Interest Income

Words you may need to know (see Glossary):

• Accrual method
• Below-market loan
• Cash method
• Demand loan
• Forgone interest
• Gift loan
• Interest
• Nominee
• Original issue discount
• Private activity bond
• Term loan

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In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income.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 amount of interest income that you receive for the tax year. This includes amounts reported to you on Form 1099-INT and amounts for which you did not receive a Form 1099-INT.

Nominees. Generally, if someone receives interest as a nominee for you, that person will 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 may also 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 regulated investment company (mutual fund) are not included in your taxable income. (However, see Information-reporting requirement, next.) You will receive a notice from the mutual fund telling you the amount of the exempt-interest dividends that you received. Exempt-interest dividends are not shown on Form 1099-DIV or Form 1099-INT.

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 to 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. 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 that you leave 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.

Money market funds. Generally, amounts you receive from money market funds should be reported as dividends, not as interest.

Money market certificates, savings certificates, 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 money market certificate. The interest you pay on money borrowed from a bank or savings institution to meet the minimum deposit required for a money market certificate 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 money market certificate. The certificate earned $575 at maturity in 2001, 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 2001 showing the $575 interest you earned. The bank also gives you a statement showing that you paid $310 interest for 2001. You must include the $575 in your income. If you itemize your deductions on Schedule A (Form 1040), 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 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:

1. The financial institution is bankrupt or insolvent, or
2. 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:

1. The net amount you withdrew from these deposits during the year, and
2. 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 2001, 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 for the year. You must exclude $20.

Bonds traded flat. If you buy a bond when interest has been defaulted or when the interest has accrued but has not been paid, that 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. 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 that 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
• Loans to qualified continuing care facilities (made after October 11, 1985) 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:

1. 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
2. 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. You can also contact the IRS to get these rates. See chapter 5 for the telephone number to call.

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:

1. A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and
2. 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) above 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 65 or older at the end of the year. For 2001, this exception applies only to the part of the total outstanding loan balance that is $144,100 or less.

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 structuring the transaction in that way 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.

For other information on U.S. savings bonds, write to:
Bureau of the Public Debt
Savings Bond Operations Office
Parkersburg, WV 26106-1328.

Or, on the Internet, visit:
www. savingsbonds.gov

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 the discussion of Series EE and series I bonds, below.

Series HH bonds. These bonds are 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. 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.

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 were first offered in July 1980. They 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. Series EE and series E bonds are issued at a discount. The face value is payable to you at maturity.

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 accrued interest is payable to you at maturity.

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 E bonds issued in 1961 and 1971 matured in 2001. If you have used method 1, you generally must report the interest on these bonds on your 2001 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 that 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 at the top, "Change in Method of Accounting Under Section 6.01 of the Appendix of Rev. Proc. 99-49" (or later update).
2. It includes your name and social security number under the label in (1).
3. It identifies the savings bonds for which you are requesting this change.
4. 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.
5. It includes your signature.

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 (including extensions) to file the statement with an amended return. To get this extension, you must have filed your original return by the due date (including extensions). At the top of the statement, print "Filed pursuant to section 301.9100-2."

By the date you file the original statement, you must also send a copy to the address below. Internal Revenue Service Attention: CC:PA:T P.O. Box 7604 Benjamin Franklin Station Washington, DC 20044.

If you use a private delivery service, send the copy to Internal Revenue, Attention: CC:PA:T, Room 6561, 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, since the other co-owner will receive a Form 1099-INT at the time of redemption, the other co-owner must provide you with another Form 1099-INT showing the amount of interest from the bond that is 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, Community Property.

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 investment income of a child under age 14, 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.

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. At the time of reissue, the former co-owner does not have to include in gross income 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, depends on the accounting and income-reporting method 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 of the 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. It should not be included in the decedent's final return. All of the 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 that was 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 H bonds that she had acquired in a trade for series E 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 E 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 E bonds and the interest, if any, payable on the series H 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 that was 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 E 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.) 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 1. You own series E bonds with accrued interest of $523 and a redemption value of $2,723 and have postponed reporting the interest. You trade the bonds for $2,500 in series HH bonds and $223 in cash. You must report the $223 as taxable income in the year of the trade.

Example 2. The facts are the same as in Example 1. 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 E bonds). (It is also the difference between the accrued interest of $523 on the series E bonds and the $223 cash received on the trade.)

Choice to report interest in year of trade. You can choose 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 make 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.

1. 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.
2. 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.
3. 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.
4. 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 chapter, for more information about the reporting requirements.)
5. 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.

If you are married, you can qualify for this exclusion only if you file a joint return with your spouse.

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

The date a bond is issued may be earlier than the date the bond is purchased because bonds are issued as of the first day of the month in which they are 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 state tuition program or to a Coverdell education savings account. For information about these programs, see Publication 970, Tax Benefits for Higher 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 program.

Eligible educational institutions. These institutions include most public, private, and nonprofit universities, colleges, and vocational schools that are accredited and are 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 certain benefits the student may have received. These benefits include:

1. Qualified scholarships that are exempt from tax (see Publication 520, Scholarships and Fellowships, for information on qualified scholarships), and
2. Any other nontaxable payments (other than gifts, bequests, or inheritances) received for educational expenses, such as:
1. Veterans' educational assistance benefits,
2. Benefits under a qualified state tuition program, or
3. Certain employer-provided educational assistance benefits.

Effect of other tax benefits. Do not include in your qualified expenses any expense used to:

1. Figure an education credit on Form 8863, or
2. Figure how much of a distribution from an education IRA you can exclude from your income.

For information about education credits or education IRAs, 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 qualified higher educational expenses for the year, you can exclude all of the interest. If the proceeds are more than the expenses, you can 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 2001, Mark and Joan, a married couple, cashed a qualified series EE U.S. savings bond they bought in April 1993. They received proceeds of $7,256, representing principal of $5,000 and interest of $2,256. In 2001, they paid $4,000 of their daughter's college tuition. They are not claiming an education credit for that amount, and they do not have an education IRA. They can exclude $1,244 ($2,256 × ($4,000 × $7,256)) of interest in 2001. They must pay tax on the remaining $1,012 ($2,256 - $1,244) interest.

Figuring the interest part of the proceeds (Form 8815, line 6). To figure the amount of 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 2001, use the Alternate Line 6 Worksheet below instead.

Modified adjusted gross income limit. The interest exclusion is limited if your modified adjusted gross income (modified AGI) is:

• $55,750 to $70,750 for taxpayers filing single or head of household, and
• $83,650 to $113,650 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 (line 20 of Form 1040A or line 34 of Form 1040) figured before the interest exclusion, and modified by adding back any:

1. Foreign earned income exclusion,
2. Foreign housing exclusion or 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, and
6. Deduction for student loan interest.

Use the worksheet in the instructions for line 9, Form 8815, to figure your modified AGI. If you claim any of the exclusion or deduction items listed above (except item 6), add the amount of the exclusion or deduction (except any deduction for student loan interest) 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 attributable to royalties and other investments is limited to your net investment income (see Investment Interest in chapter 3), you cannot figure the deduction until you have figured this interest exclusion. Therefore, if you had interest expenses attributable to royalties and deductible on Schedule E (Form 1040), you must make a special computation of your deductible interest without regard to this exclusion to figure the net royalty income included in your modified AGI.

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

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 amount of interest (in box 3) that was 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 TREASURY DIRECT system.

Treasury bills. These bills generally have a 13-week, 26-week, or 52-week maturity period. They are issued at a discount in the amount of $1,000 and multiples of $1,000. 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. 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 of these Treasury issues generally are issued in denominations of $1,000 to $1 million. Both notes and bonds 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.

Treasury notes and bonds are usually sold by auction with competitive bidding. If, after compiling the competitive bids, 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 Public Debt
Customer Information and
Current Income Branch
Parkersburg, WV 26106-2186.

Or, on the Internet, visit:
www. publicdebt.treas.gov

Treasury inflation-indexed securities. These securities pay interest twice a year at a fixed rate, based on a principal amount that is 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, not as interest income. See Publication 939, General Rule for Pensions and Annuities, for information on taxation of pension and annuity income.

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 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 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 of the proceeds are to be used in the exercise of any essential government function. However, 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. That discussion also explains what to do if you receive a Form 1099-INT for tax-exempt interest.

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 Mortgage Corporation.
• Federal Housing Administration.
• Federal National Mortgage Association.
• Government National Mortgage Corporation.
• Resolution Funding Corporation.
• Student Loan Marketing Association.

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 of 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 amount of 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), qualified student loan bond, qualified small issue bond (including a tribal manufacturing facility bond), qualified redevelopment bond, 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 that you receive on these tax-exempt bonds (except qualified 501(c)(3) 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.

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. For information on these bonds, see Publication 954.

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.

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