A bond with 10 years to maturity is bought at $1,100. The premium is $100 ($1,100 price paid - $1,000 the face amount) and must be amortized over the 10-year life of the bond. This means a drop in value of $10 each year the bond is held. This drop in price of the bond cannot be deducted from the investor’s income tax.
For example, if the investor sells the bond prior to maturity after four years, the cost basis of the bond is going to be dropped $10 for each year the bond has been held, or $40 (4 years × $10 per year). The new cost basis is now $1,060 ($1,100 - $40), and depending on whether the bond is sold above or below this price determines if the investor has a gain or loss. If the sale price is at $1,060, the investor has neither a gain nor a loss. This is because the IRS believes that the investor is aware of the premium upon purchase and that the interest income compensates for the loss of the premium.
You do not have to compute this for the TEST, but you must know that the accretion or amortization takes place. Also know that accretion for discount bonds is always taxable if purchased in the secondary market, and the amortization for the premium bonds is never taken as a loss.