If the bond yields tax-exempt interest, you must amortize the premium.
This amortized amount is not deductible in determining
taxable income. However, each year you must reduce your
basis in the bond (and tax-exempt interest otherwise reportable on
Form 1040, line 8b) by the amortization for the year using the constant yield method. This is necessary to reduce the
bondholder’s tax basis in the tax-free bond to determine if there is a
capital gain upon disposition.
As long as the bond is held to maturity, there will be no capital
gain or loss associated with the bond. If the bond is sold before
maturity, you may have capital gain or loss based is the portion of the
premium which has not yet been amortized.
Generally no reduction for premium amortization is allowed since the
interest is not taxable, but if the bonds are taxable (out-of-state)
bonds, the taxable income can be reduced by the amount of premium
amortization.
http://www.irs.gov/publications/p550/ch03.html#en_US_2014_publink100010265FYI:
How To Report Amortization
Subtract the bond premium amortization from your interest income from these bonds.
Report the bond's interest on Schedule B (Form 1040A or 1040), line 1. Under your last entry on line 1, put a subtotal of
all interest listed on line 1. Below this subtotal, print “ABP Adjustment,” and the total interest you received. Subtract this amount from the subtotal, and enter the result on line 2.
