If a taxpayer purchases taxable bonds at a premium, the amortization of the premium is elective. However, if a taxpayer purchases tax-exempt bonds at a premium, the amortization of the premium is mandatory. Explain this difference in the treatment
If mandatory amortization were not required for tax-exempt bonds, a taxpayer who held such bonds to maturity would have a recognized loss to the extent of the premium. This is not consistent with the rule that interest earned on the bonds is tax-exempt. Mandatory amortization, therefore, results in the adjusted basis of the bonds ultimately being equal to the maturity value. Thus, no loss results upon maturity. Furthermore, the amortization of the premium on tax-exempt bonds is not deductible.
For the taxable bonds and if the taxpayer does not elect to amortize the premium, a recognized capital loss results to this extent at maturity. Typically, the taxpayer will elect to amortize the premium so that it can be claimed over the life of the bond as an ordinary (rather than capital) deduction.
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