Determination of bond premium
(1) In general A holder acquires a bond at a premium if the holder's basis in the bond immediately after its acquisition by the holder exceeds the sum of all amounts payable on the bond after the acquisition date (other than payments of qualified stated interest). This excess is bond premium, which is amortizable under .
(2) Additional rules for amounts payable on certain bonds Additional rules apply to determine the amounts payable on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules, and a bond that provides for remote or incidental contingencies. See .
(e) Basis A holder determines its basis in a bond under this . This determination of basis applies only for purposes of this section and through . Because of the application of this , the holder's basis in the bond for purposes of these sections may differ from the holder's basis for determining gain or loss on the sale or exchange of the bond.
(1) Determination of basis
(i) In general In general, the holder's basis in the bond is the holder's basis for determining loss on the sale or exchange of the bond.
(ii) Bonds acquired in certain exchanges If the holder acquired the bond in exchange for other property (other than in a reorganization defined in section ) and the holder's basis in the bond is determined in whole or in part by reference to the holder's basis in the other property, the holder's basis in the bond may not exceed its fair market value immediately after the exchange. See of this section. If the bond is acquired in a reorganization, see section .
(iii) Convertible bonds
(A) General rule If the bond is a convertible bond, the holder's basis in the bond is reduced by an amount equal to the value of the conversion option. The value of the conversion option may be determined under any reasonable method. For example, the holder may determine the value of the conversion option by comparing the market price of the convertible bond to the market prices of similar bonds that do not have conversion options. See of this section.
(B) Convertible bonds acquired in certain exchanges If the bond is a convertible bond acquired in a transaction described in of this section, the holder's basis in the bond may not exceed its fair market value immediately after the exchange reduced by the value of the conversion option.
(C) Definition of convertible bond A convertible bond is a bond that provides the holder with an option to convert the bond into stock of the issuer, stock or debt of a related party (within the meaning of section or ), or into cash or other property in an amount equal to the approximate value of such stock or debt. For bonds issued on or after February 5, 2013, the term stock in the preceding sentence means an equity interest in any entity that is classified, for Federal tax purposes, as either a partnership or a corporation.
(2) Basis in bonds held by certain transferees Notwithstanding of this section, if the bond is transferred basis property (as defined in section ) and the transferor had acquired the bond at a premium, the holder's basis in the bond is—
(i) The holder's basis for determining loss on the sale or exchange of the bond; reduced by
(ii) Any amounts that the transferor could not have amortized under this or under , except to the extent that the holder's basis already reflects a reduction attributable to such nonamortizable amounts.
(f) Examples The following examples illustrate the rules of this section:
Example 1. Bond received in liquidation of a partnership interest.
(i) Facts. PR is a partner in partnership PRS. PRS does not have any unrealized receivables or inventory items as defined in section . On January 1, 1998, PRS distributes to PR a taxable bond, issued by an unrelated corporation, in liquidation of PR's partnership interest. At that time, the fair market value of PR's partnership interest is $40,000 and the basis is $100,000. The fair market value of the bond is $40,000.
(ii) Determination of basis. Under section , PR's basis in the bond is equal to PR's basis in the partnership interest. Therefore, PR's basis for determining loss on the sale or exchange of the bond is $100,000. However, because the distribution is treated as an exchange for purposes of section , PR's basis in the bond is $40,000 for purposes of this section and through . See of this section.
Example 2. Convertible bond.
(i) Facts. On January 1, A purchases for $1,100 B corporation's bond maturing in three years from the purchase date, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $30 on January 1 and July 1 of each year. In addition, the bond is convertible into 15 shares of B corporation stock at the option of the holder. On the purchase date, B corporation's nonconvertible, publicly-traded, three-year debt of comparable credit quality trades at a price that reflects a yield of 6.75 percent, compounded semiannually.
(ii) Determination of basis. A's basis for determining loss on the sale or exchange of the bond is $1,100. As of the purchase date, discounting the remaining payments on the bond at the yield at which B's similar nonconvertible bonds trade (6.75 percent, compounded semiannually) results in a present value of $980. Thus, the value of the conversion option is $120. Under of this section, A's basis is $980 ($1,100−$120) for purposes of this section and through . The sum of all amounts payable on the bond other than qualified stated interest is $1,000. Because A's basis (as determined under of this section) does not exceed $1,000, A does not acquire the bond at a premium.
(iii) Applicability date. Notwithstanding , this Example 2 applies to bonds acquired on or after July 6, 2011.
[T.D. 8746, 62 FR 68177, Dec. 31, 1997, as amended by T.D. 9533, 76 FR 39280, July 6, 2011; T.D. 9612, 78 FR 8005, Feb. 5, 2013; T.D. 9637, 78 FR 54759, Sept. 6, 2013]