1.   Investment Income

Table of Contents

Useful Items - You may want to see:

Publication

  • 525 Taxable and Nontaxable Income

  • 537 Installment Sales

  • 590 Individual Retirement Arrangements (IRAs)

  • 925 Passive Activity and At-Risk Rules

  • 1212 Guide to Original Issue Discount (OID) Instruments

Form (and Instructions)

  • Schedule B (Form 1040A or 1040) Interest and Ordinary Dividends

  • Schedule D (Form 1040) Capital Gains and Losses

  • 1040 U.S. Individual Income Tax Return

  • 1040A U.S. Individual Income Tax Return

  • 1040EZ Income Tax Return for Single and Joint Filers With No Dependents

  • 1099 General Instructions for Certain Information Returns

  • 2439 Notice to Shareholder of Undistributed Long-Term Capital Gains

  • 3115 Application for Change in Accounting Method

  • 6251 Alternative Minimum Tax — Individuals

  • 8582 Passive Activity Loss Limitations

  • 8615 Tax for Certain Children Who Have Unearned Income

  • 8814 Parents' Election To Report Child's Interest and Dividends

  • 8815 Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989

  • 8818 Optional Form To Record Redemption of Series EE and I U.S. Savings Bonds Issued After 1989

  • 8824 Like-Kind Exchanges

  • 8949 Sales and Other Dispositions of Capital Assets

  • 8960 Net Investment Income Tax—Individuals, Estates, and Trusts

See chapter 5, How To Get Tax Help , for information about getting these publications and forms.

General Information

A few items of general interest are covered here.

Recordkeeping. You should keep a list showing sources and investment income amounts you receive during the year. Also keep the forms you receive showing your investment income (Forms 1099-INT, Interest Income, and 1099-DIV, Dividends and Distributions, for example) as an important part of your records.

Net investment income tax (NIIT).   Beginning in 2013, you may be subject to the NIIT. The NIIT is a 3.8% tax on the lesser of your net investment income or the amount of your modified adjusted gross income (MAGI) that is over a threshold amount based on your filing status.

  
Filing Status Threshold Amount
Married filing jointly $250,000
Married filing separately $125,000
Single $200,000
Head of household (with qualifying person) $200,000
Qualifying Widow(er) with dependent child $250,000

   For more information, see Form 8960 and Instructions for Form 8960.

Tax on unearned income of certain children.   Part of a child's 2013 unearned income may be taxed at the parent's tax rate. This may happen if all of the following are true.
  1. The child had more than $2,000 of unearned income.

  2. The child is required to file a tax return.

  3. The child was:

    1. Under age 18 at the end of 2013,

    2. Age 18 at the end of 2013 and did not have earned income that was more than half of the child's support, or

    3. A full-time student over age 18 and under age 24 at the end of 2013 and did not have earned income that was more than half of the child's support.

  4. At least one of the child's parents was alive at the end of 2013.

  5. The child does not file a joint return for 2013.

A child born on January 1, 1996, is considered to be age 18 at the end of 2013; a child born on January 1, 1995, is considered to be age 19 at the end of 2013; a child born on January 1, 1990, is considered to be age 24 at the end of 2013.

  If all of these statements are true, Form 8615 must be completed and attached to the child's tax return. If any of these statements is not true, Form 8615 is not required and the child's income is taxed at his or her own tax rate.

   However, the parent can choose to include the child's interest and dividends on the parent's return if certain requirements are met. Use Form 8814 for this purpose.

  For more information about the tax on unearned income of children and the parents' election, see Publication 929, Tax Rules for Children and Dependents.

Beneficiary of an estate or trust.   Interest, dividends, and other investment income you receive as a beneficiary of an estate or trust is generally taxable income. You should receive a Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc., from the fiduciary. Your copy of Schedule K-1 (Form 1041) and its instructions will tell you where to report the income on your Form 1040.

Social security number (SSN).   You must give your name and SSN or individual tax identification number (ITIN) to any person required by federal tax law to make a return, statement, or other document that relates to you. This includes payers of interest and dividends. If you do not give your SSN or ITIN to the payer of interest, you may have to pay a penalty.

SSN for joint account.   If the funds in a joint account belong to one person, list that person's name first on the account and give that person's SSN to the payer. (For information on who owns the funds in a joint account, see Joint accounts , later.) If the joint account contains combined funds, give the SSN of the person whose name is listed first on the account. This is because only one name and SSN can be shown on Form 1099.

  These rules apply both to joint ownership by a married couple and to joint ownership by other individuals. For example, if you open a joint savings account with your child using funds belonging to the child, list the child's name first on the account and give the child's SSN.

Custodian account for your child.   If your child is the actual owner of an account that is recorded in your name as custodian for the child, give the child's SSN to the payer. For example, you must give your child's SSN to the payer of dividends on stock owned by your child, even though the dividends are paid to you as custodian.

Penalty for failure to supply SSN.   You will be subject to a penalty if, when required, you fail to:
  • Include your SSN on any return, statement, or other document,

  • Give your SSN to another person who must include it on any return, statement, or other document, or

  • Include the SSN of another person on any return, statement, or other document.

The penalty is $50 for each failure up to a maximum penalty of $100,000 for any calendar year.

  You will not be subject to this penalty if you can show that your failure to provide the SSN was due to reasonable cause and not to willful neglect.

  If you fail to supply an SSN, you may also be subject to backup withholding.

Backup withholding.   Your investment income is generally not subject to regular withholding. However, it may be subject to backup withholding to ensure that income tax is collected on the income. Under backup withholding, the bank, broker, or other payer of interest, original issue discount (OID), dividends, cash patronage dividends, or royalties must withhold, as income tax, on the amount you are paid, applying the appropriate withholding rate.

  Backup withholding applies if:
  1. You do not give the payer your identification number (either a social security number or an employer identification number) in the required manner,

  2. The IRS notifies the payer that you gave an incorrect identification number,

  3. The IRS notifies the payer that you are subject to backup withholding on interest or dividends because you have underreported interest or dividends on your income tax return, or

  4. You are required, but fail, to certify that you are not subject to backup withholding for the reason described in (3).

Certification.   For new accounts paying interest or dividends, you must certify under penalties of perjury that your SSN is correct and that you are not subject to backup withholding. Your payer will give you a Form W-9, Request for Taxpayer Identification Number and Certification, or similar form, to make this certification. If you fail to make this certification, backup withholding may begin immediately on your new account or investment.

Underreported interest and dividends.   You will be considered to have underreported your interest and dividends if the IRS has determined for a tax year that:
  • You failed to include any part of a reportable interest or dividend payment required to be shown on your return, or

  • You were required to file a return and to include a reportable interest or dividend payment on that return, but you failed to file the return.

How to stop backup withholding due to underreporting.   If you have been notified that you underreported interest or dividends, you can request a determination from the IRS to prevent backup withholding from starting or to stop backup withholding once it has begun. You must show that at least one of the following situations applies.
  • No underreporting occurred.

  • You have a bona fide dispute with the IRS about whether underreporting occurred.

  • Backup withholding will cause or is causing an undue hardship, and it is unlikely that you will underreport interest and dividends in the future.

  • You have corrected the underreporting by filing a return if you did not previously file one and by paying all taxes, penalties, and interest due for any underreported interest or dividend payments.

  If the IRS determines that backup withholding should stop, it will provide you with a certification and will notify the payers who were sent notices earlier.

How to stop backup withholding due to an incorrect identification number.   If you have been notified by a payer that you are subject to backup withholding because you have provided an incorrect SSN or employer identification number, you can stop it by following the instructions the payer gives you.

Reporting backup withholding.   If backup withholding is deducted from your interest or dividend income or other reportable payment, the bank or other business must give you an information return for the year (for example, a Form 1099-INT) indicating the amount withheld. The information return will show any backup withholding as “Federal income tax withheld.

Nonresident aliens.    Generally, payments made to nonresident aliens are not subject to backup withholding. You can use Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, to certify exempt status. However, this does not exempt you from the 30% (or lower treaty) withholding rate that may apply to your investment income. For information on the 30% rate, see Publication 519, U.S. Tax Guide for Aliens.

Penalties.   There are civil and criminal penalties for giving false information to avoid backup withholding. The civil penalty is $500. The criminal penalty, upon conviction, is a fine of up to $1,000, or imprisonment of up to 1 year, or both.

Where to report investment income.   Table 1-1 gives an overview of the forms and schedules to use to report some common types of investment income. But see the rest of this publication for detailed information about reporting investment income.

Joint accounts.   If two or more persons hold property (such as a savings account, bond, or stock) as joint tenants, tenants by the entirety, or tenants in common, each person's share of any interest or dividends from the property is determined by local law.

Community property states.   If you are married and receive a distribution that is community income, one-half of the distribution is generally considered to be received by each spouse. If you file separate returns, you must each report one-half of any taxable distribution. See Publication 555, Community Property, for more information on community income.

  If the distribution is not considered community property and you and your spouse file separate returns, each of you must report your separate taxable distributions.

Example.

You and your spouse have a joint money market account. Under state law, half the income from the account belongs to you, and half belongs to your spouse. If you file separate returns, you each report half the income.

Income from property given to a child.   Property you give as a parent to your child under the Model Gifts of Securities to Minors Act, the Uniform Gifts to Minors Act, or any similar law becomes the child's property.

  Income from the property is taxable to the child, except that any part used to satisfy a legal obligation to support the child is taxable to the parent or guardian having that legal obligation.

Savings account with parent as trustee.   Interest income from a savings account opened for a minor child, but placed in the name and subject to the order of the parents as trustees, is taxable to the child if, under the law of the state in which the child resides, both of the following are true.
  • The savings account legally belongs to the child.

  • The parents are not legally permitted to use any of the funds to support the child.

Table 1-1.Where To Report Common Types of Investment Income

(For detailed information about reporting investment income, see the rest of this publication, especially How To Report Interest Income and How To Report Dividend Income in chapter 1.)

Type of Income If you file Form 1040, report on ... If you can file Form 1040A, report on ... If you can file Form 1040EZ, report on ...
Tax-exempt interest (Form 1099-INT, box 8) Line 8b Line 8b Space to the left of line 2 (enter “TEI” and the amount)
Taxable interest that totals $1,500 or less Line 8a (You may need to file Schedule B as well.) Line 8a (You may need to file Schedule B as well.) Line 2
Taxable interest that totals more than $1,500 Line 8a; also use Schedule B, line 1 Line 8a; also use Schedule B, line 1  
Savings bond interest you will exclude because of higher education expenses Schedule B; also use Form 8815 Schedule B; also use Form 8815  
Ordinary dividends that total $1,500 or less Line 9a (You may need to file Schedule B as well.) Line 9a (You may need to file Schedule B as well.)  
Ordinary dividends that total more than $1,500 Line 9a; also use Schedule B, line 5 Line 9a; also use Schedule B, line 5  
Qualified dividends (if you do not have to file Schedule D) Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 2 Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 2  
Qualified dividends (if you have to file Schedule D) Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet, line 2 You cannot use Form 1040A  
 
 
You cannot use Form 1040EZ
Capital gain distributions (if you do not have to file Schedule D) Line 13; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 3 Line 10; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 3  
Capital gain distributions (if you have to file Schedule D) Schedule D, line 13; also use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet    
Section 1250, 1202, or collectibles gain (Form 1099-DIV, box 2b, 2c, or 2d) Form 8949 and Schedule D    
Nondividend distributions (Form 1099-DIV, box 3) Generally not reported*    
Undistributed capital gains (Form 2439, boxes 1a - 1d) Schedule D    
Gain or loss from sales of stocks or bonds Line 13; also use Form 8949, Schedule D, and the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet You cannot use Form 1040A  
Gain or loss from exchanges of like-kind investment property Line 13; also use Schedule D, Form 8824, and the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet    
*Report any amounts in excess of your basis in your mutual fund shares on Form 8949. Use Part II if you held the shares more than 1 year. Use Part I if you held your mutual fund shares 1 year or less. For details on Form 8949, see Reporting Capital Gains and Losses in chapter 4, and the Instructions for Form 8949.

Accuracy-related penalty.   An accuracy-related penalty of 20% can be charged for underpayments of tax due to negligence or disregard of rules or regulations or substantial understatement of tax. For information on the penalty and any interest that applies, see Penalties in chapter 2.

Interest Income

This section discusses the tax treatment of different types of interest income.

In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income. (It does not have to be entered in your passbook.) Exceptions to this rule are discussed later.

Form 1099-INT.   Interest income is generally reported to you on Form 1099-INT, or a similar statement, by banks, savings and loans, and other payers of interest. This form shows you the interest you received during the year. Keep this form for your records. You do not have to attach it to your tax return.

  Report on your tax return the total interest income you receive for the tax year.

Interest not reported on Form 1099-INT.   Even if you do not receive Form 1099-INT, you must still report all of your interest income. For example, you may receive distributive shares of interest from partnerships or S corporations. This interest is reported to you on Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., and Schedule K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc.

Nominees.   Generally, if someone receives interest as a nominee for you, that person must give you a Form 1099-INT showing the interest received on your behalf.

  If you receive a Form 1099-INT that includes amounts belonging to another person, see the discussion on Nominee distributions , later, under How To Report Interest Income.

Incorrect amount.   If you receive a Form 1099-INT that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. The new Form 1099-INT you receive will be marked “Corrected.

Form 1099-OID.   Reportable interest income also may be shown on Form 1099-OID, Original Issue Discount. For more information about amounts shown on this form, see Original Issue Discount (OID) , later in this chapter.

Exempt-interest dividends.   Exempt-interest dividends you receive from a mutual fund or other regulated investment company, including those received from a qualified fund of funds in any tax year beginning after December 22, 2010, are not included in your taxable income. (However, see Information reporting requirement , next.) Exempt-interest dividends should be shown in box 10 of Form 1099-DIV. You do not reduce your basis for distributions that are exempt-interest dividends.

Information reporting requirement.   Although exempt-interest dividends are not taxable, you must show them on your tax return if you have to file. This is an information reporting requirement and does not change the exempt-interest dividends into taxable income. See How To Report Interest Income , later.

Note.

Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. The exempt-interest dividends subject to the alternative minimum tax are shown in box 11 of Form 1099-DIV. See Form 6251 and its instructions for more information about this tax. Private activity bonds are discussed later under State or Local Government Obligations.

Interest on VA dividends.   Interest on insurance dividends left on deposit with the Department of Veterans Affairs (VA) is not taxable. This includes interest paid on dividends on converted United States Government Life Insurance policies and on National Service Life Insurance policies.

Individual retirement arrangements (IRAs).   Interest on a Roth IRA generally is not taxable. Interest on a traditional IRA is tax deferred. You generally do not include it in your income until you make withdrawals from the IRA. See Publication 590 for more information.

Taxable Interest — General

Taxable interest includes interest you receive from bank accounts, loans you make to others, and other sources. The following are some sources of taxable interest.

Dividends that are actually interest.   Certain distributions commonly called dividends are actually interest. You must report as interest so-called “dividends” on deposits or on share accounts in:
  • Cooperative banks,

  • Credit unions,

  • Domestic building and loan associations,

  • Domestic savings and loan associations,

  • Federal savings and loan associations, and

  • Mutual savings banks.

 
The “dividends” will be shown as interest income on Form 1099-INT.

Money market funds.   Money market funds are offered by nonbank financial institutions such as mutual funds and stock brokerage houses, and pay dividends. Generally, amounts you receive from money market funds should be reported as dividends, not as interest.

Certificates of deposit and other deferred interest accounts.   If you open any of these accounts, interest may be paid at fixed intervals of 1 year or less during the term of the account. You generally must include this interest in your income when you actually receive it or are entitled to receive it without paying a substantial penalty. The same is true for accounts that mature in 1 year or less and pay interest in a single payment at maturity. If interest is deferred for more than 1 year, see Original Issue Discount (OID) , later.

Interest subject to penalty for early withdrawal.   If you withdraw funds from a deferred interest account before maturity, you may have to pay a penalty. You must report the total amount of interest paid or credited to your account during the year, without subtracting the penalty. See Penalty on early withdrawal of savings under How To Report Interest Income, later, for more information on how to report the interest and deduct the penalty.

Money borrowed to invest in certificate of deposit.   The interest you pay on money borrowed from a bank or savings institution to meet the minimum deposit required for a certificate of deposit from the institution and the interest you earn on the certificate are two separate items. You must report the total interest you earn on the certificate in your income. If you itemize deductions, you can deduct the interest you pay as investment interest, up to the amount of your net investment income. See Interest Expenses in chapter 3.

Example.

You deposited $5,000 with a bank and borrowed $5,000 from the bank to make up the $10,000 minimum deposit required to buy a 6-month certificate of deposit. The certificate earned $575 at maturity in 2013, but you received only $265, which represented the $575 you earned minus $310 interest charged on your $5,000 loan. The bank gives you a Form 1099-INT for 2013 showing the $575 interest you earned. The bank also gives you a statement showing that you paid $310 interest for 2013. You must include the $575 in your income. If you itemize your deductions on Schedule A (Form 1040), Itemized Deductions, you can deduct $310, subject to the net investment income limit.

Gift for opening account.   If you receive noncash gifts or services for making deposits or for opening an account in a savings institution, you may have to report the value as interest.

  For deposits of less than $5,000, gifts or services valued at more than $10 must be reported as interest. For deposits of $5,000 or more, gifts or services valued at more than $20 must be reported as interest. The value is determined by the cost to the financial institution.

Example.

You open a savings account at your local bank and deposit $800. The account earns $20 interest. You also receive a $15 calculator. If no other interest is credited to your account during the year, the Form 1099-INT you receive will show $35 interest for the year. You must report $35 interest income on your tax return.

Interest on insurance dividends.   Interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable to you in the year it is credited to your account. However, if you can withdraw it only on the anniversary date of the policy (or other specified date), the interest is taxable in the year that date occurs.

Prepaid insurance premiums.   Any increase in the value of prepaid insurance premiums, advance premiums, or premium deposit funds is interest if it is applied to the payment of premiums due on insurance policies or made available for you to withdraw.

U.S. obligations.   Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes.

Interest on tax refunds.   Interest you receive on tax refunds is taxable income.

Interest on condemnation award.   If the condemning authority pays you interest to compensate you for a delay in payment of an award, the interest is taxable.

Installment sale payments.   If a contract for the sale or exchange of property provides for deferred payments, it also usually provides for interest payable with the deferred payments. That interest is taxable when you receive it. If little or no interest is provided for in a deferred payment contract, part of each payment may be treated as interest. See Unstated Interest and Original Issue Discount (OID) in Publication 537.

Interest on annuity contract.   Accumulated interest on an annuity contract you sell before its maturity date is taxable.

Usurious interest.   Usurious interest is interest charged at an illegal rate. This is taxable as interest unless state law automatically changes it to a payment on the principal.

Interest income on frozen deposits.   Exclude from your gross income interest on frozen deposits. A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because:
  • The financial institution is bankrupt or insolvent, or

  • The state in which the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent.

  The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of:
  • The net amount you withdrew from these deposits during the year, and

  • The amount you could have withdrawn as of the end of the year (not reduced by any penalty for premature withdrawals of a time deposit).

If you receive a Form 1099-INT for interest income on deposits that were frozen at the end of 2013, see Frozen deposits under How To Report Interest Income for information about reporting this interest income exclusion on your tax return.

  The interest you exclude is treated as credited to your account in the following year. You must include it in income in the year you can withdraw it.

Example.

$100 of interest was credited on your frozen deposit during the year. You withdrew $80 but could not withdraw any more as of the end of the year. You must include $80 in your income and exclude $20 from your income for the year. You must include the $20 in your income for the year you can withdraw it.

Bonds traded flat.    If you buy a bond at a discount when interest has been defaulted or when the interest has accrued but has not been paid, the transaction is described as trading a bond flat. The defaulted or unpaid interest is not income and is not taxable as interest if paid later. When you receive a payment of that interest, it is a return of capital that reduces the remaining cost basis of your bond. Interest that accrues after the date of purchase, however, is taxable interest income for the year received or accrued. See Bonds Sold Between Interest Dates , later in this chapter.

Below-Market Loans

If you make a below-market gift or demand loan, you must report as interest income any forgone interest (defined later) from that loan. The below-market loan rules and exceptions are described in this section. For more information, see section 7872 of the Internal Revenue Code and its regulations.

If you receive a below-market loan, you may be able to deduct the forgone interest as well as any interest you actually paid, but not if it is personal interest.

Loans subject to the rules.   The rules for below-market loans apply to:
  • Gift loans,

  • Pay-related loans,

  • Corporation-shareholder loans,

  • Tax avoidance loans, and

  • Certain loans made to qualified continuing care facilities under a continuing care contract.

A pay-related loan is any below-market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services.

A tax avoidance loan is any below-market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement.

Forgone interest.   For any period, forgone interest is:
  • The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus

  • Any interest actually payable on the loan for the period.

Applicable federal rate.   Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. Some IRS offices have these bulletins available for research. See chapter 5, How To Get Tax Help , for other ways to get this information.

Rules for below-market loans.   The rules that apply to a below-market loan depend on whether the loan is a gift loan, demand loan, or term loan.

Gift and demand loans.   A gift loan is any below-market loan where the forgone interest is in the nature of a gift.

  A demand loan is a loan payable in full at any time upon demand by the lender. A demand loan is a below-market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate.

  A demand loan or gift loan that is a below-market loan is generally treated as an arm's-length transaction in which the lender is treated as having made:
  • A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and

  • An additional payment to the borrower in an amount equal to the forgone interest.

The borrower is generally treated as transferring the additional payment back to the lender as interest. The lender must report that amount as interest income.

  The lender's additional payment to the borrower is treated as a gift, dividend, contribution to capital, pay for services, or other payment, depending on the substance of the transaction. The borrower may have to report this payment as taxable income, depending on its classification.

These transfers are considered to occur annually, generally on December 31.

Term loans.   A term loan is any loan that is not a demand loan. A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan.

  A lender who makes a below-market term loan other than a gift loan is treated as transferring an additional lump-sum cash payment to the borrower (as a dividend, contribution to capital, etc.) on the date the loan is made. The amount of this payment is the amount of the loan minus the present value, at the applicable federal rate, of all payments due under the loan. An equal amount is treated as original issue discount (OID). The lender must report the annual part of the OID as interest income. The borrower may be able to deduct the OID as interest expense. See Original Issue Discount (OID) , later.

Exceptions to the below-market loan rules.   Exceptions to the below-market loan rules are discussed here.

Exception for loans of $10,000 or less.   The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to:
  1. Gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and

  2. Pay-related loans or corporation-shareholder loans if the avoidance of federal tax is not a principal purpose of the interest arrangement.

This exception does not apply to a term loan described in (2) earlier that previously has been subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

Exception for loans to continuing care facilities.   Loans to qualified continuing care facilities under continuing care contracts are not subject to the rules for below-market loans for the calendar year if the lender or the lender's spouse is age 62 or older at the end of the year. For the definitions of qualified continuing care facility and continuing care contract, see Internal Revenue Code section 7872(h).

Exception for loans without significant tax effect.   Loans are excluded from the below-market loan rules if their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender. These loans include:
  1. Loans made available by the lender to the general public on the same terms and conditions that are consistent with the lender's customary business practice;

  2. Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public;

  3. Certain employee-relocation loans;

  4. Certain loans from a foreign person, unless the interest income would be effectively connected with the conduct of a U.S. trade or business and would not be exempt from U.S. tax under an income tax treaty;

  5. Gift loans to a charitable organization, contributions to which are deductible, if the total outstanding amount of loans between the organization and lender is $250,000 or less at all times during the tax year; and

  6. Other loans on which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower.

For a loan described in (6) above, all the facts and circumstances are used to determine if the interest arrangement has a significant effect on the federal tax liability of the lender or borrower. Some factors to be considered are:

  • Whether items of income and deduction generated by the loan offset each other;

  • The amount of these items;

  • The cost to you of complying with the below-market loan rules, if they were to apply; and

  • Any reasons other than taxes for structuring the transaction as a below-market loan.

If you structure a transaction to meet this exception and one of the principal purposes of that structure is the avoidance of federal tax, the loan will be considered a tax-avoidance loan, and this exception will not apply.

Limit on forgone interest for gift loans of $100,000 or less.   For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of federal tax is one of the main purposes of the interest arrangement.

Effective dates.    These rules apply to term loans made after June 6, 1984, and to demand loans outstanding after that date.

U.S. Savings Bonds

This section provides tax information on U.S. savings bonds. It explains how to report the interest income on these bonds and how to treat transfers of these bonds.

U.S. savings bonds currently offered to individuals include Series EE bonds and Series I bonds.

For other information on U.S. savings bonds, write to: 
 
For Series HH/H:

Bureau of the Fiscal Service 
Division of Customer Assistance 
P.O. Box 2186 
Parkersburg, WV 26106-2186

 
For Series EE and I paper savings bonds:

Bureau of the Fiscal Service 
Division of Customer Assistance 
P.O. Box 7012 
Parkersburg, WV 26106-7012

 
For Series EE and I electronic bonds:

Bureau of the Fiscal Service  
Division of Customer Assistance 
P.O. Box 7015 
Parkersburg, WV 26106-7015

Or, on the Internet, visit: www.treasurydirect.gov/indiv/indiv.htm.

Accrual method taxpayers.   If you use an accrual method of accounting, you must report interest on U.S. savings bonds each year as it accrues. You cannot postpone reporting interest until you receive it or until the bonds mature.

Cash method taxpayers.   If you use the cash method of accounting, as most individual taxpayers do, you generally report the interest on U.S. savings bonds when you receive it. But see Reporting options for cash method taxpayers , later.

Series HH bonds.   These bonds were issued at face value. Interest is paid twice a year by direct deposit to your bank account. If you are a cash method taxpayer, you must report interest on these bonds as income in the year you receive it.

  Series HH bonds were first offered in 1980 and last offered in August 2004. Before 1980, series H bonds were issued. Series H bonds are treated the same as series HH bonds. If you are a cash method taxpayer, you must report the interest when you receive it.

  Series H bonds have a maturity period of 30 years. Series HH bonds mature in 20 years. The last series H bonds matured in 2009. The last series HH bonds will mature in 2024.

Series EE and series I bonds.   Interest on these bonds is payable when you redeem the bonds. The difference between the purchase price and the redemption value is taxable interest.

Series EE bonds.   Series EE bonds were first offered in January 1980 and have a maturity period of 30 years. Before July 1980, series E bonds were issued. The original 10-year maturity period of series E bonds has been extended to 40 years for bonds issued before December 1965 and 30 years for bonds issued after November 1965. Paper series EE and series E bonds are issued at a discount. The face value is payable to you at maturity. Electronic series EE bonds are issued at their face value. The face value plus accrued interest is payable to you at maturity. As of January 1, 2012, paper savings bonds were no longer sold at financial institutions.

   Owners of paper series EE bonds can convert them to electronic bonds. These converted bonds do not retain the denomination listed on the paper certificate but are posted at their purchase price (with accrued interest).

Series I bonds.   Series I bonds were first offered in 1998. These are inflation-indexed bonds issued at their face amount with a maturity period of 30 years. The face value plus all accrued interest is payable to you at maturity.

Reporting options for cash method taxpayers.   If you use the cash method of reporting income, you can report the interest on series EE, series E, and series I bonds in either of the following ways.
  1. Method 1. Postpone reporting the interest until the earlier of the year you cash or dispose of the bonds or the year in which they mature. (However, see Savings bonds traded , later.)  
    Note. Series EE bonds issued in 1983 matured in 2013. If you have used method 1, you generally must report the interest on these bonds on your 2013 return. The last series E bonds were issued in 1980 and matured in 2010. If you used method 1, you generally should have reported the interest on these bonds on your 2010 return.

  2. Method 2. Choose to report the increase in redemption value as interest each year.

 
You must use the same method for all series EE, series E, and series I bonds you own. If you do not choose method 2 by reporting the increase in redemption value as interest each year, you must use method 1.

If you plan to cash your bonds in the same year you will pay for higher educational expenses, you may want to use method 1 because you may be able to exclude the interest from your income. To learn how, see Education Savings Bond Program, later.

Change from method 1.   If you want to change your method of reporting the interest from method 1 to method 2, you can do so without permission from the IRS. In the year of change, you must report all interest accrued to date and not previously reported for all your bonds.

  Once you choose to report the interest each year, you must continue to do so for all series EE, series E, and series I bonds you own and for any you get later, unless you request permission to change, as explained next.

Change from method 2.   To change from method 2 to method 1, you must request permission from the IRS. Permission for the change is automatically granted if you send the IRS a statement that meets all the following requirements.
  1. You have typed or printed the following number at the top: “131.

  2. It includes your name and social security number under “131.

  3. It includes the year of change (both the beginning and ending dates).

  4. It identifies the savings bonds for which you are requesting this change.

  5. It includes your agreement to:

    1. Report all interest on any bonds acquired during or after the year of change when the interest is realized upon disposition, redemption, or final maturity, whichever is earliest; and

    2. Report all interest on the bonds acquired before the year of change when the interest is realized upon disposition, redemption, or final maturity, whichever is earliest, with the exception of the interest reported in prior tax years.

  You must attach this statement to your tax return for the year of change, which you must file by the due date (including extensions).

  You can have an automatic extension of 6 months from the due date of your return for the year of change (excluding extensions) to file the statement with an amended return. On the statement, type or print “Filed pursuant to section 301.9100-2.” To get this extension, you must have filed your original return for the year of the change by the due date (including extensions).

  
By the date you file the original statement with your return, you must also send a signed copy to the address below.

  

Internal Revenue Service 
Attention: CC:IT&A (Automatic Rulings Branch) 
P.O. Box 7604 
Benjamin Franklin Station 
Washington, DC 20044

  If you use a private delivery service, send the signed copy to the address below.

Internal Revenue Service 
Attention: CC:IT&A  
(Automatic Rulings Branch) Room 5336 
1111 Constitution Avenue, NW 
Washington, DC 20224

   Instead of filing this statement, you can request permission to change from method 2 to method 1 by filing Form 3115. In that case, follow the form instructions for an automatic change. No user fee is required.

Co-owners.   If a U.S. savings bond is issued in the names of co-owners, such as you and your child or you and your spouse, interest on the bond is generally taxable to the co-owner who bought the bond.

One co-owner's funds used.   If you used your funds to buy the bond, you must pay the tax on the interest. This is true even if you let the other co-owner redeem the bond and keep all the proceeds. Under these circumstances, the co-owner who redeemed the bond will receive a Form 1099-INT at the time of redemption and must provide you with another Form 1099-INT showing the amount of interest from the bond taxable to you. The co-owner who redeemed the bond is a “nominee.” See Nominee distributions under How To Report Interest Income, later, for more information about how a person who is a nominee reports interest income belonging to another person.

Both co-owners' funds used.   If you and the other co-owner each contribute part of the bond's purchase price, the interest is generally taxable to each of you, in proportion to the amount each of you paid.

Community property.   If you and your spouse live in a community property state and hold bonds as community property, one-half of the interest is considered received by each of you. If you file separate returns, each of you generally must report one-half of the bond interest. For more information about community property, see Publication 555.

Table 1-2.   These rules are also shown in Table 1-2.

Child as only owner.   Interest on U.S. savings bonds bought for and registered only in the name of your child is income to your child, even if you paid for the bonds and are named as beneficiary. If the bonds are series EE, series E, or series I bonds, the interest on the bonds is income to your child in the earlier of the year the bonds are cashed or disposed of or the year the bonds mature, unless your child chooses to report the interest income each year.

Choice to report interest each year.   The choice to report the accrued interest each year can be made either by your child or by you for your child. This choice is made by filing an income tax return that shows all the interest earned to date, and by stating on the return that your child chooses to report the interest each year. Either you or your child should keep a copy of this return.

  Unless your child is otherwise required to file a tax return for any year after making this choice, your child does not have to file a return only to report the annual accrual of U.S. savings bond interest under this choice. However, see Tax on unearned income of certain children , earlier, under General Information. Neither you nor your child can change the way you report the interest unless you request permission from the IRS, as discussed earlier under Change from method 2 .

Ownership transferred.   If you bought series E, series EE, or series I bonds entirely with your own funds and had them reissued in your co-owner's name or beneficiary's name alone, you must include in your gross income for the year of reissue all interest that you earned on these bonds and have not previously reported. But, if the bonds were reissued in your name alone, you do not have to report the interest accrued at that time.

  This same rule applies when bonds (other than bonds held as community property) are transferred between spouses or incident to divorce.

Example.

You bought series EE bonds entirely with your own funds. You did not choose to report the accrued interest each year. Later, you transfer the bonds to your former spouse under a divorce agreement. You must include the deferred accrued interest, from the date of the original issue of the bonds to the date of transfer, in your income in the year of transfer. Your former spouse includes in income the interest on the bonds from the date of transfer to the date of redemption.

Table 1-2. Who Pays the Tax on U.S. Savings Bond Interest

IF ... THEN the interest must be reported by ...
you buy a bond in your name and the name of another person as co-owners, using only your own funds you.
you buy a bond in the name of another person, who is the sole owner of the bond the person for whom you bought the bond.
you and another person buy a bond as co-owners, each contributing part of the purchase price both you and the other co-owner, in proportion to the amount each paid for the bond.
you and your spouse, who live in a community property state, buy a bond that is community property you and your spouse. If you file separate returns, both you and your spouse generally report one-half of the interest.

Purchased jointly.   If you and a co-owner each contributed funds to buy series E, series EE, or series I bonds jointly and later have the bonds reissued in the co-owner's name alone, you must include in your gross income for the year of reissue your share of all the interest earned on the bonds that you have not previously reported. The former co-owner does not have to include in gross income at the time of reissue his or her share of the interest earned that was not reported before the transfer. This interest, however, as well as all interest earned after the reissue, is income to the former co-owner.

  This income-reporting rule also applies when the bonds are reissued in the name of your former co-owner and a new co-owner. But the new co-owner will report only his or her share of the interest earned after the transfer.

  If bonds that you and a co-owner bought jointly are reissued to each of you separately in the same proportion as your contribution to the purchase price, neither you nor your co-owner has to report at that time the interest earned before the bonds were reissued.

Example 1.

You and your spouse each spent an equal amount to buy a $1,000 series EE savings bond. The bond was issued to you and your spouse as co-owners. You both postpone reporting interest on the bond. You later have the bond reissued as two $500 bonds, one in your name and one in your spouse's name. At that time neither you nor your spouse has to report the interest earned to the date of reissue.

Example 2.

You bought a $1,000 series EE savings bond entirely with your own funds. The bond was issued to you and your spouse as co-owners. You both postponed reporting interest on the bond. You later have the bond reissued as two $500 bonds, one in your name and one in your spouse's name. You must report half the interest earned to the date of reissue.

Transfer to a trust.   If you own series E, series EE, or series I bonds and transfer them to a trust, giving up all rights of ownership, you must include in your income for that year the interest earned to the date of transfer if you have not already reported it. However, if you are considered the owner of the trust and if the increase in value both before and after the transfer continues to be taxable to you, you can continue to defer reporting the interest earned each year. You must include the total interest in your income in the year you cash or dispose of the bonds or the year the bonds finally mature, whichever is earlier.

  The same rules apply to previously unreported interest on series EE or series E bonds if the transfer to a trust consisted of series HH or series H bonds you acquired in a trade for the series EE or series E bonds. See Savings bonds traded , later.

Decedents.   The manner of reporting interest income on series E, series EE, or series I bonds, after the death of the owner (decedent), depends on the accounting and income-reporting methods previously used by the decedent.

Decedent who reported interest each year.   If the bonds transferred because of death were owned by a person who used an accrual method, or who used the cash method and had chosen to report the interest each year, the interest earned in the year of death up to the date of death must be reported on that person's final return. The person who acquires the bonds includes in income only interest earned after the date of death.

Decedent who postponed reporting interest.   If the transferred bonds were owned by a decedent who had used the cash method and had not chosen to report the interest each year, and who had bought the bonds entirely with his or her own funds, all interest earned before death must be reported in one of the following ways.
  1. The surviving spouse or personal representative (executor, administrator, etc.) who files the final income tax return of the decedent can choose to include on that return all interest earned on the bonds before the decedent's death. The person who acquires the bonds then includes in income only interest earned after the date of death.

  2. If the choice in (1) is not made, the interest earned up to the date of death is income in respect of the decedent and should not be included in the decedent's final return. All interest earned both before and after the decedent's death (except any part reported by the estate on its income tax return) is income to the person who acquires the bonds. If that person uses the cash method and does not choose to report the interest each year, he or she can postpone reporting it until the year the bonds are cashed or disposed of or the year they mature, whichever is earlier. In the year that person reports the interest, he or she can claim a deduction for any federal estate tax paid on the part of the interest included in the decedent's estate.

For more information on income in respect of a decedent, see Publication 559, Survivors, Executors, and Administrators.

Example 1.

Your uncle, a cash method taxpayer, died and left you a $1,000 series EE bond. He had bought the bond for $500 and had not chosen to report the interest each year. At the date of death, interest of $200 had accrued on the bond, and its value of $700 was included in your uncle's estate. Your uncle's executor chose not to include the $200 accrued interest in your uncle's final income tax return. The $200 is income in respect of the decedent.

You are a cash method taxpayer and do not choose to report the interest each year as it is earned. If you cash the bond when it reaches maturity value of $1,000, you report $500 interest income—the difference between maturity value of $1,000 and the original cost of $500. For that year, you can deduct (as a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit) any federal estate tax paid because the $200 interest was included in your uncle's estate.

Example 2.

If, in Example 1 , the executor had chosen to include the $200 accrued interest in your uncle's final return, you would report only $300 as interest when you cashed the bond at maturity. $300 is the interest earned after your uncle's death.

Example 3.

If, in Example 1 , you make or have made the choice to report the increase in redemption value as interest each year, you include in gross income for the year you acquire the bond all of the unreported increase in value of all series E, series EE, and series I bonds you hold, including the $200 on the bond you inherited from your uncle.

Example 4.

When your aunt died, she owned series HH bonds that she had acquired in a trade for series EE bonds. You were the beneficiary of these bonds. Your aunt used the cash method and did not choose to report the interest on the series EE bonds each year as it accrued. Your aunt's executor chose not to include any interest earned before your aunt's death on her final return.

The income in respect of the decedent is the sum of the unreported interest on the series EE bonds and the interest, if any, payable on the series HH bonds but not received as of the date of your aunt's death. You must report any interest received during the year as income on your return. The part of the interest payable but not received before your aunt's death is income in respect of the decedent and may qualify for the estate tax deduction. For information on when to report the interest on the series EE bonds traded, see Savings bonds traded , later.

Savings bonds distributed from a retirement or profit-sharing plan.   If you acquire a U.S. savings bond in a taxable distribution from a retirement or profit-sharing plan, your income for the year of distribution includes the bond's redemption value (its cost plus the interest accrued before the distribution). When you redeem the bond (whether in the year of distribution or later), your interest income includes only the interest accrued after the bond was distributed. To figure the interest reported as a taxable distribution and your interest income when you redeem the bond, see Worksheet for savings bonds distributed from a retirement or profit-sharing plan under How To Report Interest Income, later.

Savings bonds traded.   If you postponed reporting the interest on your series EE or series E bonds, you did not recognize taxable income when you traded the bonds for series HH or series H bonds, unless you received cash in the trade. (You cannot trade series I bonds for series HH bonds. After August 31, 2004, you cannot trade any other series of bonds for series HH bonds.) Any cash you received is income up to the amount of the interest earned on the bonds traded. When your series HH or series H bonds mature, or if you dispose of them before maturity, you report as interest the difference between their redemption value and your cost. Your cost is the sum of the amount you paid for the traded series EE or series E bonds plus any amount you had to pay at the time of the trade.

Example.

You traded series EE bonds (on which you postponed reporting the interest) for $2,500 in series HH bonds and $223 in cash. You reported the $223 as taxable income on your tax return. At the time of the trade, the series EE bonds had accrued interest of $523 and a redemption value of $2,723. You hold the series HH bonds until maturity, when you receive $2,500. You must report $300 as interest income in the year of maturity. This is the difference between their redemption value, $2,500, and your cost, $2,200 (the amount you paid for the series EE bonds). (It is also the difference between the accrued interest of $523 on the series EE bonds and the $223 cash received on the trade.)

Choice to report interest in year of trade.   You could have chosen to treat all of the previously unreported accrued interest on series EE or series E bonds traded for series HH bonds as income in the year of the trade. If you made this choice, it is treated as a change from method 1. See Change from method 1 under Series EE and series I bonds, earlier.

Form 1099-INT for U.S. savings bond interest.   When you cash a bond, the bank or other payer that redeems it must give you a Form 1099-INT if the interest part of the payment you receive is $10 or more. Box 3 of your Form 1099-INT should show the interest as the difference between the amount you received and the amount paid for the bond. However, your Form 1099-INT may show more interest than you have to include on your income tax return. For example, this may happen if any of the following are true.
  • You chose to report the increase in the redemption value of the bond each year. The interest shown on your Form 1099-INT will not be reduced by amounts previously included in income.

  • You received the bond from a decedent. The interest shown on your Form 1099-INT will not be reduced by any interest reported by the decedent before death, or on the decedent's final return, or by the estate on the estate's income tax return.

  • Ownership of the bond was transferred. The interest shown on your Form 1099-INT will not be reduced by interest that accrued before the transfer.

  • You were named as a co-owner, and the other co-owner contributed funds to buy the bond. The interest shown on your Form 1099-INT will not be reduced by the amount you received as nominee for the other co-owner. (See Co-owners , earlier in this section, for more information about the reporting requirements.)

  • You received the bond in a taxable distribution from a retirement or profit-sharing plan. The interest shown on your Form 1099-INT will not be reduced by the interest portion of the amount taxable as a distribution from the plan and not taxable as interest. (This amount is generally shown on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year of distribution.)

  For more information on including the correct amount of interest on your return, see U.S. savings bond interest previously reported or Nominee distributions under How To Report Interest Income, later.

  
Interest on U.S. savings bonds is exempt from state and local taxes. The Form 1099-INT you receive will indicate the amount that is for U.S. savings bonds interest in box 3. Do not include this income on your state or local income tax return.

Education Savings Bond Program

You may be able to exclude from income all or part of the interest you receive on the redemption of qualified U.S. savings bonds during the year if you pay qualified higher educational expenses during the same year. This exclusion is known as the Education Savings Bond Program.

You do not qualify for this exclusion if your filing status is married filing separately.

Form 8815.   Use Form 8815 to figure your exclusion. Attach the form to your Form 1040 or Form 1040A.

Qualified U.S. savings bonds.   A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must be issued either in your name (sole owner) or in your and your spouse's names (co-owners). You must be at least 24 years old before the bond's issue date. For example, a bond bought by a parent and issued in the name of his or her child under age 24 does not qualify for the exclusion by the parent or child.

  
The issue date of a bond may be earlier than the date the bond is purchased because the issue date assigned to a bond is the first day of the month in which it is purchased.

Beneficiary.   You can designate any individual (including a child) as a beneficiary of the bond.

Verification by IRS.   If you claim the exclusion, the IRS will check it by using bond redemption information from the Department of Treasury.

Qualified expenses.   Qualified higher educational expenses are tuition and fees required for you, your spouse, or your dependent (for whom you claim an exemption) to attend an eligible educational institution.

  Qualified expenses include any contribution you make to a qualified tuition program or to a Coverdell education savings account. For information about these programs, see Publication 970, Tax Benefits for Education.

  Qualified expenses do not include expenses for room and board or for courses involving sports, games, or hobbies that are not part of a degree or certificate granting program.

Eligible educational institutions.   These institutions include most public, private, and nonprofit universities, colleges, and vocational schools that are accredited and eligible to participate in student aid programs run by the Department of Education.

Reduction for certain benefits.   You must reduce your qualified higher educational expenses by all of the following tax-free benefits.
  1. Tax-free part of scholarships and fellowships.

  2. Expenses used to figure the tax-free portion of distributions from a Coverdell ESA.

  3. Expenses used to figure the tax-free portion of distributions from a qualified tuition program.

  4. Any tax-free payments (other than gifts or inheritances) received as educational assistance, such as:

    1. Veterans' educational assistance benefits,

    2. Qualified tuition reductions, or

    3. Employer-provided educational assistance.

  5. Any expense used in figuring the American Opportunity and lifetime learning credits.

For information about these benefits, see Publication 970.

Amount excludable.   If the total proceeds (interest and principal) from the qualified U.S. savings bonds you redeem during the year are not more than your adjusted qualified higher educational expenses for the year, you may be able to exclude all of the interest. If the proceeds are more than the expenses, you may be able to exclude only part of the interest.

  To determine the excludable amount, multiply the interest part of the proceeds by a fraction. The numerator (top part) of the fraction is the qualified higher educational expenses you paid during the year. The denominator (bottom part) of the fraction is the total proceeds you received during the year.

Example.

In February 2013, Mark and Joan, a married couple, cashed a qualified series EE U.S. savings bond they bought in April 1997. They received proceeds of $8,372, representing principal of $5,000 and interest of $3,372. In 2013, they paid $4,000 of their daughter's college tuition. They are not claiming an education credit for that amount, and their daughter does not have any tax-free educational assistance. They can exclude $1,611 ($3,372 × ($4,000 ÷ $8,372)) of interest in 2013. They must pay tax on the remaining $1,761 ($3,372 − $1,611) interest.

Figuring the interest part of the proceeds (Form 8815, line 6).   To figure the interest to report on Form 8815, line 6, use the Line 6 Worksheet in the Form 8815 instructions.

  
If you previously reported any interest from savings bonds cashed during 2013, use the Alternate Line 6 Worksheet below instead.

  
Alternate Line 6 Worksheet
1. Enter the amount from Form 8815, line 5  
2. Enter the face value of all post-1989 paper series EE bonds cashed in 2013  
3. Multiply line 2 by 50% (.50)  
4. Enter the face value of all electronic series EE bonds (including post-1989 series EE bonds converted from paper to electronic format) and all series I bonds cashed in 2013  
5. Add lines 3 and 4  
6. Subtract line 5 from line 1  
7. Enter the amount of interest reported as income in previous years  
8. Subtract line 7 from line 6. Enter the result here and on Form 8815, line 6  

Modified adjusted gross income limit.   The interest exclusion is limited if your modified adjusted gross income (modified AGI) is:
  • $74,700 to $89,700 for taxpayers filing single or head of household, and

  • $112,050 to $142,050 for married taxpayers filing jointly, or for a qualifying widow(er) with dependent child.

You do not qualify for the interest exclusion if your modified AGI is equal to or more than the upper limit for your filing status.

Modified AGI.   Modified AGI, for purposes of this exclusion, is adjusted gross income (Form 1040, line 37, or Form 1040A, line 21) figured before the interest exclusion, and modified by adding back any:
  1. Foreign earned income exclusion,

  2. Foreign housing exclusion and deduction,

  3. Exclusion of income for bona fide residents of American Samoa,

  4. Exclusion for income from Puerto Rico,

  5. Exclusion for adoption benefits received under an employer's adoption assistance program,

  6. Deduction for tuition and fees,

  7. Deduction for student loan interest, and

  8. Deduction for domestic production activities.

  Use the Line 9 Worksheet in the Form 8815 instructions to figure your modified AGI. If you claim any of the exclusion or deduction items listed above (except items 6, 7, and 8), add the amount of the exclusion or deduction (except items 6, 7, and 8) to the amount on line 5 of the worksheet, and enter the total on Form 8815, line 9, as your modified AGI.

Royalties included in modified AGI.   Because the deduction for interest expenses due to royalties and other investments is limited to your net investment income (see Investment Interest in chapter 3), you cannot figure the deduction for interest expenses until you have figured this exclusion of savings bond interest. Therefore, if you had interest expenses due to royalties and deductible on Schedule E (Form 1040), Supplemental Income and Loss, you must make a special computation of your deductible interest to figure the net royalty income included in your modified AGI. You must figure deductible interest without regard to this exclusion of bond interest.

  You can use a “dummy” Form 4952, Investment Interest Expense Deduction, to make the special computation. On this form, include in your net investment income your total interest income for the year from series EE and I U.S. savings bonds. Use the deductible interest amount from this form only to figure the net royalty income included in your modified AGI. Do not attach this form to your tax return.

  After you figure this interest exclusion, use a separate Form 4952 to figure your actual deduction for investment interest expenses and attach that form to your return.

Recordkeeping. If you claim the interest exclusion, you must keep a written record of the qualified U.S. savings bonds you redeem. Your record must include the serial number, issue date, face value, and total redemption proceeds (principal and interest) of each bond. You can use Form 8818 to record this information. You should also keep bills, receipts, canceled checks, or other documentation that shows you paid qualified higher educational expenses during the year.

U.S. Treasury Bills, Notes, and Bonds

Treasury bills, notes, and bonds are direct debts (obligations) of the U.S. Government.

Taxation of interest.   Interest income from Treasury bills, notes, and bonds is subject to federal income tax but is exempt from all state and local income taxes. You should receive Form 1099-INT showing the interest (in box 3) paid to you for the year.

  Payments of principal and interest generally will be credited to your designated checking or savings account by direct deposit through the TreasuryDirect® system.

Treasury bills.   These bills generally have a 4-week, 13-week, 26-week, or 52-week maturity period. They are generally issued at a discount in the amount of $100 and multiples of $100. The difference between the discounted price you pay for the bills and the face value you receive at maturity is interest income. Generally, you report this interest income when the bill is paid at maturity. If you paid a premium for a bill (more than face value), you generally report the premium as a section 171 deduction when the bill is paid at maturity. See Discount on Short-Term Obligations under Discount on Debt Instruments, later.

  If you reinvest your Treasury bill at its maturity in a new Treasury bill, note, or bond, you will receive payment for the difference between the proceeds of the maturing bill (par amount less any tax withheld) and the purchase price of the new Treasury security. However, you must report the full amount of the interest income on each of your Treasury bills at the time it reaches maturity.

Treasury notes and bonds.   Treasury notes have maturity periods of more than 1 year, ranging up to 10 years. Maturity periods for Treasury bonds are longer than 10 years. Both generally are issued in denominations of $100 to $1 million and both generally pay interest every 6 months. Generally, you report this interest for the year paid. When the notes or bonds mature, you can redeem these securities for face value or use the proceeds from the maturing note or bond to reinvest in another note or bond of the same type and term. If you do nothing, the proceeds from the maturing note or bond will be deposited in your bank account.

  Treasury notes and bonds are sold by auction. Two types of bids are accepted: competitive bids and noncompetitive bids. If you make a competitive bid and a determination is made that the purchase price is less than the face value, you will receive a refund for the difference between the purchase price and the face value. This amount is considered original issue discount. However, the original issue discount rules (discussed later) do not apply if the discount is less than one-fourth of 1% (.0025) of the face amount, multiplied by the number of full years from the date of original issue to maturity. See De minimis OID under Original Issue Discount (OID), later. If the purchase price is determined to be more than the face amount, the difference is a premium. (See Bond Premium Amortization in chapter 3.)

For other information on these notes or bonds, write to: 
 

Bureau of the Fiscal Service 
P.O. Box 7015 
Parkersburg, WV 26106-7015

Or, on the Internet, visit: www.treasurydirect.gov/indiv/indiv.htm.

Treasury inflation-protected securities (TIPS).   These securities pay interest twice a year at a fixed rate, based on a principal amount adjusted to take into account inflation and deflation. For the tax treatment of these securities, see Inflation-Indexed Debt Instruments under Original Issue Discount (OID), later.

Retirement, sale, or redemption.   For information on the retirement, sale, or redemption of U.S. government obligations, see Capital or Ordinary Gain or Loss in chapter 4. Also see Nontaxable Trades in chapter 4 for information about trading U.S. Treasury obligations for certain other designated issues.

Bonds Sold Between Interest Dates

If you sell a bond between interest payment dates, part of the sales price represents interest accrued to the date of sale. You must report that part of the sales price as interest income for the year of sale.

If you buy a bond between interest payment dates, part of the purchase price represents interest accrued before the date of purchase. When that interest is paid to you, treat it as a return of your capital investment, rather than interest income, by reducing your basis in the bond. See Accrued interest on bonds under How To Report Interest Income, later in this chapter, for information on reporting the payment.

Insurance

Life insurance proceeds paid to you as beneficiary of the insured person are usually not taxable. But if you receive the proceeds in installments, you must usually report part of each installment payment as interest income.

For more information about insurance proceeds received in installments, see Publication 525.

Interest option on insurance.   If you leave life insurance proceeds on deposit with an insurance company under an agreement to pay interest only, the interest paid to you is taxable.

Annuity.   If you buy an annuity with life insurance proceeds, the annuity payments you receive are taxed as pension and annuity income from a nonqualified plan, not as interest income. See Publication 939, General Rule for Pensions and Annuities, for information on taxation of pension and annuity income from nonqualified plans.

State or Local Government Obligations

Interest you receive on an obligation issued by a state or local government is generally not taxable. The issuer should be able to tell you whether the interest is taxable. The issuer should also give you a periodic (or year-end) statement showing the tax treatment of the obligation. If you invested in the obligation through a trust, a fund, or other organization, that organization should give you this information.

Even if interest on the obligation is not subject to income tax, you may have to report a capital gain or loss when you sell it. Estate, gift, or generation-skipping tax may apply to other dispositions of the obligation.

Tax-Exempt Interest

Interest on a bond used to finance government operations generally is not taxable if the bond is issued by a state, the District of Columbia, a U.S. possession, or any of their political subdivisions. Political subdivisions include:

  • Port authorities,

  • Toll road commissions,

  • Utility services authorities,

  • Community redevelopment agencies, and

  • Qualified volunteer fire departments (for certain obligations issued after 1980).

There are other requirements for tax-exempt bonds. Contact the issuing state or local government agency or see sections 103 and 141 through 150 of the Internal Revenue Code and the related regulations.

Obligations that are not bonds. Interest on a state or local government obligation may be tax exempt even if the obligation is not a bond. For example, interest on a debt evidenced only by an ordinary written agreement of purchase and sale may be tax exempt. Also, interest paid by an insurer on default by the state or political subdivision may be tax exempt.

Registration requirement.   A bond issued after June 30, 1983, generally must be in registered form for the interest to be tax exempt.

Indian tribal government.   Bonds issued after 1982 by an Indian tribal government (including tribal economic development bonds issued after February 17, 2009) are treated as issued by a state. Interest on these bonds is generally tax exempt if the bonds are part of an issue of which substantially all proceeds are to be used in the exercise of any essential government function. However, the essential government function requirement does not apply to tribal economic development bonds issued after February 17, 2009, for tax-exempt treatment. Interest on private activity bonds (other than certain bonds for tribal manufacturing facilities) is taxable.

Original issue discount.   Original issue discount (OID) on tax-exempt state or local government bonds is treated as tax-exempt interest.

  For information on the treatment of OID when you dispose of a tax-exempt bond, see Tax-exempt state and local government bonds under Discounted Debt Instruments in chapter 4.

Stripped bonds or coupons.   For special rules that apply to stripped tax-exempt obligations, see Stripped Bonds and Coupons under Original Issue Discount (OID), later.

Information reporting requirement.   If you must file a tax return, you are required to show any tax-exempt interest you received on your return. This is an information reporting requirement only. It does not change tax-exempt interest to taxable interest. See Reporting tax-exempt interest under How To Report Interest Income, later in this chapter.

Taxable Interest

Interest on some state or local obligations is taxable.

Federally guaranteed bonds.   Interest on federally guaranteed state or local obligations issued after 1983 is generally taxable. This rule does not apply to interest on obligations guaranteed by the following U.S. government agencies.
  • Bonneville Power Authority (if the guarantee was under the Northwest Power Act as in effect on July 18, 1984).

  • Department of Veterans Affairs.

  • Federal home loan banks. (The guarantee must be made after July 30, 2008, in connection with the original bond issue during the period beginning on July 30, 2008, and ending on December 31, 2010 (or a renewal or extension of a guarantee so made) and the bank must meet safety and soundness requirements.)

  • Federal Home Loan Mortgage Corporation.

  • Federal Housing Administration.

  • Federal National Mortgage Association.

  • Government National Mortgage Corporation.

  • Resolution Funding Corporation.

  • Student Loan Marketing Association.

Tax credit bonds.   Tax credit bonds generally do not pay interest. Instead, the bondholder is allowed an annual tax credit. The credit compensates the holder for lending money to the issuer and functions as interest paid on the bond. Use Form 8912, Credit to Holders of Tax Credit Bonds, to claim the credit for the following tax credit bonds and to figure the amount of the credit to report as interest income.
  • Clean renewable energy bond (CREB).

  • New clean renewable energy bond (NCREB).

  • Qualified energy conservation bond (QECB).

  • Qualified zone academy bond (QZAB).

  • Qualified school construction bond (QSCB).

  • Build America bond (BAB)

Mortgage revenue bonds.   The proceeds of these bonds are used to finance mortgage loans for homebuyers. Generally, interest on state or local government home mortgage bonds issued after April 24, 1979, is taxable unless the bonds are qualified mortgage bonds or qualified veterans' mortgage bonds.

Arbitrage bonds.   Interest on arbitrage bonds issued by state or local governments after October 9, 1969, is taxable. An arbitrage bond is a bond any portion of the proceeds of which is expected to be used to buy (or to replace funds used to buy) higher yielding investments. A bond is treated as an arbitrage bond if the issuer intentionally uses any part of the proceeds of the issue in this manner.

Private activity bonds.   Interest on a private activity bond that is not a qualified bond (defined below) is taxable. Generally, a private activity bond is part of a state or local government bond issue that meets both the following requirements.
  1. More than 10% of the proceeds of the issue is to be used for a private business use.

  2. More than 10% of the payment of the principal or interest is:

    1. Secured by an interest in property to be used for a private business use (or payments for this property), or

    2. Derived from payments for property (or borrowed money) used for a private business use.

Also, a bond is generally considered a private activity bond if the proceeds to be used to make or finance loans to persons other than government units is more than 5% of the proceeds or $5 million (whichever is less).

Qualified bond.   Interest on a private activity bond that is a qualified bond is tax exempt. A qualified bond is an exempt-facility bond (including an enterprise zone facility bond, a New York Liberty bond, a Midwestern disaster area bond, a Hurricane Ike disaster area bond, a Gulf Opportunity Zone bond treated as an exempt-facility bond, or any recovery zone facility bond issued after February 17, 2009, and before January 1, 2012), qualified student loan bond, qualified small issue bond (including a tribal manufacturing facility bond), qualified redevelopment bond, qualified mortgage bond (including a Gulf Opportunity Zone bond, a Midwestern disaster area bond, or a Hurricane Ike disaster area bond treated as a qualified mortgage bond), qualified veterans' mortgage bond, or qualified 501(c)(3) bond (a bond issued for the benefit of certain tax-exempt organizations).

  Interest you receive on these tax-exempt bonds, if issued after August 7, 1986, generally is a “tax preference item” and may be subject to the alternative minimum tax. See Form 6251 and its instructions for more information.

  The interest on the following bonds is not a tax preference item and is not subject to the alternative minimum tax.
  • Qualified 501(c)(3) bonds.

  • New York Liberty bonds.

  • Gulf Opportunity Zone bonds.

  • Midwestern disaster area bonds.

  • Hurricane Ike disaster area bonds.

  • Exempt facility bonds issued after July 30, 2008.

  • Qualified mortgage bonds issued after July 30, 2008.

  • Qualified veterans' mortgage bonds issued after July 30, 2008.

Qualified bonds issued in 2009 or 2010.   The interest on any qualified bond issued in 2009 or 2010 is not a tax preference item and is not subject to the alternative minimum tax. For this purpose, a refunding bond (whether a current or advanced refunding) is treated as issued on the date the refunded bond was issued (or on the date the original bond was issued in the case of a series of refundings). However, this rule does not apply to any refunding bond issued to refund any qualified bond issued during 2004 through 2008 or after 2010.

Qualified bonds issued after December 31, 2010.   A portion of the interest on specified private activity bonds issued after December 31, 2010, may be a tax preference item subject to the alternative minimum tax. The tax preference status will apply to the portion of the interest that remains after reducing it by deductions that would be allowed if the interest were taxable.

Enterprise zone facility bonds.   Interest on certain private activity bonds issued by a state or local government to finance a facility used in an empowerment zone or enterprise community is tax exempt.

New York Liberty bonds.   New York Liberty bonds are bonds issued after March 9, 2002, to finance the construction and rehabilitation of real property in the designated “Liberty Zone” of New York City. Interest on these bonds issued before 2012 is tax exempt.

Market discount.   Market discount on a tax-exempt bond is not tax-exempt. If you bought the bond after April 30, 1993, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as taxable interest. See Market Discount Bonds under Discount on Debt Instruments, later. If you do not make that choice, or if you bought the bond before May 1, 1993, any gain from market discount is taxable when you dispose of the bond.

  For more information on the treatment of market discount when you dispose of a tax-exempt bond, see Discounted Debt Instruments under Capital or Ordinary Gain or Loss in chapter 4.

Discount on Debt Instruments

A debt instrument, such as a bond, note, debenture, or other evidence of indebtedness, that bears no interest or bears interest at a lower than current market rate will usually be issued at less than its face amount. This discount is, in effect, additional interest income. The following are some types of discounted debt instruments.

  • U.S. Treasury bonds.

  • Corporate bonds.

  • Municipal bonds.

  • Certificates of deposit.

  • Notes between individuals.

  • Stripped bonds and coupons.

  • Collateralized debt obligations (CDOs).

The discount on these instruments (except municipal bonds) is taxable in most instances. The discount on municipal bonds generally is not taxable (but see State or Local Government Obligations , earlier, for exceptions). See also REMICs, FASITs, and Other CDOs , later, for information about applying the rules discussed in this section to the regular interest holder of a real estate mortgage investment conduit, a financial asset securitization investment trust, or other CDO.

Original Issue Discount (OID)

OID is a form of interest. You generally include OID in your income as it accrues over the term of the debt instrument, whether or not you receive any payments from the issuer.

A debt instrument generally has OID when the instrument is issued for a price that is less than its stated redemption price at maturity. OID is the difference between the stated redemption price at maturity and the issue price.

All debt instruments that pay no interest before maturity are presumed to be issued at a discount. Zero coupon bonds are one example of these instruments.

The OID accrual rules generally do not apply to short-term obligations (those with a fixed maturity date of 1 year or less from date of issue). See Discount on Short-Term Obligations , later.

For information about the sale of a debt instrument with OID, see Original issue discount (OID) on debt instruments in chapter 4.

De minimis OID.   You can treat the discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity. This small discount is known as “ de minimis ” OID.

Example 1.

You bought a 10-year bond with a stated redemption price at maturity of $1,000, issued at $980 with OID of $20. One-fourth of 1% of $1,000 (stated redemption price) times 10 (the number of full years from the date of original issue to maturity) equals $25. Because the $20 discount is less than $25, the OID is treated as zero. (If you hold the bond at maturity, you will recognize $20 ($1,000 − $980) of capital gain.)

Example 2.

The facts are the same as in Example 1 , except that the bond was issued at $950. The OID is $50. Because the $50 discount is more than the $25 figured in Example 1, you must include the OID in income as it accrues over the term of the bond.

Debt instrument bought after original issue.   If you buy a debt instrument with de minimis OID at a premium, the discount is not includible in income. If you buy a debt instrument with de minimis OID at a discount, the discount is reported under the market discount rules. See Market Discount Bonds , later in this chapter.

Exceptions to reporting OID.   The OID rules discussed here do not apply to the following debt instruments.
  1. Tax-exempt obligations. (However, see Stripped tax-exempt obligations , later.)

  2. U.S. savings bonds.

  3. Short-term debt instruments (those with a fixed maturity date of not more than 1 year from the date of issue).

  4. Obligations issued by an individual before March 2, 1984.

  5. Loans between individuals, if all the following are true.

    1. The lender is not in the business of lending money.

    2. The amount of the loan, plus the amount of any outstanding prior loans between the same individuals, is $10,000 or less.

    3. Avoiding any federal tax is not one of the principal purposes of the loan.

Form 1099-OID

The issuer of the debt instrument (or your broker, if you held the instrument through a broker) should give you Form 1099-OID, or a similar statement, if the total OID for the calendar year is $10 or more. Form 1099-OID will show, in box 1, the amount of OID for the part of the year that you held the bond. It also will show, in box 2, the stated interest you must include in your income. A copy of Form 1099-OID will be sent to the IRS. Do not file your copy with your return. Keep it for your records.

In most cases, you must report the entire amount in boxes 1 and 2 of Form 1099-OID as interest income. But see Refiguring OID shown on Form 1099-OID , later in this discussion, and also Original issue discount (OID) adjustment under How To Report Interest Income, later in this chapter, for more information.

Form 1099-OID not received.   If you had OID for the year but did not receive a Form 1099-OID, you may have to figure the correct amount of OID to report on your return. See Publication 1212 for details on how to figure the correct OID.

Nominee.   If someone else is the holder of record (the registered owner) of an OID instrument belonging to you and receives a Form 1099-OID on your behalf, that person must give you a Form 1099-OID.

  If you receive a Form 1099-OID that includes amounts belonging to another person, see Nominee distributions under How To Report Interest Income, later.

Refiguring OID shown on Form 1099-OID.   You must refigure the OID shown in box 1 or box 8 of Form 1099-OID if either of the following apply.
  • You bought the debt instrument after its original issue and paid a premium or an acquisition premium.

  • The debt instrument is a stripped bond or a stripped coupon (including certain zero coupon instruments). See Figuring OID under Stripped Bonds and Coupons, later in this chapter.

 
See Original issue discount (OID) adjustment under How To Report Interest Income, later in this chapter, for information about reporting the correct amount of OID.

Premium.   You bought a debt instrument at a premium if its adjusted basis immediately after purchase was greater than the total of all amounts payable on the instrument after the purchase date, other than qualified stated interest.

  If you bought an OID debt instrument at a premium, you generally do not have to report any OID as ordinary income.

Qualified stated interest.   In general, this is stated interest unconditionally payable in cash or property (other than debt instruments of the issuer) at least annually at a fixed rate.

Acquisition premium.   You bought a debt instrument at an acquisition premium if both the following are true.
  • You did not pay a premium.

  • The instrument's adjusted basis immediately after purchase (including purchase at original issue) was greater than its adjusted issue price. This is the issue price plus the OID previously accrued, minus any payment previously made on the instrument other than qualified stated interest.

 
Acquisition premium reduces the amount of OID includible in your income. For information about figuring the correct amount of OID to include in your income, see Figuring OID on Long-Term Debt Instruments in Publication 1212.

Refiguring periodic interest shown on Form 1099-OID.   If you disposed of a debt instrument or acquired it from another holder during the year, see Bonds Sold Between Interest Dates , earlier, for information about the treatment of periodic interest that may be shown in box 2 of Form 1099-OID for that instrument.

Applying the OID Rules

The rules for reporting OID depend on the date the long-term debt instrument was issued.

Debt instruments issued after 1954 and before May 28, 1969 (before July 2, 1982, if a government instrument).   For these instruments, you do not report the OID until the year you sell, exchange, or redeem the instrument. If a gain results and the instrument is a capital asset, the amount of gain equal to the OID is ordinary interest income. The rest is capital gain. If there is a loss on the sale of the instrument, the entire loss is a capital loss and no reporting of OID is required.

  In general, the amount of gain that is ordinary interest income equals the following amount:
Number of full months    
you held the instrument × OID
Number of full months from date of    
original issue to date of maturity    

Debt instruments issued after May 27, 1969 (after July 1, 1982, if a government instrument), and before 1985.   If you hold these debt instruments as capital assets, you must include a part of the discount in your gross income each year that you own the instruments.

Effect on basis.    Your basis in the instrument is increased by the amount of OID you include in your gross income.

Debt instruments issued after 1984.   For these debt instruments, you report the total OID that applies each year regardless of whether you hold that debt instrument as a capital asset.

Effect on basis.    Your basis in the instrument is increased by the amount of OID you include in your gross income.

Certificates of Deposit (CDs)

If you buy a CD with a maturity of more than 1 year, you must include in income each year a part of the total interest due and report it in the same manner as other OID.

This also applies to similar deposit arrangements with banks, building and loan associations, etc., including:

  • Time deposits,

  • Bonus plans,

  • Savings certificates,

  • Deferred income certificates,

  • Bonus savings certificates, and

  • Growth savings certificates.

Bearer CDs.   CDs issued after 1982 generally must be in registered form. Bearer CDs are CDs not in registered form. They are not issued in the depositor's name and are transferable from one individual to another.

  Banks must provide the IRS and the person redeeming a bearer CD with a Form 1099-INT.

Time deposit open account arrangement.   This is an arrangement with a fixed maturity date in which you make deposits on a schedule arranged between you and your bank. But there is no actual or constructive receipt of interest until the fixed maturity date is reached. For instance, you and your bank enter into an arrangement under which you agree to deposit $100 each month for a period of 5 years. Interest will be compounded twice a year at 7½%, but payable only at the end of the 5-year period. You must include a part of the interest in your income as OID each year. Each year the bank must give you a Form 1099-OID to show you the amount you must include in your income for the year.

Redemption before maturity.   If, before the maturity date, you redeem a deferred interest account for less than its stated redemption price at maturity, you can deduct OID that you previously included in income but did not receive.

Renewable certificates.   If you renew a CD at maturity, it is treated as a redemption and a purchase of a new certificate. This is true regardless of the terms of renewal.

Face-Amount Certificates

These certificates are subject to the OID rules. They are a form of endowment contracts issued by insurance or investment companies for either a lump-sum payment or periodic payments, with the face amount becoming payable on the maturity date of the certificate.

In general, the difference between the face amount and the amount you paid for the contract is OID. You must include a part of the OID in your income over the term of the certificate.

The issuer must give you a statement on Form 1099-OID indicating the amount you must include in your income each year.

Inflation-Indexed Debt Instruments

If you hold an inflation-indexed debt instrument (other than a series I U.S. savings bond), you must report as OID any increase in the inflation-adjusted principal amount of the instrument that occurs while you held the instrument during the year. In general, an inflation-indexed debt instrument is a debt instrument on which the payments are adjusted for inflation and deflation (such as Treasury Inflation-Protected Securities). You should receive Form 1099-OID from the payer showing the amount you must report as OID and any qualified stated interest paid to you during the year. For more information, see Publication 1212.

Stripped Bonds and Coupons

If you strip one or more coupons from a bond and sell the bond or the coupons, the bond and coupons are treated as separate debt instruments issued with OID.

The holder of a stripped bond has the right to receive the principal (redemption price) payment. The holder of a stripped coupon has the right to receive interest on the bond.

Stripped bonds and stripped coupons include:

  • Zero coupon instruments available through the Department of the Treasury's Separate Trading of Registered Interest and Principal of Securities (STRIPS) program and government-sponsored enterprises such as the Resolution Funding Corporation and the Financing Corporation, and

  • Instruments backed by U.S. Treasury securities that represent ownership interests in those securities, such as obligations backed by U.S. Treasury bonds offered primarily by brokerage firms.

Seller.   If you strip coupons from a bond and sell the bond or coupons, include in income the interest that accrued while you held the bond before the date of sale, to the extent you did not previously include this interest in your income. For an obligation acquired after October 22, 1986, you must also include the market discount that accrued before the date of sale of the stripped bond (or coupon) to the extent you did not previously include this discount in your income.

  Add the interest and market discount that you include in income to the basis of the bond and coupons. Allocate this adjusted basis between the items you keep and the items you sell, based on the fair market value of the items. The difference between the sale price of the bond (or coupon) and the allocated basis of the bond (or coupon) is your gain or loss from the sale.

  Treat any item you keep as an OID bond originally issued and bought by you on the sale date of the other items. If you keep the bond, treat the amount of the redemption price of the bond that is more than the basis of the bond as OID. If you keep the coupons, treat the amount payable on the coupons that is more than the basis of the coupons as OID.

Buyer.   If you buy a stripped bond or stripped coupon, treat it as if it were originally issued on the date you buy it. If you buy a stripped bond, treat as OID any excess of the stated redemption price at maturity over your purchase price. If you buy a stripped coupon, treat as OID any excess of the amount payable on the due date of the coupon over your purchase price.

Figuring OID.   The rules for figuring OID on stripped bonds and stripped coupons depend on the date the debt instruments were purchased, not the date issued.

  You must refigure OID shown on the Form 1099-OID you receive for a stripped bond or coupon. For information about figuring the correct amount of OID on these instruments to include in your income, see Figuring OID on Stripped Bonds and Coupons in Publication 1212. Owners of stripped bonds and coupons should not rely on the OID shown in Section II of the OID tables (available by going to IRS.gov and searching for “OID Tables”) because the amounts listed in Section II for stripped bonds or coupons are figured without reference to the date or price at which you acquired them.

Stripped inflation-indexed debt instruments.   OID on stripped inflation-indexed debt instruments is figured under the discount bond method. This method is described in Regulations section 1.1275-7(e).

Stripped tax-exempt obligations.   You do not have to pay tax on OID on any stripped tax-exempt bond or coupon you bought before June 11, 1987. However, if you acquired it after October 22, 1986, you must accrue OID on it to determine its basis when you dispose of it. See Original issue discount (OID) on debt instruments under Stocks and Bonds in chapter 4.

   You may have to pay tax on part of the OID on stripped tax-exempt bonds or coupons that you bought after June 10, 1987. For information on figuring the taxable part, see Tax-Exempt Bonds and Coupons under Figuring OID on Stripped Bonds and Coupons in Publication 1212.

Market Discount Bonds

A market discount bond is any bond having market discount except:

  • Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),

  • Tax-exempt obligations you bought before May 1, 1993,

  • U.S. savings bonds, and

  • Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date. Generally, this is due to an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

  • You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments under Capital Gains and Losses in chapter 4.

  • You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount. See Partial principal payments , later in this discussion.

  • If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Limit on interest deduction for market discount bonds under When To Deduct Investment Interest in chapter 3.

Market discount.   Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond).

  If a market discount bond also has OID, the market discount is the sum of the bond's issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.

Bonds acquired at original issue.   Generally, a bond you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you are also considered to have acquired it at original issue.

Exceptions.   A bond you acquired at original issue can be a market discount bond if either of the following is true.
  • Your cost basis in the bond is less than the bond's issue price.

  • The bond is issued in exchange for a market discount bond under a plan of reorganization. (This does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same.)

Accrued market discount.   The accrued market discount is figured in one of two ways.

Ratable accrual method.   Treat the market discount as accruing in equal daily installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.

Constant yield method.   Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond.

  For information about using the constant yield method, see Constant yield method under Debt Instruments Issued After 1984 in Publication 1212. To use this method to figure market discount (instead of OID), treat the bond as having been issued on the date you acquired it. Treat the amount of your basis (immediately after you acquired the bond) as the issue price and apply the formula shown in Publication 1212.

Choosing to include market discount in income currently.   You can make this choice if you have not revoked a prior choice to include market discount in income currently within the last 5 calendar years. Make the choice by attaching to your timely filed return a statement in which you:
  • State that you have included market discount in your gross income for the year under section 1278(b) of the Internal Revenue Code, and

  • Describe the method you used to figure the accrued market discount for the year.

  Once you make this choice, it will apply to all market discount bonds you acquire during the tax year and in later tax years. You cannot revoke your choice without the consent of the IRS. For information on how to revoke your choice, see section 32 of the Appendix to Revenue Procedure 2011-14 in Internal Revenue Bulletin 2011-4. You can find this revenue procedure at www.irs.gov/irb/2011-04_IRB/ar08.html.

  Also see Election To Report All Interest as OID , later. If you make that election, you must use the constant yield method.

Effect on basis.   You increase the basis of your bonds by the amount of market discount you include in your income.

Partial principal payments.   If you receive a partial payment of principal on a market discount bond you acquired after October 22, 1986, and you did not choose to include the discount in income currently, you must treat the payment as ordinary interest income up to the amount of the bond's accrued market discount. Reduce the amount of accrued market discount reportable as interest at disposition by that amount.

  There are three methods you can use to figure accrued market discount for this purpose.
  1. On the basis of the constant yield method, described earlier.

  2. In proportion to the accrual of OID for any accrual period, if the debt instrument has OID.

  3. In proportion to the amount of stated interest paid in the accrual period, if the debt instrument has no OID.

   Under method (2) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator (top part) of the fraction is the OID for the period, and the denominator (bottom part) is the total remaining OID at the beginning of the period.

  Under method (3) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator is the stated interest paid in the accrual period, and the denominator is the total stated interest remaining to be paid at the beginning of the accrual period.

Discount on Short-Term Obligations

When you buy a short-term obligation (one with a fixed maturity date of 1 year or less from the date of issue), other than a tax-exempt obligation, you can generally choose to include any discount and interest payable on the obligation in income currently. If you do not make this choice, the following rules generally apply.

  • You must treat any gain when you sell, exchange, or redeem the obligation as ordinary income, up to the amount of the ratable share of the discount. See Discounted Debt Instruments under Capital Gains and Losses in chapter 4.

  • If you borrow money to buy or carry the obligation, your deduction for interest paid on the debt is limited. See Limit on interest deduction for short-term obligations under When To Deduct Investment Interest in chapter 3.

Short-term obligations for which no choice is available.   You must include any discount or interest in current income as it accrues for any short-term obligation (other than a tax-exempt obligation) that is:
  • Held by an accrual-basis taxpayer;

  • Held primarily for sale to customers in the ordinary course of your trade or business;

  • Held by a bank, regulated investment company, or common trust fund;

  • Held by certain pass-through entities;

  • Identified as part of a hedging transaction; or

  • A stripped bond or stripped coupon held by the person who stripped the bond or coupon (or by any other person whose basis in the obligation is determined by reference to the basis in the hands of the person who stripped the bond or coupon).

Effect on basis.   Increase the basis of your obligation by the amount of discount you include in income currently.

Figuring the accrued discount.   Figure the accrued discount by using either the ratable accrual method or the constant yield method discussed in Accrued market discount under Market Discount Bonds, earlier.

Government obligations.   For an obligation described above that is a short-term government obligation, the amount you include in your income for the current year is the accrued acquisition discount, if any, plus any other accrued interest payable on the obligation. The acquisition discount is the stated redemption price at maturity minus your basis.

  If you choose to use the constant yield method to figure accrued acquisition discount, treat the cost of acquiring the obligation as the issue price. If you choose to use this method, you cannot change your choice.

Nongovernment obligations.   For an obligation listed above that is not a government obligation, the amount you include in your income for the current year is the accrued OID, if any, plus any other accrued interest payable. If you choose the constant yield method to figure accrued OID, apply it by using the obligation's issue price.

Choosing to include accrued acquisition discount instead of OID.   You can choose to report accrued acquisition discount (defined earlier under Government obligations) rather than accrued OID on these short-term obligations. Your choice will apply to the year for which it is made and to all later years and cannot be changed without the consent of the IRS.

  You must make your choice by the due date of your return, including extensions, for the first year for which you are making the choice. Attach a statement to your return or amended return indicating:
  • Your name, address, and social security number;

  • The choice you are making and that it is being made under section 1283(c)(2) of the Internal Revenue Code;

  • The period for which the choice is being made and the obligation to which it applies; and

  • Any other information necessary to show you are entitled to make this choice.

Choosing to include accrued discount and other interest in current income.   If you acquire short-term discount obligations that are not subject to the rules for current inclusion in income of the accrued discount or other interest, you can choose to have those rules apply. This choice applies to all short-term obligations you acquire during the year and in all later years. You cannot change this choice without the consent of the IRS.

  The procedures to use in making this choice are the same as those described for choosing to include acquisition discount instead of OID on nongovernment obligations in current income. However, you should indicate that you are making the choice under section 1282(b)(2) of the Internal Revenue Code.

   Also see the following discussion. If you make the election to report all interest currently as OID, you must use the constant yield method.

Election To Report All Interest as OID

Generally, you can elect to treat all interest on a debt instrument acquired during the tax year as OID and include it in income currently. For purposes of this election, interest includes stated interest, acquisition discount, OID, de minimis OID, market discount, de minimis market discount, and unstated interest as adjusted by any amortizable bond premium or acquisition premium. See Regulations section 1.1272-3.

When To Report Interest Income

When to report your interest income depends on whether you use the cash method or an accrual method to report income.

Cash method.   Most individual taxpayers use the cash method. If you use this method, you generally report your interest income in the year in which you actually or constructively receive it. However, there are special rules for reporting the discount on certain debt instruments. See U.S. Savings Bonds and Discount on Debt Instruments , earlier.

Example.

On September 1, 2011, you loaned another individual $2,000 at 12% compounded annually. You are not in the business of lending money. The note stated that principal and interest would be due on August 31, 2013. In 2013, you received $2,508.80 ($2,000 principal and $508.80 interest). If you use the cash method, you must include in income on your 2013 return the $508.80 interest you received in that year.

Constructive receipt.   You constructively receive income when it is credited to your account or made available to you. You do not need to have physical possession of it. For example, you are considered to receive interest, dividends, or other earnings on any deposit or account in a bank, savings and loan, or similar financial institution, or interest on life insurance policy dividends left to accumulate, when they are credited to your account and subject to your withdrawal. This is true even if they are not yet entered in your passbook.

  You constructively receive income on the deposit or account even if you must:
  • Make withdrawals in multiples of even amounts,

  • Give a notice to withdraw before making the withdrawal,

  • Withdraw all or part of the account to withdraw the earnings, or

  • Pay a penalty on early withdrawals, unless the interest you are to receive on an early withdrawal or redemption is substantially less than the interest payable at maturity.

Accrual method.   If you use an accrual method, you report your interest income when you earn it, whether or not you have received it. Interest is earned over the term of the debt instrument.

Example.

If, in the previous example, you use an accrual method, you must include the interest in your income as you earn it. You would report the interest as follows: 2011, $80; 2012, $249.60; and 2013, $179.20.

Coupon bonds.   Interest on coupon bonds is taxable in the year the coupon becomes due and payable. It does not matter when you mail the coupon for payment.

How To Report Interest Income

Generally, you report all your taxable interest income on Form 1040, line 8a; Form 1040A, line 8a; or Form 1040EZ, line 2.

You cannot use Form 1040EZ if your taxable interest income is more than $1,500. Instead, you must use Form 1040A or Form 1040.

In addition, you cannot use Form 1040EZ if you must use Form 1040, as described later, or if any of the statements listed under Schedule B (Form 1040A or 1040) , later, are true.

Form 1040A.   You must complete Schedule B (Form 1040A or 1040), Part I, if you file Form 1040A and any of the following are true.
  1. Your taxable interest income is more than $1,500.

  2. You are claiming the interest exclusion under the Education Savings Bond Program (discussed earlier).

  3. You received interest from a seller-financed mortgage, and the buyer used the property as a home.

  4. You received a Form 1099-INT for U.S. savings bond interest that includes amounts you reported before 2013.

  5. You received, as a nominee, interest that actually belongs to someone else.

  6. You received a Form 1099-INT for interest on frozen deposits.

  7. You are reporting OID in an amount less than the amount shown on Form 1099-OID.

  8. You received a Form 1099-INT for interest on a bond you bought between interest payment dates.

  9. You acquired taxable bonds after 1987 and choose to reduce interest income from the bonds by any amortizable bond premium (discussed in chapter 3 under Bond Premium Amortization ).

List each payer's name and the amount of interest income received from each payer on line 1. If you received a Form 1099-INT or Form 1099-OID from a brokerage firm, list the brokerage firm as the payer.

  You cannot use Form 1040A if you must use Form 1040, as described next.

Form 1040.   You must use Form 1040 instead of Form 1040A or Form 1040EZ if:
  1. You forfeited interest income because of the early withdrawal of a time deposit;

  2. You acquired taxable bonds after 1987, you choose to reduce interest income from the bonds by any amortizable bond premium, and you are deducting the excess of bond premium amortization for the accrual period over the qualified stated interest for the period (discussed in chapter 3 under Bond Premium Amortization ); or

  3. You received tax-exempt interest from private activity bonds issued after August 7, 1986.

Schedule B (Form 1040A or 1040).   You must complete Schedule B (Form 1040A or 1040), Part I, if you file Form 1040 and any of the following apply.
  1. Your taxable interest income is more than $1,500.

  2. You are claiming the interest exclusion under the Education Savings Bond Program (discussed earlier).

  3. You received interest from a seller-financed mortgage, and the buyer used the property as a home.

  4. You received a Form 1099-INT for U.S. savings bond interest that includes amounts you reported before 2013.

  5. You received, as a nominee, interest that actually belongs to someone else.

  6. You received a Form 1099-INT for interest on frozen deposits.

  7. You received a Form 1099-INT for interest on a bond you bought between interest payment dates.

  8. You are reporting OID in an amount less than the amount shown on Form 1099-OID.

  9. Statement (2) in the preceding list is true.

In Part I, line 1, list each payer's name and the amount received from each. If you received a Form 1099-INT or Form 1099-OID from a brokerage firm, list the brokerage firm as the payer.

Reporting tax-exempt interest.    Total your tax-exempt interest (such as interest or accrued OID on certain state and municipal bonds, including tax-exempt interest on zero coupon municipal bonds) and exempt-interest dividends from a mutual fund as shown on Form 1099-INT, box 8, and Form 1099-DIV, box 10. Add these amounts to any other tax-exempt interest you received. Report the total on line 8b of Form 1040A or Form 1040.

  If you file Form 1040EZ, enter “TEI” and the amount in the space to the left of line 2. Do not add tax-exempt interest in the total on Form 1040EZ, line 2.

  Form 1099-INT, box 9, and Form 1099-DIV, box 11, show the tax-exempt interest subject to the alternative minimum tax on Form 6251. These amounts are already included in the amounts on Form 1099-INT, box 8, and Form 1099-DIV, box 10. Do not add the amounts in Form 1099-INT, box 9 and Form 1099-DIV, box 11 to, or subtract them from, the amounts on Form 1099-INT, box 8, and Form 1099-DIV, box 10.

  
Do not report interest from an individual retirement arrangement (IRA) as tax-exempt interest.

Form 1099-INT.   Your taxable interest income, except for interest from U.S. savings bonds and Treasury obligations, is shown in box 1 of Form 1099-INT. Add this amount to any other taxable interest income you received. You must report all your taxable interest income even if you do not receive a Form 1099-INT. Contact your financial institution if you do not receive a Form 1099-INT by February 15. Your identifying number may be truncated on any paper Form 1099-INT you receive.

  If you forfeited interest income because of the early withdrawal of a time deposit, the deductible amount will be shown on Form 1099-INT in box 2. See Penalty on early withdrawal of savings , later.

  Box 3 of Form 1099-INT shows the interest income you received from U.S. savings bonds, Treasury bills, Treasury notes, and Treasury bonds. Add the amount shown in box 3 to any other taxable interest income you received, unless part of the amount in box 3 was previously included in your interest income. If part of the amount shown in box 3 was previously included in your interest income, see U.S. savings bond interest previously reported , later. If you redeemed U.S. savings bonds you bought after 1989 and you paid qualified educational expenses, see Interest excluded under the Education Savings Bond Program , later.

  Box 4 of Form 1099-INT will contain an amount if you were subject to backup withholding. Report the amount from box 4 on Form 1040EZ, line 7; on Form 1040A, line 36; or on Form 1040, line 62.

  Box 5 of Form 1099-INT shows investment expenses you may be able to deduct as an itemized deduction. Chapter 3 discusses investment expenses.

  If there are entries in boxes 6 and 7 of Form 1099-INT, you must file Form 1040. You may be able to take a credit for the amount shown in box 6 unless you deduct this amount on line 8 of Schedule A (Form 1040). To take the credit, you may have to file Form 1116, Foreign Tax Credit. For more information, see Publication 514, Foreign Tax Credit for Individuals.

Form 1099-OID.   The taxable OID on a discounted obligation for the part of the year you owned it is shown in box 1 of Form 1099-OID. Include this amount in your total taxable interest income. But see Refiguring OID shown on Form 1099-OID under Original Issue Discount (OID), earlier. Your identifying number may be truncated on any paper Form 1099-OID you receive.

  You must report all taxable OID even if you do not receive a Form 1099-OID.

  Box 2 of Form 1099-OID shows any taxable interest on the obligation other than OID. Add this amount to the OID shown in box 1 and include the result in your total taxable income.

  If you forfeited interest or principal on the obligation because of an early withdrawal, the deductible amount will be shown in box 3. See Penalty on early withdrawal of savings , later.

  Box 4 of Form 1099-OID will contain an amount if you were subject to backup withholding. Report the amount from box 4 on Form 1040EZ, line 7; on Form 1040A, line 36; or on Form 1040, line 62.

  Box 9 of Form 1099-OID shows investment expenses you may be able to deduct as an itemized deduction. Chapter 3 discusses investment expenses.

U.S. savings bond interest previously reported.   If you received a Form 1099-INT for U.S. savings bond interest, the form may show interest you do not have to report. See Form 1099-INT for U.S. savings bond interest under U.S. Savings Bonds, earlier.

  On Schedule B (Form 1040A or 1040), Part I, line 1, report all the interest shown on your Form 1099-INT. Then follow these steps.
  1. Several lines above line 2, enter a subtotal of all interest listed on line 1.

  2. Below the subtotal enter “U.S. Savings Bond Interest Previously Reported” and enter amounts previously reported or interest accrued before you received the bond.

  3. Subtract these amounts from the subtotal and enter the result on line 2.

Example 1.

Your parents bought U.S. savings bonds for you when you were a child. The bonds were issued in your name, and the interest on the bonds was reported each year as it accrued. (See Choice to report interest each year under U.S. Savings Bonds, earlier.)

In March 2013, you redeemed one of the bonds — a $1,000 series EE bond. The bond was originally issued in March 1994. When you redeemed the bond, you received $1,061.60 for it.

The Form 1099-INT you received shows interest income of $561.60. However, since the interest on your savings bonds was reported yearly, you need only include the $10.80 interest that accrued from January 2013 to March 2013.

You received no other taxable interest for 2013. You file Form 1040A.

On Schedule B (Form 1040A or 1040), Part I, line 1, enter your interest income as shown on Form 1099-INT — $561.60. (If you had other taxable interest income, you would enter it next and then enter a subtotal, as described earlier, before going to the next step.) Several lines above line 2, enter “U.S. Savings Bond Interest Previously Reported” and enter $550.80 ($561.60 − $10.80). Subtract $550.80 from $561.60 and enter $10.80 on line 2. Enter $10.80 on Schedule B (Form 1040A or 1040), line 4, and on Form 1040A, line 8a.

Example 2.

Your uncle died and left you a $1,000 series EE bond. You redeem the bond when it reaches maturity.

Your uncle paid $500 for the bond, so $500 of the amount you receive upon redemption is interest income. Your uncle's executor included in your uncle's final return $200 of the interest that had accrued at the time of your uncle's death. You have to include only $300 in your income.

The bank where you redeem the bond gives you a Form 1099-INT showing interest income of $500. You also receive a Form 1099-INT showing taxable interest income of $300 from your savings account.

You file Form 1040 and complete Schedule B (Form 1040A or 1040). On line 1 of Schedule B (Form 1040A or 1040), you list the $500 and $300 interest amounts shown on your Forms 1099. Several lines above line 2, you put a subtotal of $800. Below this subtotal, enter “U.S. Savings Bond Interest Previously Reported” and enter the $200 interest included in your uncle's final return. Subtract the $200 from the subtotal and enter $600 on line 2. You then complete the rest of the form.

Worksheet for savings bonds distributed from a retirement or profit-sharing plan.   If you cashed a savings bond acquired in a taxable distribution from a retirement or profit-sharing plan (as discussed under U.S. Savings Bonds , earlier), your interest income does not include the interest accrued before the distribution and taxed as a distribution from the plan.

Use the worksheet below to figure the amount you subtract from the interest shown on Form 1099-INT.

A. Enter the amount of cash received upon redemption of the bond  
     
B. Enter the value of the bond at the time of distribution by the plan  
     
C. Subtract the amount on line B from the amount on line A. This is the amount of interest accrued on the bond since it was distributed by the plan  
     
D. Enter the amount of interest shown on your Form 1099-INT  
     
E. Subtract the amount on line C from the amount on line D. This is the amount you include in “U.S. Savings Bond Interest Previously Reported  

Your employer should tell you the value of each bond on the date it was distributed.

Example.

You received a distribution of series EE U.S. savings bonds in December 2010 from your company's profit-sharing plan.

In March 2013, you redeemed a $100 series EE bond that was part of the distribution you received in 2010. You received $85.96 for the bond the company bought in May 1996. The value of the bond at the time of distribution in 2010 was $83.84. (This is the amount you included on your 2010 return.) The bank gave you a Form 1099-INT that shows $35.96 interest (the total interest from the date the bond was purchased to the date of redemption). Since a part of the interest was included in your income in 2010, you need to include in your 2013 income only the interest that accrued after the bond was distributed to you.

On Schedule B (Form 1040A or 1040), line 1, include all the interest shown on your Form 1099-INT as well as any other taxable interest income you received. Several lines above line 2, put a subtotal of all interest listed on line 1. Below this subtotal enter “U.S. Savings Bond Interest Previously Reported” and enter the amount figured on the worksheet below.

A. Enter the amount of cash received upon redemption of the bond $85.96
B. Enter the value of the bond at the time of distribution by the plan $83.84
C. Subtract the amount on line B from the amount on line A. This is the amount of interest accrued on the bond since it was distributed by the plan $2.12
D. Enter the amount of interest shown on your Form 1099-INT $35.96
E. Subtract the amount on line C from the amount on line D. This is the amount you include in “U.S. Savings Bond Interest Previously Reported $33.84

Subtract $33.84 from the subtotal and enter the result on Schedule B (Form 1040A or 1040), line 2. You then complete the rest of the form.

Interest excluded under the Education Savings Bond Program.   Use Form 8815 to figure your interest exclusion when you redeem qualified savings bonds and pay qualified higher educational expenses during the same year.

  For more information on the exclusion and qualified higher educational expenses, see the earlier discussion under Education Savings Bond Program , earlier.

  You must show your total interest from qualified savings bonds you cashed during 2013 on Form 8815, line 6, and on Schedule B (Form 1040A or 1040). After completing Form 8815, enter the result from line 14 (Form 8815) on Schedule B (Form 1040A or 1040), line 3.

Interest on seller-financed mortgage.   If an individual buys his or her home from you in a sale that you finance, you must report the amount of interest received on Schedule B (Form 1040A or 1040), line 1. Include on line 1 the buyer's name, address, and SSN. If you do not, you may have to pay a $50 penalty. The buyer may have to pay a $50 penalty if he or she does not give you this information.

  You must also give your name, address, and SSN (or employer identification number) to the buyer. If you do not, you may have to pay a $50 penalty.

Frozen deposits.   Even if you receive a Form 1099-INT for interest on deposits that you could not withdraw at the end of 2013, you must exclude these amounts from your gross income. (See Interest income on frozen deposits under Interest Income, earlier.) Do not include this income on line 8a of Form 1040A or 1040. On Schedule B (Form 1040A or 1040), Part I, include the full amount of interest shown on your Form 1099-INT on line 1. Several lines above line 2, put a subtotal of all interest income. Below this subtotal, enter “Frozen Deposits” and show the amount of interest that you are excluding. Subtract this amount from the subtotal and enter the result on line 2.

Accrued interest on bonds.   If you received a Form 1099-INT that reflects accrued interest paid on a bond you bought between interest payment dates, include the full amount shown as interest on the Form 1099-INT on Schedule B (Form 1040A or 1040), Part I, line 1. Then, below a subtotal of all interest income listed, enter “Accrued Interest” and the amount of accrued interest you paid to the seller. That amount is taxable to the seller, not you. Subtract that amount from the interest income subtotal. Enter the result on line 2 and also on line 8a of Form 1040A or 1040.

  For more information, see Bonds Sold Between Interest Dates , earlier.

Nominee distributions.   If you received a Form 1099-INT that includes an amount you received as a nominee for the real owner, report the full amount shown as interest on the Form 1099-INT on Part I, line 1 of Schedule B (Form 1040A or 1040). Then, below a subtotal of all interest income listed, enter “Nominee Distribution” and the amount that actually belongs to someone else. Subtract that amount from the interest income subtotal. Enter the result on line 2 and also on line 8a of Form 1040A or 1040.

File Form 1099-INT with the IRS.   If you received interest as a nominee in 2013, you must file a Form 1099-INT for that interest with the IRS. Send Copy A of Form 1099-INT with a Form 1096, Annual Summary and Transmittal of U.S. Information Returns, to your Internal Revenue Service Center by February 28, 2014 (March 31, 2014, if you file Form 1099-INT electronically). Give the actual owner of the interest Copy B of the Form 1099-INT by January 31, 2014. On Form 1099-INT, you should be listed as the “Payer.” Prepare one Form 1099-INT for each other owner and show that person as the “Recipient.” However, you do not have to file Form 1099-INT to show payments for your spouse. For more information about the reporting requirements and the penalties for failure to file (or furnish) certain information returns, see the General Instructions for Certain Information Returns.

  Similar rules apply to OID reported to you as a nominee on Form 1099-OID. You must file a Form 1099-OID with Form 1096 to show the proper distributions of the OID.

Example.

You and your sister have a joint savings account that paid $1,500 interest for 2013. Your sister deposited 30% of the funds in this account, and you and she have agreed to share the yearly interest income in proportion to the amount each of you has invested. Because your SSN was given to the bank, you received a Form 1099-INT for 2013 that includes the interest income earned belonging to your sister. This amount is $450, or 30% of the total interest of $1,500.

You must give your sister a Form 1099-INT by January 31, 2014, showing $450 of interest income she earned for 2013. You must also send a copy of the nominee Form 1099-INT, along with Form 1096, to the Internal Revenue Service Center by February 28, 2014 (March 31, 2014, if you file Form 1099-INT electronically). Show your own name, address, and SSN as that of the “Payer” on the Form 1099-INT. Show your sister's name, address, and SSN in the blocks provided for identification of the “Recipient.

When you prepare your own federal income tax return, report the total amount of interest income, $1,500, on Schedule B (Form 1040A or 1040), Part I, line 1, and identify the name of the bank that paid this interest. Show the amount belonging to your sister, $450, as a subtraction from a subtotal of all interest on Schedule B (Form 1040A or 1040) and identify this subtraction as a “Nominee Distribution.” (Your sister will report the $450 of interest income on her own tax return, if she has to file a return, and identify you as the payer of that amount.)

Original issue discount (OID) adjustment.   If you are reporting OID in an amount less than the amount shown on Form 1099-OID or other written statement (such as for a REMIC regular interest), include the full amount of OID shown on your Form 1099-OID or other statement on Schedule B (Form 1040A or 1040), Part I, line 1. Show OID you do not have to report below a subtotal of the interest and OID listed. Identify the amount as “OID Adjustment” and subtract it from the subtotal.

Penalty on early withdrawal of savings.    If you withdraw funds from a certificate of deposit or other deferred interest account before maturity, you may be charged a penalty. The Form 1099-INT or similar statement given to you by the financial institution will show the total amount of interest in box 1 and will show the penalty separately in box 2. You must include in income all interest shown in box 1. You can deduct the penalty on Form 1040, line 30. Deduct the entire penalty even if it is more than your interest income.

Dividends and Other Distributions

Dividends are distributions of money, stock, or other property paid to you by a corporation or by a mutual fund. You also may receive dividends through a partnership, an estate, a trust, or an association that is taxed as a corporation. However, some amounts you receive called dividends are actually interest income. (See Dividends that are actually interest under Taxable Interest — General, earlier.)

The most common kinds of distributions are:

  • Ordinary dividends,

  • Capital gain distributions, and

  • Nondividend distributions.

Most distributions are paid in cash (check). However, distributions can consist of more stock, stock rights, other property, or services.

Form 1099-DIV.   Most corporations use Form 1099-DIV to show you the distributions you received from them during the year. Keep this form with your records. You do not have to attach it to your tax return.Your identifying number may be truncated on any paper Form 1099-DIV you receive.

Dividends not reported on Form 1099-DIV.   Even if you do not receive Form 1099-DIV, you must still report all your taxable dividend income. For example, you may receive distributive shares of dividends from partnerships or S corporations. These dividends are reported to you on Schedule K-1 (Form 1065) and Schedule K-1 (Form 1120S).

Nominees.   If someone receives distributions as a nominee for you, that person will give you a Form 1099-DIV, which will show distributions received on your behalf.

  If you receive a Form 1099-DIV that includes amounts belonging to another person, see Nominees under How To Report Dividend Income, later, for more information.

Form 1099-MISC.   Certain substitute payments in lieu of dividends or tax-exempt interest received by a broker on your behalf must be reported to you on Form 1099-MISC, Miscellaneous Income, or a similar statement. See also Reporting Substitute Payments under Short Sales in chapter 4.

Incorrect amount shown on a Form 1099.   If you receive a Form 1099 that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. The new Form 1099 you receive will be marked “Corrected.

Dividends on stock sold.   If stock is sold, exchanged, or otherwise disposed of after a dividend is declared but before it is paid, the owner of record (usually the payee shown on the dividend check) must include the dividend in income.

Dividends received in January.   If a mutual fund (or other regulated investment company) or real estate investment trust (REIT) declares a dividend (including any exempt-interest dividend or capital gain distribution) in October, November, or December, payable to shareholders of record on a date in one of those months but actually pays the dividend during January of the next calendar year, you are considered to have received the dividend on December 31. You report the dividend in the year it was declared.

Ordinary Dividends

Ordinary dividends are the most common type of distribution from a corporation or a mutual fund. They are paid out of earnings and profits and are ordinary income to you. This means they are not capital gains. You can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation or mutual fund tells you otherwise. Ordinary dividends will be shown in box 1a of the Form 1099-DIV you receive.

Qualified Dividends

Qualified dividends are the ordinary dividends subject to the same 0%, 15%, or 20% maximum tax rate that applies to net capital gain. They should be shown in box 1b of the Form 1099-DIV you receive.

The maximum rate of tax on qualified dividends is:

  • 0% on any amount that otherwise would be taxed at a 10% or 15% rate.

  • 15% on any amount that otherwise would be taxed at rates greater than 15% but less than 39.6%.

  • 20% on any amount that otherwise would be taxed at a 39.6% rate.

To qualify for the maximum rate, all of the following requirements must be met.

Holding period.   You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it. See the examples, below.

Exception for preferred stock.   In the case of preferred stock, you must have held the stock more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days. If the preferred dividends are due to periods totaling less than 367 days, the holding period in the preceding paragraph applies.

Example 1.

You bought 5,000 shares of XYZ Corp. common stock on July 9, 2013. XYZ Corp. paid a cash dividend of 10 cents per share. The ex-dividend date was July 16, 2013. Your Form 1099-DIV from XYZ Corp. shows $500 in box 1a (ordinary dividends) and in box 1b (qualified dividends). However, you sold the 5,000 shares on August 12, 2013. You held your shares of XYZ Corp. for only 34 days of the 121-day period (from July 10, 2013, through August 12, 2013). The 121-day period began on May 17, 2013 (60 days before the ex-dividend date), and ended on September 14, 2013. You have no qualified dividends from XYZ Corp. because you held the XYZ stock for less than 61 days.

Example 2.

Assume the same facts as in Example 1 except that you bought the stock on July 15, 2013 (the day before the ex-dividend date), and you sold the stock on September 16, 2013. You held the stock for 63 days (from July 16, 2013, through September 16, 2013). The $500 of qualified dividends shown in box 1b of your Form 1099-DIV are all qualified dividends because you held the stock for 61 days of the 121-day period (from July 16, 2013, through September 14, 2013).

Example 3.

You bought 10,000 shares of ABC Mutual Fund common stock on July 9, 2013. ABC Mutual Fund paid a cash dividend of 10 cents per share. The ex-dividend date was July 16, 2013. The ABC Mutual Fund advises you that the portion of the dividend eligible to be treated as qualified dividends equals 2 cents per share. Your Form 1099-DIV from ABC Mutual Fund shows total ordinary dividends of $1,000 and qualified dividends of $200. However, you sold the 10,000 shares on August 12, 2013. You have no qualified dividends from ABC Mutual Fund because you held the ABC Mutual Fund stock for less than 61 days.

Holding period reduced where risk of loss is diminished.   When determining whether you met the minimum holding period discussed earlier, you cannot count any day during which you meet any of the following conditions.
  1. You had an option to sell, were under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities.

  2. You were grantor (writer) of an option to buy substantially identical stock or securities.

  3. Your risk of loss is diminished by holding one or more other positions in substantially similar or related property.

  For information about how to apply condition (3), see Regulations section 1.246-5.

Qualified foreign corporation.   A foreign corporation is a qualified foreign corporation if it meets any of the following conditions.
  1. The corporation is incorporated in a U.S. possession.

  2. The corporation is eligible for the benefits of a comprehensive income tax treaty with the United States that the Department of the Treasury determines is satisfactory for this purpose and that includes an exchange of information program. For a list of those treaties, see Table 1-3.

  3. The corporation does not meet (1) or (2) above, but the stock for which the dividend is paid is readily tradable on an established securities market in the United States. See Readily tradable stock , later.

Exception.   A corporation is not a qualified foreign corporation if it is a passive foreign investment company during its tax year in which the dividends are paid or during its previous tax year.

Controlled foreign corporation (CFC).   Dividends paid out of a CFC's earnings and profits that were not previously taxed are qualified dividends if the CFC is otherwise a qualified foreign corporation and the other requirements in this discussion are met. Certain dividends paid by a CFC that would be treated as a passive foreign investment company but for section 1297(d) of the Internal Revenue Code may be treated as qualified dividends. For more information, see Notice 2004-70, which can be found at www.irs.gov/irb/2004-44_IRB/ar09.html.

Readily tradable stock.   Any stock or American depositary receipt in respect of that stock is considered to satisfy requirement (3) under Qualified foreign corporation , if it is listed on a national securities exchange that is registered under section 6 of the Securities Exchange Act of 1934 or on the Nasdaq Stock Market. For a list of the exchanges that meet these requirements, see www.sec.gov/divisions/marketreg/mrexchanges.shtml.

Table 1-3. Income Tax Treaties

Income tax treaties that the United States has with the following countries satisfy requirement (2) under Qualified foreign corporation.
Australia Indonesia Romania
Austria Ireland Russian
Bangladesh Israel Federation
Barbados Italy Slovak
Belgium Jamaica Republic
Bulgaria Japan Slovenia
Canada Kazakhstan South Africa
China Korea Spain
Cyprus Latvia Sri Lanka
Czech Lithuania Sweden
Republic Luxembourg Switzerland
Denmark Malta Thailand
Egypt Mexico Trinidad and
Estonia Morocco Tobago
Finland Netherlands Tunisia
France New Zealand Turkey
Germany Norway Ukraine
Greece Pakistan United
Hungary Philippines Kingdom
Iceland Poland Venezuela
India Portugal  
 

Dividends that are not qualified dividends.   The following dividends are not qualified dividends. They are not qualified dividends even if they are shown in box 1b of Form 1099-DIV.
  • Capital gain distributions.

  • Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, federal savings and loan associations, and similar financial institutions. (Report these amounts as interest income.)

  • Dividends from a corporation that is a tax-exempt organization or farmer's cooperative during the corporation's tax year in which the dividends were paid or during the corporation's previous tax year.

  • Dividends paid by a corporation on employer securities held on the date of record by an employee stock ownership plan (ESOP) maintained by that corporation.

  • Dividends on any share of stock to the extent you are obligated (whether under a short sale or otherwise) to make related payments for positions in substantially similar or related property.

  • Payments in lieu of dividends, but only if you know or have reason to know the payments are not qualified dividends.

  • Payments shown on Form 1099-DIV, box 1b, from a foreign corporation to the extent you know or have reason to know the payments are not qualified dividends.

Dividends Used To Buy More Stock

The corporation in which you own stock may have a dividend reinvestment plan. This plan lets you choose to use your dividends to buy (through an agent) more shares of stock in the corporation instead of receiving the dividends in cash. Most mutual funds also permit shareholders to automatically reinvest distributions in more shares in the fund, instead of receiving cash. If you use your dividends to buy more stock at a price equal to its fair market value, you still must report the dividends as income.

If you are a member of a dividend reinvestment plan that lets you buy more stock at a price less than its fair market value, you must report as dividend income the fair market value of the additional stock on the dividend payment date.

You also must report as dividend income any service charge subtracted from your cash dividends before the dividends are used to buy the additional stock. But you may be able to deduct the service charge. See Expenses of Producing Income in chapter 3.

In some dividend reinvestment plans, you can invest more cash to buy shares of stock at a price less than fair market value. If you choose to do this, you must report as dividend income the difference between the cash you invest and the fair market value of the stock you buy. When figuring this amount, use the fair market value of the stock on the dividend payment date.

Money Market Funds

Report amounts you receive from money market funds as dividend income. Money market funds are a type of mutual fund and should not be confused with bank money market accounts that pay interest.

Capital Gain Distributions

Capital gain distributions (also called capital gain dividends) are paid to you or credited to your account by mutual funds (or other regulated investment companies) and real estate investment trusts (REITs). They will be shown in box 2a of the Form 1099-DIV you receive from the mutual fund or REIT.

Report capital gain distributions as long-term capital gains, regardless of how long you owned your shares in the mutual fund or REIT. See Capital gain distributions under How To Report Dividend Income, later in this chapter.

Undistributed capital gains of mutual funds and REITs.   Some mutual funds and REITs keep their long-term capital gains and pay tax on them. You must treat your share of these gains as distributions, even though you did not actually receive them. However, they are not included on Form 1099-DIV. Instead, they are reported to you in box 1a of Form 2439.

  Form 2439 will also show how much, if any, of the undistributed capital gains is:
  • Unrecaptured section 1250 gain (box 1b),

  • Gain from qualified small business stock (section 1202 gain, box 1c), or

  • Collectibles (28%) gain (box 1d).

For information about these terms, see Capital Gain Tax Rates in chapter 4.

  The tax paid on these gains by the mutual fund or REIT is shown in box 2 of Form 2439.

Basis adjustment.    Increase your basis in your mutual fund, or your interest in a REIT, by the difference between the gain you report and the credit you claim for the tax paid.

Nondividend Distributions

A nondividend distribution is a distribution that is not paid out of the earnings and profits of a corporation or a mutual fund. You should receive a Form 1099-DIV or other statement showing you the nondividend distribution. On Form 1099-DIV, a nondividend distribution will be shown in box 3. If you do not receive such a statement, you report the distribution as an ordinary dividend.

Basis adjustment.   A nondividend distribution reduces the basis of your stock. It is not taxed until your basis in the stock is fully recovered. This nontaxable portion is also called a return of capital; it is a return of your investment in the stock of the company. If you buy stock in a corporation in different lots at different times, and you cannot definitely identify the shares subject to the nondividend distribution, reduce the basis of your earliest purchases first.

  When the basis of your stock has been reduced to zero, report any additional nondividend distribution you receive as a capital gain. Whether you report it as a long-term or short-term capital gain depends on how long you have held the stock. See Holding Period in chapter 4.

Example 1.

You bought stock in 2000 for $100. In 2003, you received a nondividend distribution of $80. You did not include this amount in your income, but you reduced the basis of your stock to $20. You received a nondividend distribution of $30 in 2013. The first $20 of this amount reduced your basis to zero. You report the other $10 as a long-term capital gain for 2013. You must report as a long-term capital gain any nondividend distribution you receive on this stock in later years.

Example 2.

You bought shares in Daugh Mutual Fund in 2009 for $12 a share. In 2010, you received a nondividend distribution of $5 a share. You reduced your basis in each share by $5 to an adjusted basis of $7. In 2011, you received a nondividend distribution of $1 per share and further reduced your basis in each share to $6. In 2012, you received a nondividend distribution of $2 per share. Your basis was reduced to $4. In 2013, the nondividend distribution from the mutual fund was $5 a share. You reduce your basis in each share to zero and report $1 of gain. See the Instructions for Form 8949 for details and more information.

  
For more information on Form 8949 and Schedule D (Form 1040), see Reporting Capital Gains and Losses in chapter 4. Also, see the Instructions for Form 8949 and the Instructions for Schedule D (Form 1040).

Liquidating Distributions

Liquidating distributions, sometimes called liquidating dividends, are distributions you receive during a partial or complete liquidation of a corporation. These distributions are, at least in part, one form of a return of capital. They may be paid in one or more installments. You will receive Form 1099-DIV from the corporation showing you the amount of the liquidating distribution in box 8 or 9.

Any liquidating distribution you receive is not taxable to you until you have recovered the basis of your stock. After the basis of your stock has been reduced to zero, you must report the liquidating distribution as a capital gain. Whether you report the gain as a long-term or short-term capital gain depends on how long you have held the stock. See Holding Period in chapter 4.

Stock acquired at different times.   If you acquired stock in the same corporation in more than one transaction, you own more than one block of stock in the corporation. If you receive distributions from the corporation in complete liquidation, you must divide the distribution among the blocks of stock you own in the following proportion: the number of shares in that block over the total number of shares you own. Divide distributions in partial liquidation among that part of the stock redeemed in the partial liquidation. After the basis of a block of stock is reduced to zero, you must report the part of any later distribution for that block as a capital gain.

Distributions less than basis.   If the total liquidating distributions you receive are less than the basis of your stock, you may have a capital loss. You can report a capital loss only after you have received the final distribution in liquidation that results in the redemption or cancellation of the stock. Whether you report the loss as a long-term or short-term capital loss depends on how long you held the stock. See Holding Period in chapter 4.

Distributions of Stock and Stock Rights

Distributions by a corporation of its own stock are commonly known as stock dividends. Stock rights (also known as “stock options”) are distributions by a corporation of rights to acquire the corporation's stock. Generally, stock dividends and stock rights are not taxable to you, and you do not report them on your return.

Taxable stock dividends and stock rights.   Distributions of stock dividends and stock rights are taxable to you if any of the following apply.
  1. You or any other shareholder have the choice to receive cash or other property instead of stock or stock rights.

  2. The distribution gives cash or other property to some shareholders and an increase in the percentage interest in the corporation's assets or earnings and profits to other shareholders.

  3. The distribution is in convertible preferred stock and has the same result as in (2).

  4. The distribution gives preferred stock to some common stock shareholders and common stock to other common stock shareholders.

  5. The distribution is on preferred stock. (The distribution, however, is not taxable if it is an increase in the conversion ratio of convertible preferred stock made solely to take into account a stock dividend, stock split, or similar event that would otherwise result in reducing the conversion right.)

  The term “stock” includes rights to acquire stock, and the term “shareholder” includes a holder of rights or convertible securities.

If you receive taxable stock dividends or stock rights, include their fair market value at the time of distribution in your income.

Constructive distributions.   You must treat certain transactions that increase your proportionate interest in the earnings and profits or assets of a corporation as if they were distributions of stock or stock rights. These constructive distributions are taxable if they have the same result as a distribution described in (2), (3), (4), or (5) of the above discussion.

  This treatment applies to a change in your stock's conversion ratio or redemption price, a difference between your stock's redemption price and issue price, a redemption not treated as a sale or exchange of your stock, and any other transaction having a similar effect on your interest in the corporation.

Preferred stock redeemable at a premium.   If you hold preferred stock having a redemption price higher than its issue price, the difference (the redemption premium) generally is taxable as a constructive distribution of additional stock on the preferred stock.

For stock issued before October 10, 1990, you include the redemption premium in your income ratably over the period during which the stock cannot be redeemed. For stock issued after October 9, 1990, you include the redemption premium on the basis of its economic accrual over the period during which the stock cannot be redeemed, as if it were original issue discount on a debt instrument. See Original Issue Discount (OID) , earlier in this chapter.

The redemption premium is not a constructive distribution, and is not taxable as a result, in the following situations.

  1. The stock was issued before October 10, 1990 (before December 20, 1995, if redeemable solely at the option of the issuer), and the redemption premium is “reasonable.” (For stock issued before October 10, 1990, only the part of the redemption premium that is not “reasonable” is a constructive distribution.) The redemption premium is reasonable if it is not more than 10% of the issue price on stock not redeemable for 5 years from the issue date or is in the nature of a penalty for making a premature redemption.

  2. The stock was issued after October 9, 1990 (after December 19, 1995, if redeemable solely at the option of the issuer), and the redemption premium is “ de minimis.” The redemption premium is de minimis if it is less than one-fourth of 1% (.0025) of the redemption price multiplied by the number of full years from the date of issue to the date redeemable.

  3. The stock was issued after October 9, 1990, and must be redeemed at a specified time or is redeemable at your option, but the redemption is unlikely because it is subject to a contingency outside your control (not including the possibility of default, insolvency, etc.).

  4. The stock was issued after December 19, 1995, and is redeemable solely at the option of the issuer, but the redemption premium is in the nature of a penalty for premature redemption or redemption is not more likely than not to occur. The redemption will be treated under a “safe harbor” as not more likely than not to occur if all of the following are true.

    1. You and the issuer are not related under the rules discussed in chapter 4 under Losses on Sales or Trades of Property , substituting “20%” for “50%.

    2. There are no plans, arrangements, or agreements that effectively require or are intended to compel the issuer to redeem the stock.

    3. The redemption would not reduce the stock's yield.

Basis.   Your basis in stock or stock rights received in a taxable distribution is their fair market value when distributed. If you receive stock or stock rights that are not taxable to you, see Stocks and Bonds under Basis of Investment Property in chapter 4 for information on how to figure their basis.

Fractional shares.   You may not own enough stock in a corporation to receive a full share of stock if the corporation declares a stock dividend. However, with the approval of the shareholders, the corporation may set up a plan in which fractional shares are not issued but instead are sold, and the cash proceeds are given to the shareholders. Any cash you receive for fractional shares under such a plan is treated as an amount realized on the sale of the fractional shares. Report this transaction on Form 8949. Enter your gain or loss, the difference between the cash you receive and the basis of the fractional shares sold, in column (h) of Schedule D (Form 1040) in Part I or Part II, whichever is appropriate.

  
Report these transactions on Form 8949 with the correct box checked.

  For more information on Form 8949 and Schedule D (Form 1040), see Reporting Capital Gains and Losses in chapter 4. Also see the Instructions for Form 8949 and the Instructions for Schedule D (Form 1040).

Example.

You own one share of common stock that you bought on January 3, 2004, for $100. The corporation declared a common stock dividend of 5% on June 29, 2013. The fair market value of the stock at the time the stock dividend was declared was $200. You were paid $10 for the fractional-share stock dividend under a plan described in the discussion above. You figure your gain or loss as follows:

Fair market value of old stock $200.00
Fair market value of stock dividend 
(cash received)
+ 10.00
Fair market value of old stock and stock dividend $210.00
Basis (cost) of old stock 
after the stock dividend 
(($200 ÷ $210) × $100)
$95.24
Basis (cost) of stock dividend 
(($10 ÷ $210) × $100)
+ 4.76
Total $100.00
Cash received $10.00
Basis (cost) of stock dividend − 4.76
   
Gain $5.24

Because you had held the share of stock for more than 1 year at the time the stock dividend was declared, your gain on the stock dividend is a long-term capital gain.

Scrip dividends.   A corporation that declares a stock dividend may issue you a scrip certificate that entitles you to a fractional share. The certificate is generally nontaxable when you receive it. If you choose to have the corporation sell the certificate for you and give you the proceeds, your gain or loss is the difference between the proceeds and the part of your basis in the corporation's stock allocated to the certificate.

  However, if you receive a scrip certificate that you can choose to redeem for cash instead of stock, the certificate is taxable when you receive it. You must include its fair market value in income on the date you receive it.

Other Distributions

You may receive any of the following distributions during the year.

Exempt-interest dividends.   Exempt-interest dividends you receive from a mutual fund or other regulated investment company, including those received from a qualified fund of funds in any tax year beginning after December 22, 2010, are not included in your taxable income. (However, see Information reporting requirement, next.) Exempt-interest dividends should be shown in box 10 of Form 1099-DIV.

Information reporting requirement.   Although exempt-interest dividends are not taxable, you must show them on your tax return if you have to file a return. This is an information reporting requirement and does not change the exempt-interest dividends to taxable income. See Reporting tax-exempt interest under How To Report Interest Income, earlier.

Alternative minimum tax treatment.   Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. The exempt-interest dividends subject to the alternative minimum tax should be shown in box 11 of Form 1099-DIV. See Form 6251 and its instructions for more information.

Dividends on insurance policies.   Insurance policy dividends the insurer keeps and uses to pay your premiums are not taxable. However, you must report as taxable interest income the interest that is paid or credited on dividends left with the insurance company.

   If dividends on an insurance contract (other than a modified endowment contract) are distributed to you, they are a partial return of the premiums you paid. Do not include them in your gross income until they are more than the total of all net premiums you paid for the contract. (For information on the treatment of a distribution from a modified endowment contract, see Distribution Before Annuity Starting Date From a Nonqualified Plan under Taxation of Nonperiodic Payments in Publication 575.) Report any taxable distributions on insurance policies on Form 1040, line 21.

Dividends on veterans' insurance.   Dividends you receive on veterans' insurance policies are not taxable. In addition, interest on dividends left with the Department of Veterans Affairs is not taxable.

Patronage dividends.   Generally, patronage dividends you receive in money from a cooperative organization are included in your income.

  Do not include in your income patronage dividends you receive on:
  • Property bought for your personal use, or

  • Capital assets or depreciable property bought for use in your business. But you must reduce the basis (cost) of the items bought. If the dividend is more than the adjusted basis of the assets, you must report the excess as income.

  These rules are the same whether the cooperative paying the dividend is a taxable or tax-exempt cooperative.

Alaska Permanent Fund dividends.   Do not report these amounts as dividends. Instead, report these amounts on Form 1040, line 21; Form 1040A, line 13; or Form 1040EZ, line 3.

How To Report Dividend Income

Generally, you can use either Form 1040 or Form 1040A to report your dividend income. Report the total of your ordinary dividends on line 9a of Form 1040 or Form 1040A. Report qualified dividends on line 9b.

If you receive capital gain distributions, you may be able to use Form 1040A or you may have to use Form 1040. See Capital gain distributions , later. If you receive nondividend distributions required to be reported as capital gains, you must use Form 1040. You cannot use Form 1040EZ if you receive any dividend income.

Form 1099-DIV.   If you owned stock on which you received $10 or more in dividends and other distributions, you should receive a Form 1099-DIV. Even if you do not receive a Form 1099-DIV, you must report all your dividend income.

  See Form 1099-DIV and its instructions for more information on how to report dividend income.

Form 1040A or Form 1040.   You must complete Schedule B (Form 1040A or 1040), Part II, and attach it to your Form 1040A or 1040, if:
  • Your ordinary dividends (Form 1099-DIV, box 1a) are more than $1,500, or

  • You received, as a nominee, dividends that actually belong to someone else.

If your ordinary dividends are more than $1,500, you must also complete Schedule B (Form 1040A or 1040), Part III.

  List on Schedule B (Form 1040A or 1040), Part II, line 5, each payer's name and the ordinary dividends you received. If your securities are held by a brokerage firm (in “street name”), list the name of the brokerage firm shown on Form 1099-DIV as the payer. If your stock is held by a nominee who is the owner of record, and the nominee credited or paid you dividends on the stock, show the name of the nominee and the dividends you received or for which you were credited.

  Enter on line 6 the total of the amounts listed on line 5. (However, if you hold stock as a nominee, see Nominees , later.) Also enter this total on line 9a of Form 1040A or 1040.

Dividends received on restricted stock.   Restricted stock is stock you get from your employer for services you perform and that is nontransferable and subject to a substantial risk of forfeiture. You do not have to include the value of the stock in your income when you receive it. However, if you get dividends on restricted stock, you must include them in your income as wages, not dividends. See Restricted Property in Publication 525 for information on restricted stock dividends.

  Your employer should include these dividends in the wages shown on your Form W-2, Wage and Tax Statement. If you also get a Form 1099-DIV for these dividends, list them on Schedule B (Form 1040A or 1040), line 5, with the other dividends you received. Enter a subtotal of all your dividend income several lines above line 6. Below the subtotal, enter “Dividends on restricted stock reported as wages on Form 1040 (or Form 1040A), line 7,” and enter the dividends included in your wages on line 7 of Form 1040 or Form 1040A. Subtract this amount from the subtotal and enter the result on line 6.

Election.   You can choose to include the value of restricted stock in gross income as pay for services. If you make this choice, report the dividends on the stock like any other dividends. List them on Part II, line 5, of Schedule B (Form 1040A or 1040), along with your other dividends (if the amount of ordinary dividends received from all sources is more than $1,500). If you receive both a Form 1099-DIV and a Form W-2 showing these dividends, do not include the dividends in your wages reported on line 7 of Form 1040 or Form 1040A. Attach a statement to your Form 1040 or Form 1040A explaining why the amount shown on line 7 of your Form 1040 or Form 1040A is different from the amount shown on your Form W-2.

Independent contractor.   If you received restricted stock for services as an independent contractor, the rules in the previous discussion apply. Generally, you must treat dividends you receive on the stock as income from self-employment.

Qualified dividends.   Report qualified dividends (Form 1099-DIV, box 1b) on line 9b of Form 1040 or Form 1040A. The amount in box 1b is already included in box 1a. Do not add the amount in box 1b to, or subtract it from, the amount in box 1a. Do not include any of the following on line 9b.
  • Qualified dividends you received as a nominee. See Nominees , later.

  • Dividends on stock for which you did not meet the holding period. See Holding period , earlier under Qualified Dividends.

  • Dividends on any share of stock to the extent you are obligated (whether under a short sale or otherwise) to make related payments for positions in substantially similar or related property.

  • Payments in lieu of dividends, but only if you know or have reason to know the payments are not qualified dividends.

  • Payments shown on Form 1099-DIV, box 1b, from a foreign corporation to the extent you know or have reason to know the payments are not qualified dividends.

  If you have qualified dividends, you must figure your tax by completing the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 or 1040A instructions or the Schedule D Tax Worksheet in the Schedule D (Form 1040) instructions, whichever applies. Enter qualified dividends on line 2 of the worksheet.

Investment interest deducted.   If you claim a deduction for investment interest, you may have to reduce the amount of your qualified dividends that are eligible for the 0%, 15%, or 20% tax rate. Reduce it by the qualified dividends you choose to include in investment income when figuring the limit on your investment interest deduction. This is done on the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet. For more information about the limit on investment interest, see Interest Expenses in chapter 3.

Capital gain distributions.   If you received capital gain distributions, you report them directly on Form 1040A, line 10, Form 1040, line 13, or on Schedule D (Form 1040), line 13, depending on your situation. Distributions of net realized short-term capital gains are not treated as capital gains. Instead, they are included on Form 1099-DIV as ordinary dividends. Report them on your tax return as ordinary dividends.

Exceptions to filing Form 8949 and Schedule D (Form 1040).   There are certain situations where you may not have to file Form 8949 and/or Schedule D (Form 1040).

Exception 1.   You do not have to file Form 8949 or Schedule D (Form 1040) if you have no capital losses and your only capital gains are capital gain distributions from Form(s) 1099-DIV, box 2a (or substitute statements). (If any Form(s) 1099-DIV (or substitute statements) you receive have an amount in box 2b (unrecaptured section 1250 gain), box 2c (section 1202 gain), or box 2d (collectibles (28%) gain), you do not qualify for this exception.) If you qualify for this exception, report your capital gain distributions directly on line 13 of Form 1040 (and check the box on line 13). Also use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax. You can report your capital gain distributions on line 10 of Form 1040A, instead of on Form 1040, if you do not have to file Form 1040.

Exception 2.   You must file Schedule D (Form 1040), but generally do not have to file Form 8949, if Exception 1 does not apply and your only capital gains and losses are:
  • Capital gain distributions;

  • A capital loss carryover;

  • A gain from Form 2439, Form 6252, Installment Sale Income, or Part I of Form 4797, Sales of Business Property;

  • A gain or loss from Form 4684, Casualties and Thefts, Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, or Form 8824;

  • A gain or loss from a partnership, S corporation, estate, or trust; or

  • Gains and losses from transactions for which you received a Form 1099-B (or substitute statement) that shows basis was reported to the IRS and for which you do not need to make any adjustments in column (g) of Form 8949 or enter any codes in column (f) of Form 8949.

Undistributed capital gains.   To report undistributed capital gains, you must complete Schedule D (Form 1040) and attach it to your return. Report these gains on Schedule D (Form 1040), line 11, column (h), and attach Copy B of Form 2439 to your return. Report the tax paid by the mutual fund on these gains on Form 1040, line 71, and check box a on that line.

The mutual fund (or other regulated investment company) or real estate investment trust (REIT) making the distribution should tell you how much of it is:

  • Unrecaptured section 1250 gain (Form 1099-DIV, box 2b), or

  • Section 1202 gain (Form 1099-DIV, box 2c).

For information about these terms, see Capital Gain Tax Rates in chapter 4.

Enter on line 11 of the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions the part reported to you as unrecaptured section 1250 gain. If you have a gain on qualified small business stock (section 1202 gain), follow the reporting instructions under Section 1202 Exclusion in chapter 4.

Nondividend distributions.   Report nondividend distributions (box 3 of Form 1099-DIV) only after your basis in the stock has been reduced to zero. After the basis of your stock has been reduced to zero, you must show this excess amount in Form 8949, Part I, if you held the stock 1 year or less. Show it in Form 8949, Part II, if you held the stock for more than 1 year. Enter “Nondividend Distribution Exceeding Basis” in column (a) of Form 8949 and the name of the company. Report the amount of the excess distribution in column (d) and your zero basis in column (e) of Form 8949.

  
Report these transactions on Form 8949 with the correct box checked.

  For more information on Form 8949 and Schedule D (Form 1040), see Reporting Capital Gains and Losses in chapter 4. Also see the Instructions for Form 8949 and the Instructions for Schedule D (Form 1040).

Nominees.   If you received ordinary dividends as a nominee (that is, the dividends are in your name but actually belong to someone else), include them on line 5 of Schedule B (Form 1040A or 1040). Several lines above line 6, put a subtotal of all dividend income listed on line 5. Below this subtotal, enter “Nominee Distribution” and show the amount received as a nominee. Subtract the total of your nominee distributions from the subtotal. Enter the result on line 6.

  If you received a capital gain distribution or were allocated an undistributed capital gain as a nominee, report only the amount that belongs to you on Form 1040A, line 10; Form 1040, line 13; or Schedule D (Form 1040), line 13, whichever is appropriate. Attach a statement to your return showing the full amount you received or were allocated and the amount you received or were allocated as a nominee.

File Form 1099-DIV with the IRS.   If you received dividends as a nominee in 2013, you must file a Form 1099-DIV (or Form 2439) for those dividends with the IRS. Send the Form 1099-DIV with a Form 1096 to your Internal Revenue Service Center by February 28, 2014 (March 31, 2014, if you file Form 1099-DIV electronically). Give the actual owner of the dividends Copy B of the Form 1099-DIV by January 31, 2014. On Form 1099-DIV, you should be listed as the “Payer.” The other owner should be listed as the “Recipient.” You do not, however, have to file a Form 1099-DIV to show payments for your spouse. For more information about the reporting requirements and the penalties for failure to file (or furnish) certain information returns, see the General Instructions for Certain Information Returns and the Instructions for Form 2439.

Liquidating distributions.   If you receive a liquidating distribution on stock, the corporation will give you a Form 1099-DIV showing the liquidating distribution in boxes 8 and 9.

Stripped Preferred Stock

If the dividend rights are stripped from certain preferred stock, the holder of the stripped preferred stock may have to include amounts in income equal to the amounts that would have been included if the stock were a bond with OID.

Stripped preferred stock defined.   Stripped preferred stock is any stock that meets both of the following tests.
  1. There has been a separation in ownership between the stock and any dividend on the stock that has not become payable.

  2. The stock:

    1. Is limited and preferred as to dividends,

    2. Does not participate in corporate growth to any significant extent, and

    3. Has a fixed redemption price.

Treatment of buyer.   If you buy stripped preferred stock after April 30, 1993, you must include certain amounts in your gross income while you hold the stock. These amounts are ordinary income. They are equal to the amounts you would have included in gross income if the stock were a bond that:
  1. Was issued on the purchase date of the stock, and

  2. Has OID equal to:

    1. The redemption price for the stock, minus

    2. The price at which you bought the stock.

Report these amounts as other income on Form 1040, line 21. For information about OID, see Original Issue Discount (OID) , earlier.

  This treatment also applies to you if you acquire the stock in such a way (for example, by gift) that your basis in the stock is determined by using a buyer's basis.

Treatment of person stripping stock.   If you strip the rights to one or more dividends from stripped preferred stock, you are treated as having purchased the stock. You are treated as making the purchase on the date you disposed of the dividend rights. Your adjusted basis in the stripped preferred stock is treated as your purchase price. The rules described in Treatment of buyer, earlier, apply to you.

REMICs, FASITs, and Other CDOs

Holders of interests in real estate mortgage investment conduits (REMICs), financial asset securitization investment trusts (FASITs), and other collateralized debt obligations (CDOs) must follow special rules for reporting income and any expenses from these investment products.

REMICs

A REMIC is an entity formed for the purpose of holding a fixed pool of mortgages secured by interests in real property. A REMIC issues regular and residual interests to investors. For tax purposes, a REMIC is generally treated as a partnership with the residual interest holders treated as the partners. The regular interests are treated as debt instruments.

REMIC income or loss is not income or loss from a passive activity.

For more information about the qualifications and tax treatment that apply to a REMIC and the interests of investors in a REMIC, see sections 860A through 860G of the Internal Revenue Code, and the regulations under those sections.

Regular Interest

A REMIC can have several classes (also known as “tranches”) of regular interests. A regular interest unconditionally entitles the holder to receive a specified principal amount (or other similar amount).

A REMIC regular interest is treated as a debt instrument for income tax purposes. Accordingly, the OID, market discount, and income reporting rules that apply to bonds and other debt instruments as described earlier in this publication under Discount on Debt Instruments apply, with certain modifications discussed below.

Generally, you report your income from a regular interest on line 8a of Form 1040A or 1040. For more information on how to report interest and OID, see How To Report Interest Income , earlier.

Holders must use accrual method.   Holders of regular interests must use an accrual method of accounting to report OID and interest income. Because income under an accrual method is not determined by the receipt of cash, you may have to include OID or interest income in your taxable income even if you have not received any cash payments.

Forms 1099-INT and 1099-OID.   You should receive a copy of Form 1099-INT or Form 1099-OID from the REMIC. See the General Instructions for Certain Information Returns for information on when you should receive your copy of Form 1099-INT or Form 1099-OID and a written statement providing additional information. The statement should contain enough information to enable you to figure your accrual of market discount or amortizable bond premium.

  Form 1099-INT shows interest income that accrued to you for the period you held the regular interest.

  Form 1099-OID shows OID and interest, if any, that accrued to you for the period you held the regular interest. You will not need to make any adjustments to the amounts reported even if you held the regular interest for only a part of the calendar year. However, if you bought the regular interest at a premium or acquisition premium, see Refiguring OID shown on Form 1099-OID under Original Issue Discount (OID), earlier.

You may not get a Form 1099.   Corporations and other persons specified in Regulations section 1.6049-7(c) will not receive Forms 1099. These persons and fiscal year taxpayers may obtain tax information by contacting the REMIC or the issuer of the CDO, if they hold their interest directly from the REMIC or issuer of the CDO. Publication 938, Real Estate Mortgage Investment Conduits Reporting Information, explains how to request this information.

Publication 938 is available only on the Internet at www.irs.gov/formspubs/.

If you hold a regular interest or CDO through a nominee (rather than directly), you can request the information from the nominee.

Allocated investment expenses.   Regular interest holders in a REMIC may be allowed to deduct the REMIC's investment expenses, but only if the REMIC is a single-class REMIC. A single-class REMIC is one that generally would be classified as a trust for tax purposes if it had not elected REMIC status.

  The single-class REMIC will report your share of its investment expenses in box 5 of Form 1099-INT or box 9 of Form 1099-OID.

  You may be able to take a deduction for these expenses subject to a 2% limit that also applies to certain other miscellaneous itemized deductions. See Expenses of Producing Income in chapter 3 for more information.

Redemption of regular interests at maturity.   Redemption of debt instruments at their maturity is treated as a sale or exchange. You must report redemptions on your tax return whether or not you realize gain or loss on the transaction. Your basis is your adjusted issue price, which includes any OID you previously reported in income.

  Any amount you receive on the retirement of a debt instrument is treated as if you had sold or exchanged that instrument. A debt instrument is retired when it is reacquired or redeemed by the issuer and canceled.

Sale or exchange of a regular interest.   Some of your gain on the sale or exchange of a REMIC regular interest may be ordinary income. The ordinary income part, if any, is:
  • The amount that would have been included in your income if the yield to maturity on the regular interest had been 110% of the applicable federal rate at the beginning of your holding period, minus

  • The amount you included in your income.

Residual Interest

A residual interest is an interest in a REMIC that is not a regular interest. It is designated as a residual interest by the REMIC.

If you acquire a residual interest in a REMIC, you must take into account on a quarterly basis your daily portion of the taxable income or net loss of the REMIC for each day during the tax year you hold the residual interest. You must report these amounts as ordinary income or loss.

Basis in the residual interest.   Your basis in the residual interest is increased by taxable income you take into account. Your basis is decreased (but not below zero) by the cash or the fair market value of any property distributed to you, and by any net loss you have taken into account. If you sell your residual interest, you must adjust your basis to reflect your share of the REMIC's taxable income or net loss immediately before the sale. See Wash Sales , in chapter 4, for more information about selling a residual interest.

Treatment of distributions.   You must include in your gross income the part of any distribution that is more than your adjusted basis. Treat the distribution as a gain from the sale or exchange of your residual interest.

Schedule Q (Form 1066).   If you hold a REMIC residual interest, you should receive Schedule Q (Form 1066), Quarterly Notice to Residual Interest Holder of REMIC Taxable Income or Net Loss Allocation, and instructions from the REMIC each quarter. Schedule Q (Form 1066) will indicate your share of the REMIC's quarterly taxable income (or loss). Do not attach Schedule Q (Form 1066) to your tax return. Keep it for your records.

  Use Schedule E (Form 1040), Part IV, to report your total share of the REMIC's taxable income (or loss) for each quarter included in your tax year.

  For more information about reporting your income (or loss) from a residual interest in a REMIC, follow the Schedule Q (Form 1066) and Schedule E (Form 1040) instructions.

Expenses.    Subject to the 2%-of-adjusted- gross-income limit, you may be able to claim a miscellaneous itemized deduction for certain ordinary and necessary expenses you paid or incurred in connection with your investment in a REMIC. These expenses may include certain expense items incurred by the REMIC and passed through to you. The REMIC will report these expenses to you on Schedule Q (Form 1066), line 3b. See Expenses of Producing Income in chapter 3 for information on how to report these expenses.

Collateralized Debt Obligations (CDOs)

A collateralized debt obligation (CDO) is a debt instrument, other than a REMIC regular interest, that is secured by a pool of mortgages or other evidence of debt and that has principal payments subject to acceleration. (Note: While REMIC regular interests are collateralized debt obligations, they have unique rules that do not apply to CDOs issued before 1987.) CDOs, also known as “pay-through bonds,” are commonly divided into different classes (also called “tranches”).

CDOs can be secured by a pool of mortgages, automobile loans, equipment leases, or credit card receivables.

For more information about the qualifications and the tax treatment that apply to an issuer of a CDO, see section 1272(a)(6) of the Internal Revenue Code and the regulations under that section.

The OID, market discount, and income-reporting rules that apply to bonds and other debt instruments, as described earlier in this chapter under Discount on Debt Instruments , also apply to a CDO.

You must include interest income from your CDO in your gross income under your regular method of accounting. Also include any OID accrued on your CDO during the tax year.

Generally, you report your income from a CDO on line 8a of Form 1040A or 1040. For more information about reporting these amounts on your return, see How To Report Interest Income , earlier.

Forms 1099-INT and 1099-OID.   You should receive a copy of Form 1099-INT or Form 1099-OID. See the General Instructions for Certain Information Returns for information on when you should receive your copy of Form 1099-INT or Form 1099-OID and a written statement providing additional information. The statement should contain enough information about the CDO to enable you to figure your accrual of market discount or amortizable bond premium.

  Form 1099-INT shows the interest income paid to you for the period you held the CDO.

  Form 1099-OID shows the OID accrued to you and the interest, if any, paid to you for the period you held the CDO. You should not need to make any adjustments to the amounts reported even if you held the CDO for only a part of the calendar year. However, if you bought the CDO at a premium or acquisition premium, see Refiguring OID shown on Form 1099-OID under Original Issue Discount (OID), earlier.

  If you did not receive a Form 1099, see You may not get a Form 1099 under REMICs, earlier.

FASITs

A financial asset securitization investment trust (FASIT) is an entity that securitizes debt obligations such as credit card receivables, home equity loans, and automobile loans.

A regular interest in a FASIT is treated as a debt instrument. The rules described under Collateralized Debt Obligations (CDOs) , earlier, apply to a regular interest in a FASIT, except that a holder of a regular interest in a FASIT must use an accrual method of accounting to report OID and interest income.

For more information about FASITs, see sections 860H through 860L of the Internal Revenue Code.

Beginning January 1, 2005, the special rules for FASITs are repealed. However, the special rules still apply to any FASIT in existence on October 22, 2004, to the extent that regular interests issued by the FASIT before that date continue to remain outstanding in accordance with the original terms of issuance.

S Corporations

In general, an S corporation does not pay a tax on its income. Instead, its income and expenses are passed through to the shareholders, who then report these items on their own income tax returns.

If you are an S corporation shareholder, your share of the corporation's current year income or loss and other tax items are taxed to you whether or not you receive any amount. Generally, those items increase or decrease the basis of your S corporation stock as appropriate. For more information on basis adjustments for S corporation stock, see Stocks and Bonds under Basis of Investment Property in chapter 4.

Generally, S corporation distributions, except dividend distributions, are considered a return of capital and reduce your basis in the stock of the corporation. The part of any distribution that is more than your basis is treated as a gain from the sale or exchange of property. The corporation's distributions may be in the form of cash or property.

S corporation distributions are not treated as dividends except in certain cases in which the corporation has accumulated earnings and profits from years before it became an S corporation.

Reporting S corporation income, deductions, and credits.   The S corporation should send you a copy of Schedule K-1 (Form 1120S) showing your share of the S corporation's income, credits, and deductions for the tax year. You must report your distributive share of the S corporation's income, gain, loss, deductions, or credits on the appropriate lines and schedules of your Form 1040.

  For more information about your treatment of S corporation tax items, see Shareholder's Instructions for Schedule K-1 (Form 1120S).

Limit on losses and deductions.   The deduction for your share of losses and deductions shown on Schedule K-1 (Form 1120S) is limited to the adjusted basis of your stock and any debt the corporation owes you. Any loss or deduction not allowed because of this limit is carried over and treated as a loss or deduction in the next tax year.

Passive activity losses.   Rules apply that limit losses from passive activities. Your copy of Schedule K-1 (Form 1120S) and its instructions will explain the limits and tell you where on your return to report your share of S corporation items from passive activities.

Form 8582.   If you have a passive activity loss from an S corporation, you must complete Form 8582 to figure the allowable loss to enter on your return. See Publication 925 for more information.

Investment Clubs

An investment club is formed when a group of friends, neighbors, business associates, or others pool their money to invest in stock or other securities. The club may or may not have a written agreement, a charter, or bylaws.

Usually the group operates informally with members pledging to pay a regular amount into the club monthly. Some clubs have a committee that gathers information on securities, selects the most promising securities, and recommends that the club invest in them. Other clubs rotate these responsibilities among all their members. Most clubs require all members to vote for or against all investments, sales, trades, and other transactions.

Identifying number.    Each club must have an employer identification number (EIN) to use when filing its return. The club's EIN also may have to be given to the payer of dividends or other income from investments recorded in the club's name. To obtain an EIN, file Form SS-4, Application for Employer Identification Number. See chapter 5, How To Get Tax Help , for more information about how to get this form.

Investments in name of member.   When an investment is recorded in the name of one club member, this member must give his or her SSN to the payer of investment income. (When an investment is held in the names of two or more club members, the SSN of only one member must be given to the payer.) This member is considered the record owner for the actual owner, the investment club. This member is a “nominee” and must file an information return with the IRS. For example, the nominee member must file Form 1099-DIV for dividend income, showing the club as the owner of the dividend, his or her SSN, and the EIN of the club.

Tax Treatment of the Club

Generally, an investment club is treated as a partnership for federal tax purposes unless it chooses otherwise. In some situations, however, it is taxed as a corporation or a trust.

Clubs formed before 1997.    Before 1997, the rules for determining how an investment club is treated were different from those explained in the following discussions. An investment club that existed before 1997 is treated for later years the same way it was treated before 1997, unless it chooses to be treated a different way under the new rules. To make that choice, the club must file Form 8832, Entity Classification Election.

Club as a Partnership

If your club is not taxed as a corporation or a trust, it will be treated as a partnership.

Filing requirement.   If your investment club is treated as a partnership, it must file Form 1065, U.S. Return of Partnership Income. However, as a partner in the club, you must report on your individual return your share of the club's income, gains, losses, deductions, and credits for the club's tax year. (Its tax year generally must be the same tax year as that of the partners owning a majority interest.) You must report these items whether or not you actually receive any distribution from the partnership.

Schedule K-1 (Form 1065).   You should receive a copy of Schedule K-1 (Form 1065) from the partnership. The amounts shown on Schedule K-1 (Form 1065) are your share of the partnership's income, deductions, and credits. Report each amount on the appropriate lines and schedules of your income tax return.

  The club's expenses for producing or collecting income, for managing investment property, or for determining any tax are listed separately on Schedule K-1 (Form 1065). Each individual partner who itemizes deductions on Schedule A (Form 1040) can deduct his or her share of those expenses. The expenses are listed on Schedule A (Form 1040), line 23, along with other miscellaneous deductions subject to the 2% limit. See Expenses of Producing Income in chapter 3 for more information on the 2% limit.

  For more information about reporting your income from a partnership, see the Schedule K-1 (Form 1065) instructions. Also see Publication 541, Partnerships.

Passive activity losses.   Rules apply that limit losses from passive activities. Your copy of Schedule K-1 (Form 1065) and its instructions will tell you where on your return to report your share of partnership items from passive activities. If you have a passive activity loss from a partnership, you must complete Form 8582 to figure the amount of the allowable loss to enter on your tax return.

No social security coverage for investment club earnings.   If an investment club partnership's activities are limited to investing in savings certificates, stock, or securities, and collecting interest or dividends for its members' accounts, a member's share of income is not earnings from self-employment. You cannot voluntarily pay the self-employment tax to increase your social security coverage and ultimate benefits.

Club as a Corporation

An investment club formed after 1996 is taxed as a corporation if:

  • It is formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic,

  • It is formed under a state law that refers to it as a joint-stock company or joint-stock association, or

  • It chooses to be taxed as a corporation.

Choosing to be taxed as a corporation.   To choose to be taxed as a corporation, the club cannot be a trust (see Club as a Trust , later) or otherwise subject to special treatment under the tax law. The club must file Form 8832 to make the choice.

Filing requirement.   If your club is taxed as a corporation, it must file Form 1120, U.S. Corporation Income Tax Return. In that case, you do not report any of its income or expenses on your individual return. All ordinary income and expenses and capital gains and losses must be reported on the Form 1120. Any distribution the club makes that qualifies as a dividend must be reported on Form 1099-DIV if total distributions to the shareholder are $10 or more for the year.

  You must report any distributions you receive from the club on your individual return. You should receive a copy of Form 1099-DIV from the club showing the distributions you received.

  Some corporations can choose not to be taxed and have earnings taxed to the shareholders. See S Corporations , earlier.

  For more information about corporations, see Publication 542, Corporations.

Club as a Trust

In a few cases, an investment club is taxed as a trust. In general, a trust is an arrangement through which trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. An arrangement is treated as a trust for tax purposes if its purpose is to vest in trustees responsibility for protecting and conserving property for beneficiaries who cannot share in that responsibility and so are not associates in a joint enterprise for the conduct of business for profit. If you need more information about trusts, see Regulations section 301.7701-4.

Filing requirement.    If your club is taxed as a trust, it must file Form 1041, U.S. Income Tax Return for Estates and Trusts. You should receive a copy of Schedule K-1 (Form 1041) from the trust. Report the amounts shown on Schedule K-1 (Form 1041) on the appropriate lines and schedules of your income tax return.


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