[Code of Federal Regulations]
[Title 26, Volume 1]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.171-1]

[Page 164-166]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.171-1  Bond premium.

    (a) Overview--(1) In general. This section and Sec. Sec. 1.171-2 
through 1.171-5 provide rules for the determination and amortization of 
bond premium by a holder. In general, a holder amortizes bond premium by 
offsetting the interest allocable to an accrual period with the premium 
allocable to that period. Bond premium is allocable to an accrual period 
based on a constant yield. The use of a constant yield to amortize bond 
premium is intended to generally conform the treatment of bond premium 
to the treatment of original issue discount under sections 1271 through 
1275. Unless otherwise provided, the terms used in this section and 
Sec. Sec. 1.171-2 through 1.171-5 have the same meaning as those terms 
in sections 1271 through 1275 and the corresponding regulations. 
Moreover, unless otherwise provided, the provisions of this section and 
Sec. Sec. 1.171-2 through 1.171-5 apply in a manner consistent with 
those of sections 1271 through 1275 and the corresponding regulations. 
In addition, the anti-abuse rule in Sec. 1.1275-2(g) applies for 
purposes of this section and Sec. Sec. 1.171-2 through 1.171-5.
    (2) Cross-references. For rules dealing with the adjustments to a 
holder's basis to reflect the amortization of bond premium, see Sec. 
1.1016-5(b). For rules dealing with the treatment of bond issuance 
premium by an issuer, see Sec. 1.163-13.
    (b) Scope--(1) In general. Except as provided in paragraph (b)(2) of 
this section and Sec. 1.171-5, this section and Sec. Sec. 1.171-2 
through 1.171-4 apply to any bond that, upon its acquisition by the 
holder, is held with bond premium. For purposes of this section and 
Sec. Sec. 1.171-2 through 1.171-5, the term bond has the same meaning 
as the term debt instrument in Sec. 1.1275-1(d).
    (2) Exceptions. This section and Sec. Sec. 1.171-2 through 1.171-5 
do not apply to--
    (i) A bond described in section 1272(a)(6)(C) (regular interests in 
a REMIC, qualified mortgages held by a REMIC, and certain other debt 
instruments, or pools of debt instruments, with payments subject to 
acceleration);
    (ii) A bond to which Sec. 1.1275-4 applies (relating to certain 
debt instruments that provide for contingent payments);
    (iii) A bond held by a holder that has made a Sec. 1.1272-3 
election with respect to the bond;
    (iv) A bond that is stock in trade of the holder, a bond of a kind 
that would properly be included in the inventory of the holder if on 
hand at the close of the taxable year, or a bond held primarily for sale 
to customers in the ordinary course of the holder's trade or business; 
or
    (v) A bond issued before September 28, 1985, unless the bond bears 
interest and was issued by a corporation or by a government or political 
subdivision thereof.
    (c) General rule--(1) Tax-exempt obligations. A holder must amortize 
bond premium on a bond that is a tax-exempt obligation. See Sec. 1.171-
2(c) Example 4.
    (2) Taxable bonds. A holder may elect to amortize bond premium on a 
taxable bond. Except as provided in paragraph (c)(3) of this section, a 
taxable bond is any bond other than a tax-exempt obligation. See Sec. 
1.171-4 for rules relating to the election to amortize bond premium on a 
taxable bond.
    (3) Bonds the interest on which is partially excludable. For 
purposes of this section and Sec. Sec. 1.171-2 through 1.171-5, a bond 
the interest on which is partially excludable from gross income is 
treated as two instruments, a tax-exempt

[[Page 165]]

obligation and a taxable bond. The holder's basis in the bond and each 
payment on the bond are allocated between the two instruments based on a 
reasonable method.
    (d) Determination of bond premium--(1) In general. A holder acquires 
a bond at a premium if the holder's basis in the bond immediately after 
its acquisition by the holder exceeds the sum of all amounts payable on 
the bond after the acquisition date (other than payments of qualified 
stated interest). This excess is bond premium, which is amortizable 
under Sec. 1.171-2.
    (2) Additional rules for amounts payable on certain bonds. 
Additional rules apply to determine the amounts payable on a variable 
rate debt instrument, an inflation-indexed debt instrument, a bond that 
provides for certain alternative payment schedules, and a bond that 
provides for remote or incidental contingencies. See Sec. 1.171-3.
    (e) Basis. A holder determines its basis in a bond under this 
paragraph (e). This determination of basis applies only for purposes of 
this section and Sec. Sec. 1.171-2 through 1.171-5. Because of the 
application of this paragraph (e), the holder's basis in the bond for 
purposes of these sections may differ from the holder's basis for 
determining gain or loss on the sale or exchange of the bond.
    (1) Determination of basis--(i) In general. In general, the holder's 
basis in the bond is the holder's basis for determining loss on the sale 
or exchange of the bond.
    (ii) Bonds acquired in certain exchanges. If the holder acquired the 
bond in exchange for other property (other than in a reorganization 
defined in section 368) and the holder's basis in the bond is determined 
in whole or in part by reference to the holder's basis in the other 
property, the holder's basis in the bond may not exceed its fair market 
value immediately after the exchange. See paragraph (f) Example 1 of 
this section. If the bond is acquired in a reorganization, see section 
171(b)(4)(B).
    (iii) Convertible bonds--(A) General rule. If the bond is a 
convertible bond, the holder's basis in the bond is reduced by an amount 
equal to the value of the conversion option. The value of the conversion 
option may be determined under any reasonable method. For example, the 
holder may determine the value of the conversion option by comparing the 
market price of the convertible bond to the market prices of similar 
bonds that do not have conversion options. See paragraph (f) Example 2 
of this section.
    (B) Convertible bonds acquired in certain exchanges. If the bond is 
a convertible bond acquired in a transaction described in paragraph 
(e)(1)(ii) of this section, the holder's basis in the bond may not 
exceed its fair market value immediately after the exchange reduced by 
the value of the conversion option.
    (C) Definition of convertible bond. A convertible bond is a bond 
that provides the holder with an option to convert the bond into stock 
of the issuer, stock or debt of a related party (within the meaning of 
section 267(b) or 707(b)(1)), or into cash or other property in an 
amount equal to the approximate value of such stock or debt.
    (2) Basis in bonds held by certain transferees. Notwithstanding 
paragraph (e)(1) of this section, if the bond is transferred basis 
property (as defined in section 7701(a)(43)) and the transferor had 
acquired the bond at a premium, the holder's basis in the bond is--
    (i) The holder's basis for determining loss on the sale or exchange 
of the bond; reduced by
    (ii) Any amounts that the transferor could not have amortized under 
this paragraph (e) or under Sec. 1.171-4(c), except to the extent that 
the holder's basis already reflects a reduction attributable to such 
nonamortizable amounts.
    (f) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Bond received in liquidation of a partnership interest--
(i) Facts. PR is a partner in partnership PRS. PRS does not have any 
unrealized receivables or inventory items as defined in section 751. On 
January 1, 1998, PRS distributes to PR a taxable bond, issued by an 
unrelated corporation, in liquidation of PR's partnership interest. At 
that time, the fair market value of PR's partnership interest is $40,000 
and the basis is $100,000. The fair market value of the bond is $40,000.
    (ii) Determination of basis. Under section 732(b), PR's basis in the 
bond is equal to PR's

[[Page 166]]

basis in the partnership interest. Therefore, PR's basis for determining 
loss on the sale or exchange of the bond is $100,000. However, because 
the distribution is treated as an exchange for purposes of section 
171(b)(4), PR's basis in the bond is $40,000 for purposes of this 
section and Sec. Sec. 1.171-2 through 1.171-5. See paragraph (e)(1)(ii) 
of this section.
    Example 2. Convertible bond--(i) Facts. On January 11, 1998, A 
purchases for $1,100 B corporation's bond maturing on January 1, 2001, 
with a stated principal amount of $1,000, payable at maturity. The bond 
provides for unconditional payments of interest of $30 on January 1 and 
July 1 of each year. In addition, the bond is convertible into 15 shares 
of B corporation stock at the option of the holder. On January 1, 1998, 
B corporation's nonconvertible, publicly-traded, three-year debt with a 
similar credit rating trades at a price that reflects a yield of 6.75 
percent, compounded semiannually.
    (ii) Determination of basis. A's basis for determining loss on the 
sale or exchange of the bond is $1,100. As of January 1, 1998, 
discounting the remaining payments on the bond at the yield at which B's 
similar nonconvertible bonds trade (6.75 percent, compounded 
semiannually) results in a present value of $980. Thus, the value of the 
conversion option is $120. Under paragraph (e)(1)(iii)(A) of this 
section, A's basis is $980 ($1,100-$120) for purposes of this section 
and Sec. Sec. 1.171-2 through 1.171-5. The sum of all amounts payable 
on the bond other than qualified stated interest is $1,000. Because A's 
basis (as determined under paragraph (e)(1)(iii)(A) of this section) 
does not exceed $1,000, A does not acquire the bond at a premium.

[T.D. 8746, 62 FR 68177, Dec. 31, 1997]