Have you ever checked your tax return and asked your accountant questions? If you look on Schedule B of your Form 1040, do you have anything that says ABP? Or maybe OID? A lot of people do, but I’m not sure everyone understands what those are and why they are there. So, here is a quick summary to impress your friends and understand a little more about your investments and tax reporting.
What’s that stand for?
ABP stands for Amortizable Bond Premium, which is often found on 1099-Bs from your brokerage accounts. OID stands for Original Issue Discount and can also be found on 1099’s. To understand what these are, you must first know what bonds are.
A bond is an instrument of indebtedness of the bond issuer to the holders. Bonds have a face value, which is also known as the par value. They are sold on the primary market at par value to raise funds. Each bond has what is called a coupon rate, which is an interest rate that the issuer is obliged to pay the holder. Once that bond is sold on the primary market, it now can be sold on the secondary market.
The secondary market is where the bond premium or discount comes into play. If you buy a bond on the secondary market for an amount over the par value, then you have just purchased it at a premium. This typically means that the stated interest rate on the bond is higher than the stated interest rates of new bonds being issued and, therefore, will produce and accrue more interest income to you. That premium you paid is essentially an expense, or in ‘tax eyes,’ viewed as accrued interest paid. This expense cannot be taken immediately, but must be amortized over the life of the bond.
Amortization, in short, is like depreciation where the expense is taken over time. So, amortization of bond premium is just that – we are reducing the interest income for the amortization amount for that year on your tax return. The premium paid is an expense directly related to the bond interest income and, therefore, should reduce interest income. This explains why it is reported on Schedule B on your Form 1040 and not anywhere else.
Original Issue Discount is the opposite. This means you purchased the bond below the par value and received a discount. The discount is essentially income to you and you were provided the discount to make up for the lower interest rate. You can think of it as prepaid interest to you, but because it related to the interest rate and interest income, we are now going to accrete (opposite of amortization) the discount by adding a portion of it into interest income each year until the bond reaches maturity, at which point the bond issuer pays the principal (par value) to the holder.
Although most CPAs and accountants are not also financial advisors, we cannot advise you in purchasing or selling bonds or any other investments. But due to our career field, we do have to have a basic understanding of how bonds and other investments work to ensure we account for them correctly.
Please don’t hesitate to reach out to your Henry+Horne advisor for additional information on why things are the way they are on your tax return. We are always happy when clients take an interest (pun intended) in how things work – especially in their own tax return. If you are seeking financial advice, please contact your financial advisor first and then inform your accountant of any major changes that may be reflected in your income.
Chris Morrison, CPA, MAFM