Important Changes for 2002

Reporting interest and dividends.    Interest or ordinary dividend income that exceeds a certain amount must be reported on a separate schedule. For 2002, this amount has increased. If you file Form 1040A, you must now attach Schedule 1 to your return if your interest or dividend income is more than $1,500; if you file Form 1040, you must now attach Schedule B to your return if your interest or dividend income is more than $1,500. Before 2002, you had to attach Schedule 1 or Schedule B if your interest or dividend income was more than $400.

Interest on 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 a newly designated Liberty Zone of New York City. Interest on these bonds is tax exempt.

Tax shelter disclosure statement.    You must file a disclosure statement for each reportable tax shelter transaction in which you participated, directly or indirectly, if your income tax liability was affected by the transaction. See Tax Shelter Disclosure Statement under Investor Reporting in chapter 2.

Important Changes for 2003

Reportable transactions.    You may have to disclose information about certain transactions (called reportable transactions) in which you participated, directly or indirectly. This disclosure requirement applies to reportable transactions entered into after 2002. Reportable transactions include transactions that are the same or substantially similar to tax avoidance transactions identified by the IRS, transactions that are offered under conditions of confidentiality, and transactions that result in large losses. You must disclose information about reportable transactions on Form 8886, Reportable Transaction Disclosure Statement. For more information, see the instructions for Form 8886.

Sale of DC Zone assets.   Beginning in 2003, investments in District of Columbia Enterprise Zone (DC Zone) assets held more than 5 years will qualify for a special tax benefit. If you sell or trade a DC Zone asset at a gain, you will not have to include any qualified capital gain in your gross income. This exclusion applies to an interest in, or property of, certain businesses operating in the District of Columbia. For more information, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities.

Important Reminders

8% capital gain rate.   The 10% capital gain rate was lowered to 8% for qualified 5-year gain. For more information, see Capital Gain Tax Rates in chapter 4.

18% capital gain rate.   Beginning in 2006, the 20% capital gain rate will be lowered to 18% for qualified 5-year gain from property.

U.S. property acquired from a foreign person.   If you acquire a U.S. real property interest from a foreign person or firm, you may have to withhold income tax on the amount you pay for the property (including cash, the fair market value of other property, and any assumed liability). Domestic or foreign corporations, partnerships, trusts, and estates may also have to withhold on certain distributions and other transactions involving U.S. real property interests. If you fail to withhold, you may be held liable for the tax, penalties that apply, and interest. For more information, see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.

Foreign source income.   If you are a U.S. citizen with investment income from sources outside the United States (foreign income), you must report that income on your tax return unless it is exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form 1099 from the foreign payer.

Alien's individual taxpayer identification number (ITIN).   The IRS will issue an ITIN to a nonresident or resident alien who does not have and is not eligible to get a social security number (SSN). To apply for an ITIN, file Form W-7, Application for IRS Individual Taxpayer Identification Number, with the IRS. Enter your ITIN wherever an SSN is requested on a tax return. If you must include another person's SSN on your return and that person does not have and cannot get an SSN, enter that person's ITIN.

An ITIN is for tax use only. It does not entitle you to social security benefits or change your employment or immigration status under U.S. law.

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800- 843-5678) if you recognize a child.

Introduction

This publication provides information on the tax treatment of investment income and expenses. It explains what investment income is taxable and what investment expenses are deductible. It explains when and how to show these items on your tax return. It also explains how to determine and report gains and losses on the disposition of investment property and provides information on property trades and tax shelters.

There is a glossary at the end of this publication that defines many of the terms used.

Investment income.   This generally includes interest, dividends, capital gains, and other types of distributions.

Investment expenses.   These include interest paid or incurred to acquire investment property and expenses to manage or collect income from investment property.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

You can write to us at the following address:

Internal Revenue Service
Tax Forms and Publications
W:CAR:MP:FP
1111 Constitution Ave. NW
Washington, DC 20224

We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence.

Investment Income

Topics

This chapter discusses:

• Interest income,
• Dividends and other corporate distributions,
• Real estate mortgage investment conduits (REMICs), financial asset securitization investment trusts (FASITs), and other collateralized debt obligations (CDOs),
• S corporations, and
• Investment clubs.

Useful Items You may want to see:

Publication

• 525   Taxable and Nontaxable Income
• 537   Installment Sales
• 564   Mutual Fund Distributions
• 590   Individual Retirement Arrangements (IRAs)
• 925   Passive Activity and At-Risk Rules
• 1212   List of Original Issue Discount Instruments

Form (and Instructions)

• Schedule B (Form 1040)   Interest and Ordinary Dividends
• Schedule 1 (Form 1040A)   Interest and Ordinary Dividends for Form 1040A Filers
• 1099   General Instructions for Forms 1099, 1098, 5498, and W-2G
• 3115   Application for Change in Accounting Method
• 6251   Alternative Minimum Tax - Individuals
• 8582   Passive Activity Loss Limitations
• 8615   Tax for Children Under Age 14 Who Have Investment Income of More Than $1,500
• 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

See chapter 5 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 amounts of investment income that you receive during the year. Also, keep the forms you receive that show your investment income (Forms 1099-INT, Interest Income, and 1099-DIV, Dividends and Distributions, for example) as an important part of your records.

Tax on investment income of a child under age 14.   Part of a child's 2002 investment income may be taxed at the parent's tax rate. This may happen if all of the following are true.

1. The child was under age 14 at the end of 2002. A child born on January 1, 1989, is considered to be age 14 at the end of 2002.
2. The child had more than $1,500 of investment income (such as taxable interest and dividends) and has to file a tax return.
3. Either parent was alive at the end of 2002.

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 investment 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 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 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.

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.

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:

1. Include your SSN on any return, statement, or other document,
2. Give your SSN to another person who has to include it on any return, statement, or other document, or
3. 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 a 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, a percentage of the amount you are paid. For 2003, the percentage is 30%.

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 Internal Revenue Service (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 social security number (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:

1. You failed to include any part of a reportable interest or dividend payment required to be shown on your return, or
2. 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.

1. No underreporting occurred.
2. You have a bona fide dispute with the IRS about whether underreporting occurred.
3. Backup withholding will cause or is causing an undue hardship, and it is unlikely that you will underreport interest and dividends in the future.
4. 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) that indicates 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.

Example.   You and your husband have a joint money market account. Under state law, half the income from the account belongs to you, and half belongs to your husband. If you file separate returns, you each report half of 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 child who is a minor, 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.

1. The savings account legally belongs to the child.
2. The parents are not legally permitted to use any of the funds to support the child.

(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.

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

Income	If you file Form 1040	If you can file Form 1040A	If you can file Form 1040EZ
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 1 as well.)	Line 2
Ordinary dividends that total $1,500 or less	Line 9 (You may need to file Schedule B as well.)	Line 9 (You may need to file Schedule 1 as well.)
Taxable interest that totals more than $1,500	Line 8a; also use Schedule B	Line 9; also use Schedule 1
Ordinary dividends that total more than $1,500	Line 9; also use Schedule B	Line 9; also use Schedule 1
Savings bond interest you will exclude because of higher education expenses	Schedule B; also use Form 8815	Schedule 1; also use Form 8815	You cannot use Form 1040EZ
Capital gain distributions (if you do not have to file Schedule D)	Line 13	Line 10
Capital gain distributions (if you have to file Schedule D)	Schedule D, line 13
Gain or loss from sale of stocks or bonds	Line 13; also use Schedule D	You cannot use Form 1040A
Gain or loss from exchanges of investment property	Line 13; also use Schedule D and Form 8824

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.

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