When a municipal bond is purchased at a premium, the bond's premium must be amortized to find an adjusted cost basis. If the bond is sold above the adjusted cost basis, the result is a capital gain. If the bond is sold below the adjusted cost basis, the result is a capital loss. If the bond is held to maturity, there is neither a loss nor a gain for tax purposes. This is because the adjusted basis would equal the par value after the premium is amortized.
This bond is purchased at $105,000 with a 5-year maturity. The premium of $5,000 ($105,000 - $100,000 = $5,000) must be amortized over a 5-year period ($5,000 divided by 5 years equals $1,000 per year). Therefore, each year the original cost of the bond is reduced by $1,000.
If the bond is sold after 2 years, the adjusted cost basis is $103,000 ($105,000 - $2,000 = $103,000). Since the bond is sold at $95,000, there is a capital loss of $8,000 ($103,000 - $95,000). (21-12