Dear Harry: Back in 2003, I purchased a City of Philadelphia bond for $5,736 plus accrued interest and a fee to the broker. The bond matured in September 2009, and I received only $5,000. I called the broker and he told me that he would write me an explanation. In his letter, he said that "this debt instrument was purchased at a premium which should have been amortized by you." I did not understand, so I called again, got a similar answer and then a real shocker: He told me that I could not deduct the loss on my tax return! He told me to call IRS for more information if I needed it. Harry, I trust you more than the broker or the IRS. What's going on here?
What Harry says: Thanks for your trust. What he said is correct, in the language of finance. At the time you bought the bond, the interest rate that it would pay was higher than the market interest rate. In order to bring that rate down, you had to pay more for the bond. The extra amount you paid is spread, or amortized, over the remaining life of the bond, reducing both the interest and the premium you paid. The math involved is a bit tricky, so let me give a simplified illustration: Take a $10,000 bond with an interest rate of 6 percent at a time when rates of similar bonds have a market rate of 5 percent. If the bond has a 10-year remaining life, it would sell for $11,000 in our simplified example. The extra $1,000 would be spread out over the 10 years at $100 a year to reduce the interest from $600 a year to $500. This brings the interest rate down to the market rate and the cost down to $5,000.