The IRS issued final regulations (T.D. 9653) on bond premium carryforwards under Sections 171. The final regulations adopt and replace temporary regulations issued in January 2013.

A holder acquires a bond at a premium if immediately after the acquisition, the holder's basis in the bond exceeds the sum of all amounts payable on the bond after the acquisition date. This excess bond premium can be amortized under Treas. Reg. Sec. 1.171-2. Section 171(a)(1) provides that "amortizable bond premium" for a taxable bond is allowed as a deduction. However, Section 171 applies only to a taxable bond if the taxpayer elects for it to apply under Section 171(c).

Under Treas. Reg. Sec. 1.171-2(a)(1), a bond holder offsets the qualified stated interest that can be allocated to an accrual period with the allocable bond premium for such accrual period. If the allocable bond premium for an accrual period exceeds the qualified stated interest allocable to such accrual period, the excess is a bond premium deduction under Section 171(a)(1) for such accrual period. However, under Treas. Reg. Sec. 1.171-2(a)(4), the amount treated as a bond premium deduction is limited to the excess of:

(i) The amount of the holder's total interest inclusions on the bond in prior accrual periods over

(ii) The total amount treated by the holder as a bond premium deduction on the bond in prior accrual periods (the "interest limitation")

If the interest limitation applies, the excess allocable bond premium is carried forward to the next accrual period and is treated as bond premium that can be allocated to that period.

Pursuant to Treas. Reg. Sec. 1.1016-5(b), a holder's basis in a bond is reduced by the amount of the bond premium used to offset the qualified stated interest. Thus, if the interest limitation applies and the holder disposes of the bond, the bond premium that can be allocated for a period subject to an interest limitation would still be included in the basis of the bond in determining the gain or loss from the disposition of such bond.

The newly issued final regulations provide that if there is a bond premium carryforward as of the end of the holder's accrual period in which a bond is disposed of, the holder treats the amount of the carryforward as a bond premium deduction under Section 171(a)(1), and the holder's basis in the bond is reduced by the amount of the bond premium allowed as a deduction for purposes of Treas. Reg. Sec. 1.1016-5.

In the preamble to final regulations, the IRS said the interest limitation would apply to a zero coupon debt instrument, including certain notes issued by the U.S. Treasury Department, because there is no qualified stated interest. Thus, absent Treas. Reg. Sec. 1.171-2(a)(4)(i)(C) (1), an electing holder would have a capital loss upon disposition of the debt instrument rather than an ordinary deduction related to bond premium carryforward.

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