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Publication 525 2002 Tax Year

Taxable & Nontaxable Income

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Life Insurance Proceeds

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract.

Proceeds not received in installments.   If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person's death. If the benefit payable at death is not specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.

Proceeds received in installments.   If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.

To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.

Example.   The face amount of the policy is $75,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 ÷ 120), or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is interest income to you.

Installments for life.   If, as the beneficiary under an insurance contract, you are entitled to receive the proceeds in installments for the rest of your life without a refund or period-certain guarantee, you figure the excluded part of each installment by dividing the amount held by the insurance company by your life expectancy. If there is a refund or period-certain guarantee, the amount held by the insurance company for this purpose is reduced by the actuarial value of the guarantee.

Surviving spouse.   If your spouse died before October 23, 1986, and insurance proceeds paid to you because of the death of your spouse are received in installments, you can exclude up to $1,000 a year of the interest included in the installments. If you remarry, you can continue to take the exclusion.

Interest option on insurance.   If an insurance company pays you interest only on proceeds from life insurance left on deposit, the interest you are paid is taxable.

If you chose to receive only the interest from your insurance proceeds, the $1,000 interest exclusion for a surviving spouse does not apply. If you later decide to receive the proceeds from the policy in installments, you can take the interest exclusion from the time you begin to receive the installments.

Surrender of policy for cash.   If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. In general, your cost (or investment in the contract) is the total of premiums that you paid for the life insurance policy, less any refunded premiums, rebates, dividends, or unrepaid loans that were not included in your income.

You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 16a and 16b of Form 1040, or on lines 12a and 12b of Form 1040A.

Endowment proceeds.   Endowment proceeds paid in a lump sum to you at maturity are taxable only if the proceeds are more than the cost of the policy. To determine your cost, add the aggregate amount of premiums (or other consideration) paid for the contract and subtract any amount that you previously received under the contract and excluded from your income. Include the part of the lump sum payment that is more than your cost in your income.

Endowment proceeds that you choose to receive in installments instead of a lump-sum payment at the maturity of the policy are taxed as an annuity. This is explained in Publication 575. For this treatment to apply, you must choose to receive the proceeds in installments before receiving any part of the lump sum. This election must be made within 60 days after the lump-sum payment first becomes payable to you.

Accelerated Death Benefits

Certain amounts paid as accelerated death benefits under a life insurance contract or viatical settlement before the insured's death are excluded from income if the insured is terminally or chronically ill.

Viatical settlement.   This is the sale or assignment of any part of the death benefit under a life insurance contract to a viatical settlement provider. A viatical settlement provider is a person who regularly engages in the business of buying or taking assignment of life insurance contracts on the lives of insured individuals who are terminally or chronically ill and who meets the requirements of section 101(g)(2)(B) of the Internal Revenue Code.

Exclusion for terminal illness.   Accelerated death benefits are fully excludable if the insured is a terminally ill individual. This is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months from the date of the certification.

Exclusion for chronic illness.   If the insured is a chronically ill individual who is not terminally ill, accelerated death benefits paid on the basis of costs incurred for qualified long-term care services are fully excludable. Accelerated death benefits paid on a per diem or other periodic basis are excludable up to a limit. This limit applies to the total of the accelerated death benefits and any periodic payments received from long-term care insurance contracts. For information on the limit and the definitions of chronically ill individual, qualified long-term care services, and long-term care insurance contracts, see Long-Term Care Insurance Contracts under Sickness and Injury Benefits, earlier.

Exception.   The exclusion does not apply to any amount paid to a person (other than the insured) who has an insurable interest in the life of the insured because the insured:

  • Is a director, officer, or employee of the person, or
  • Has a financial interest in the person's business.

Form 8853.   To claim an exclusion for accelerated death benefits made on a per diem or other periodic basis, you must file Form 8853 with your return. You do not have to file Form 8853 to exclude accelerated death benefits paid on the basis of actual expenses incurred.

Recoveries

A recovery is a return of an amount you deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of deductions itemized on Schedule A (Form 1040). You also may have recoveries of non-itemized deductions (such as payments on previously deducted bad debts) and recoveries of items for which you previously claimed a tax credit.

Tax benefit rule.   You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from the deduction or credit is considered to have reduced your tax in the earlier year.

Federal income tax refund.   Refunds of federal income taxes are not included in your income because they are never allowed as a deduction from income.

State income tax refund.   If you received a state or local income tax refund (or credit or offset) in 2002, you generally must include it in income if you deducted the tax in an earlier year. You should receive Form 1099-G, Certain Government Payments, from the payer by January 31, 2003. The IRS also will receive a copy of the Form 1099-G. Use the worksheet in the 2002 Form 1040 instructions for line 10 to figure the amount (if any) to include in your income.

Mortgage interest refund.   If you received a refund or credit in 2002 of mortgage interest paid in an earlier year, the amount should be shown in box 3 of your Form 1098, Mortgage Interest Statement. Do not subtract the refund amount from the interest you paid in 2002. You may have to include it in your income under the rules explained in the following discussions.

Interest on recovery.   Interest on any of the amounts you recover must be reported as interest income in the year received. For example, report any interest you received on state or local income tax refunds on line 8a of Form 1040.

Recovery and expense in same year.   If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and is not reported as income.

Recovery for 2 or more years.   If you receive a refund or other recovery that is for amounts you paid in 2 or more separate years, you must allocate, on a pro rata basis, the recovered amount between the years in which you paid it. This allocation is necessary to determine the amount of recovery from any earlier years and to determine the amount, if any, of your allowable deduction for this item for the current year.

Example.   You paid 2001 estimated state income tax of $4,000 in four equal payments. You made your fourth payment in January 2002. You had no state income tax withheld during 2001. In 2002, you received a $400 tax refund based on your 2001 state income tax return. You claimed itemized deductions each year on your federal income tax return.

You must allocate the $400 refund between 2001 and 2002, the years in which you paid the tax on which the refund is based. You paid 75% ($3,000 ÷ $4,000) of the estimated tax in 2001, so 75% of the $400 refund, or $300, is for amounts you paid in 2001 and is a recovery item. If all of the $300 is a taxable recovery item, you will include $300 on line 10, Form 1040, for 2002, and attach a copy of your computation showing why that amount is less than the amount shown on the Form 1099-G you received from the state.

The balance ($100) of the $400 refund is for your January 2002 estimated tax payment. When you figure your deduction for state and local income taxes paid during 2002, you will reduce the $1,000 paid in January by $100. Your deduction for state and local income taxes paid during 2002 will include the January net amount of $900 ($1,000 - $100), plus any estimated state income taxes paid in 2002 for 2002, and any state income tax withheld during 2002.

Deductions not itemized.   If you did not itemize deductions for the year for which you received the recovery of an expense that was deductible only if you itemized, do not include any of the recovery amount in your income.

Example.   You filed your 2001 federal income tax return on Form 1040A. In 2002 you received a refund of your 2001 state income tax. Do not report any of the refund as income because you did not itemize deductions for 2001.

Itemized Deduction Recoveries

The following discussion explains how to determine the amount to include in your income from a recovery of an amount deducted in an earlier year as an itemized deduction. However, you generally do not need to use this discussion if the recovery is for state or local income taxes paid in 2001. Instead, use the worksheet in the 2002 Form 1040 instructions for line 10 to figure the amount (if any) to include in your income.

You cannot use the Form 1040 worksheet and must use this discussion if any of the following statements is true.

  • The recovery is for a tax year other than 2001.
  • The recovery is for a deducted item other than state or local income taxes, such as real property taxes.
  • Your 2001 taxable income was less than zero.
  • You made your last payment of 2001 state or local estimated tax in 2002.
  • You owed alternative minimum tax for 2001.
  • You could not deduct all your tax credits for 2001 because their total was more than the amount of tax shown on line 42 of your 2001 Form 1040 minus any foreign tax credit shown on line 43 of that form.
  • You could be claimed as a dependent by someone else in 2001.

CAUTION: If you also recovered an amount deducted as a non-itemized deduction, figure the amount of that recovery to include in your income and add it to your adjusted gross income before applying the rules explained here. See Non-Itemized Deduction Recoveries, later.

Total recovery included in income.   If you recover any amount that you deducted in an earlier year on Schedule A (Form 1040), you generally must include the full amount of the recovery in your income in the year you receive it. This rule applies if, for the earlier year, all of the following statements are true.

  1. Your itemized deductions exceeded the standard deduction by at least the amount of the recovery. (If your itemized deductions did not exceed the standard deduction by at least the amount of the recovery, see Standard deduction limit, later.)
  2. You had taxable income. (If you had no taxable income, see Negative taxable income, later.)
  3. Your deduction for the item recovered equals or exceeds the amount recovered. (If your deduction was less than the amount recovered, see Recovery limited to deduction, later.)
  4. Your itemized deductions were not subject to the limit on itemized deductions. (If your deductions were limited, see Itemized deductions limited, later.)
  5. You had no unused tax credits. (If you had unused tax credits, see Unused tax credits, later.)
  6. You were not subject to alternative minimum tax. (If you were subject to alternative minimum tax, see Subject to alternative minimum tax, later.)

If any of the above statements is not true, see Total recovery not included in income, later.

Where to report.   Enter your state or local income tax refund on line 10 of Form 1040, and the total of all other recoveries as other income on line 21 of Form 1040. You cannot use Form 1040A or Form 1040EZ.

Example.   For 2001, you filed a joint return. Your taxable income was $20,000 and you were not entitled to any tax credits. Your standard deduction was $7,600, and you had itemized deductions of $9,000. In 2002, you received the following recoveries for amounts deducted on your 2001 return:

Medical expenses $200
State and local income tax refund 400
Refund of mortgage interest 325
Total recoveries $925

Your total recoveries are less than the amount by which your itemized deductions exceeded the standard deduction ($9,000 - $7,600 = $1,400), so you must include your total recoveries in your income for 2002. Report the state and local income tax refund of $400 on line 10 of Form 1040, and the balance of your recoveries, $525, on line 21 of Form 1040.

Total recovery not included in income.   If one or more of the six statements listed in the preceding discussion is not true, you may be able to exclude at least part of the recovery from your income. If statements (4), (5), and (6) are true (your itemized deductions were not limited, you had no unused tax credits, and you were not subject to the alternative minimum tax), you can use Table 1 to determine the part of your recovery of amounts deducted after 1986 to include in your income.

Table 1. Worksheet for Recoveries of Itemized Deductions
To determine whether you should complete this worksheet to figure the part of a recovery amount to include in income on your 2002 Form 1040, see Total recovery not included in income under Itemized Deduction Recoveries. If you recovered amounts from more than one year, such as a state income tax refund from 2001 and a casualty loss reimbursement from 2000, complete a separate worksheet for each year. Use information from Schedule A (Form 1040) for the year the expense was deducted.   A recovery is included in income only to the extent of the deduction amount that reduced your tax in the prior year (year of the deduction). If you were subject to the alternative minimum tax or your tax credits reduced your tax to zero, see Unused tax credits and Subject to alternative minimum tax under Itemized Deduction Recoveries. If your recovery was for an itemized deduction that was limited, you should read Itemized deductions limited under Itemized Deduction Recoveries.  
1. State/local income tax refund or credit 1    1.       
2. Enter the total of all other Schedule A refunds or reimbursements (excluding the amount you entered on line 1) 1    2.       
3. Add lines 1 and 2    3.       
4. Itemized deductions for the prior year (for example, line 28 of Schedule A for 2001) 4.          
5. Enter any amount previously refunded to you (do not enter an amount from line 1 or line 2) 5.          
6. Subtract line 5 from line 4 6.          
7. Standard deduction for the prior year. (The standard deduction amounts for 2001, 2000, and 1999 are shown in Tables 2, 3, and 4.) 7.          
8. Subtract line 7 from line 6. If the result is zero or less, stop here. The amounts on lines 1 and 2 are not taxable    8.       
9. Enter the smaller of line 3 or line 8    9.       
10. Taxable income for prior year 2 (for example, line 39, Form 1040 for 2001) 10.          
11. Amount to include in income for 2002:
  • If line 10 is zero or more, enter the amount from line 9.
  • If line 10 is a negative amount, add lines 9 and 10 and enter the result (but not less than zero). 3
 11.       
  If line 11 equals line 3 -    Enter the amount from line 1 on line 10, Form 1040.    Enter the amount from line 2 on line 21, Form 1040.
  If line 11 is less than line 3 and either line 1 or line 2 is zero -    If there is an amount on line 1, enter the amount from line 11 on line 10, Form 1040.    If there is an amount on line 2, enter the amount from line 11 on line 21, Form 1040.
  If line 11 is less than line 3, and there are amounts on both lines 1 and 2, complete the following worksheet.
  A. Divide the amount on line 1 by the amount on line 3. Enter the percentage A.          
  B. Multiply the amount on line 11 by the percentage on line A. Enter the result here and on line 10, Form 1040 B.       
  C. Subtract the amount on line B from the amount on line 11. Enter the result here and on line 21, Form 1040 C.       

1 Do not enter more than the amount deducted for the prior year.
2 If taxable income is a negative amount, enter that amount in brackets. Do not enter zero unless your taxable income is exactly zero. Taxable income will have to be adjusted for any net operating loss carryover. For more information, see Publication 536, Net Operating Losses.
3 For example, $700 + ($400) = $300

Table 2 – 2001 standard deduction

Table 3 – 2000 standard deduction

Table 4 – 1999 standard deduction

Allocating the included part.   If you are not required to include all of your recoveries in your income, and you have both a state income tax refund and other itemized deduction recoveries, you must allocate the taxable recoveries between the state tax refund you report on line 10 of Form 1040 and the amount you report as other income on line 21 of Form 1040. If you do not use Table 1, make the allocation as follows.

  1. Divide your state income tax refund by the total of all your itemized deduction recoveries.
  2. Multiply the amount of taxable recoveries by the percentage in (1). This is the amount you report as a state income tax refund.
  3. Subtract the result in (2) above from the amount of taxable recoveries. This is the amount you report as other income.

Example.   In 2002 you recovered $2,500 of your 2001 itemized deductions, but the recoveries you must include in your 2002 income are only $1,500. Of the $2,500 you recovered, $500 was due to your state income tax refund. The amount you report as a state tax refund on line 10 of Form 1040 is $300 [($500 ÷ $2,500) × $1,500]. The balance of the taxable recoveries, $1,200, is reported as other income on line 21 of Form 1040.

Standard deduction limit.   You generally are allowed to claim the standard deduction if you do not itemize your deductions. Only your itemized deductions that are more than your standard deduction are subject to the recovery rule (unless you are required to itemize your deductions). If your total deductions on the earlier year return were not more than your income for that year, include in your income this year the lesser of:

  • Your recoveries, or
  • The amount by which your itemized deductions exceeded the standard deduction.

Standard deduction for earlier years.   To determine if amounts recovered in 2002 must be included in your income, you must know the standard deduction for your filing status for the year the deduction was claimed. The standard deduction tables for 2001, 2000, and 1999 are shown in Tables 2, 3, and 4. If you need the standard deduction amounts for years before 1999, see the copy of your return for that year.

Example.   You filed a joint return for 2001 with taxable income of $25,000. Your itemized deductions were $8,700. The standard deduction that you could have claimed was $7,600. In 2002, you recovered $2,400 of your 2001 itemized deductions. None of the recoveries were more than the actual deductions for 2001. Include $1,100 of the recoveries in your 2002 income. This is the smaller of your recoveries ($2,400) or the amount by which your itemized deductions were more than the standard deduction ($8,700 - $7,600 = $1,100).

Negative taxable income.   If your taxable income was a negative amount, reduce the recovery you must otherwise include in your income by the negative amount.

Example.   The facts are the same as in the previous example except you had a negative taxable income of $200 in 2001. You must include $900 in your 2002 income, rather than $1,100.

Recovery limited to deduction.   You do not include in your income any amount of your recovery that is more than the amount you deducted in the earlier year. The amount you include in your income is limited to the smaller of:

  • The amount deducted on Schedule A (Form 1040), or
  • The amount recovered.

Example.   During 2001, you paid $1,700 for medical expenses. From this amount you subtracted $1,500, which was 7.5% of your adjusted gross income. Your actual medical expense deduction was $200. In 2002, you received a $500 reimbursement from your medical insurance for your 2001 expenses. The only amount of the $500 reimbursement that must be included in your income for 2002 is $200 - the amount actually deducted.

Itemized deductions limited.   You were subject to the limit on itemized deductions in the earlier year if your adjusted gross income (AGI) was more than a base amount. For example, this amount was:

  • For 2001, $132,950 ($66,475 if married filing separately),
  • For 2000, $128,950 ($64,475 if married filing separately), and
  • For 1999, $126,600 ($63,300 if married filing separately).

If the limit applied, your itemized deductions were reduced by the smaller of the following amounts.

  • 3% of the amount by which your AGI exceeded the base amount.
  • 80% of your otherwise allowable deductions other than medical and dental expenses, investment interest expense, nonbusiness casualty and theft losses, and gambling losses.

If the amount you recovered was deducted in a year in which your itemized deductions were limited, you must include it in income up to the difference between the amount of itemized deductions actually allowed that year and the amount you would have been allowed (the greater of your itemized deductions or your standard deduction) if you had figured your deductions using only the net amount of the recovery item.

To determine the part of the recovery you must include in income, follow the four steps below. If your earlier tax year does not involve negative taxable income or an unused tax credit, skip steps 1 and 2 and start with step 3.

  1. If your taxable income for the earlier year was a negative amount, reduce your recovery by the negative amount.
  2. If your tax for the earlier year was reduced to zero by a tax credit that was not fully used in that year, and if reducing your deduction for that year by the recovery would result in tax for that year, reduce your recovery to an amount equal to your recovery multiplied by the following fraction:
    1. Your tax for the earlier year, determined after reducing your deductions by the recovery and applying the credit, over
    2. The total increase in your tax for the earlier year, determined by subtracting your actual tax before applying the credit from the tax in (a) before applying the credit.
  3. Figure the greater of:
    1. The standard deduction for the earlier year, or
    2. The amount of itemized deductions you would have been allowed for the earlier year (after taking into account the limit on itemized deductions) if you had figured them using only the net amount of the recovery item. The net amount is the amount you actually paid reduced by the recovery amount (as reduced in steps 1 and 2, if they apply).
    Note. If you were required to itemize your deductions in the earlier year, use step 3(b) and not step 3(a).

  4. Subtract the amount in step 3 from the amount of itemized deductions actually allowed in the earlier year after applying the limit on itemized deductions.

The result of step 4 is the amount of the recovery to include in your income for the year you receive the recovery.

For more information on this computation, see Revenue Ruling 93-75. This ruling is in Cumulative Bulletin 1993-2.

Example.   Eileen Martin is single. She had an AGI of $1,132,950 and itemized her deductions on her federal income tax return for 2001. She was not subject to alternative minimum tax and was not entitled to any credit against income tax. Her only allowable deduction was $40,000 of state income taxes. However, Eileen deducted only $10,000 in 2001 because her otherwise allowable deductions of $40,000 were reduced by $30,000. In 2002, she received a $5,000 refund of her state income taxes for 2001.

The following table shows how Eileen figured the $30,000 reduction and other amounts from the Itemized Deduction Worksheet in the 2001 Schedule A (Form 1040) instructions. These amounts are needed to figure the part of the $5,000 refund that Eileen must include in her income for 2002.

AGI for 2001 $1,132,950
State income taxes paid in 2001 $40,000
3% reduction (amount on line 8 of  2001 Itemized Deduction  Worksheet)   [($1,132,950 - $132,950) × 3%] $30,000
80% reduction not applied (amount  on line 4 of 2001 Itemized  DeductionWorksheet)  ($40,000 × 80%) $32,000
2001 deduction (amount on line 10  of 2001 Itemized Deduction  Worksheet)  ($40,000 - $30,000) $10,000
Refund received in 2002 of 2001  state income tax $5,000
Net amount of 2001 state income  tax ($40,000 - $5,000) $35,000

If Eileen had used the $35,000 net amount of state income tax to figure her itemized deductions for 2001, the deduction allowed would have been $7,000. This is her otherwise allowable deduction of $35,000 reduced by $28,000 ($35,000 × 80%). By deducting the full $10,000 paid in 2001, she derived a tax benefit of $3,000 ($10,000 - $7,000). Therefore, only $3,000 of the $5,000 refund is included in her income for 2002.

Unused tax credits.   If you recover an item deducted in an earlier year in which you had unused tax credits, you must refigure the earlier year's tax to determine if you must include the recovery in your income. To do this, add the amount of the recovery to your earlier year's taxable income and refigure the tax and the credits on the recomputed amount. If the recomputed tax, after application of the credits, is more than the actual tax in the earlier year, include the recovery in your income up to the amount by which it reduced the tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year. If the recovery is for an itemized deduction claimed in a year in which the deductions were limited, see Itemized deductions limited, earlier.

If your tax, after application of the credits, does not change, you did not have a tax benefit from the deduction. Do not include the recovery in your income.

Example.   In 2001, Jean Black filed as head of household and itemized her deductions. Her taxable income was $5,260 and her tax was $791. She claimed a child care credit of $1,200. The credit reduced her tax to zero and she had an unused tax credit of $409 ($1,200 - $791). In 2002, Jean recovered $1,000 of her itemized deductions. She reduces her 2001 itemized deductions by $1,000 and recomputes that year's tax on taxable income of $6,260. However, the child care credit exceeds the recomputed tax of $941. Jean's tax liability for 2001 is not changed by reducing her deductions by the recovery. She did not have a tax benefit from the recovered deduction and does not include any of the recovery in her income for 2002.

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