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 ofinterest income. In general, any interest that you receive or that is credited toyour account and can be withdrawn is taxable income. (It does not haveto be entered in your passbook.) Exceptions to this rule are discussedlater. Form1099-INT.Interest income is generally reported to you on Form1099-INT, or a similar statement, by banks, savings and loans,and other payers of interest. This form shows you the interest youreceived during the year. Keep this form for your records. You do nothave to attach it to your tax return. Report on your tax return the total amount of interest income thatyou receive for the tax year. This includes amounts reported to you onForm 1099-INT and amounts for which you did not receive a Form1099-INT. Nominees. Generally, if someone receives interest as a nominee for you, thatperson will give you a Form 1099-INT showing the interestreceived on your behalf. If you receive a Form 1099-INT that includes amountsbelonging to another person, see the discussion on nomineedistributions, 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 acorrected form. The new Form 1099-INT you receive will be marked"CORRECTED." Form 1099-OID.Reportable interest income may also be shown on Form1099-OID, Original Issue Discount. For moreinformation about amounts shown on this form, see Original IssueDiscount (OID), later in this chapter. Exempt-interest dividends.Exempt-interest dividends you receive from a regulated investmentcompany (mutual fund) are not included in your taxable income.(However, see Information-reporting requirement, next.) Youwill receive a notice from the mutual fund telling you the amount ofthe exempt-interest dividends that you received. Exempt-interestdividends are not shown on Form 1099-DIV or Form 1099-INT. Information-reporting requirement.Although exempt-interest dividends are not taxable, you must showthem on your tax return if you have to file. This is aninformation-reporting requirement and does not change theexempt-interest dividends to taxable income. See How To ReportInterest Income, later. Note.Exempt-interest dividends paid from specified private activitybonds may be subject to the alternative minimum tax. See Form 6251 andits instructions for more information about this tax. (Privateactivity bonds are discussed later under hoteles MaastrichtState or LocalGovernment Obligations.) Interest on VA dividends.Interest on insurance dividends that you leave on deposit with theDepartment of Veterans Affairs (VA) is not taxable. This includesinterest paid on dividends on converted United States Government LifeInsurance policies and on National Service Life Insurance policies. Individual retirement arrangements (IRAs).Interest on a Roth IRA or education IRA generally is not taxable.Interest on a traditional IRA is tax deferred. You generally do notinclude it in your income until you make withdrawals from the IRA. SeePublication 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 somesources of taxable interest. Dividends that are actually interest.Certain distributions commonly called dividends are actuallyinterest. You must report as interest so-called "dividends" ondeposits 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 bereported as dividends, not as interest. Money market certificates, savings certificates, and otherdeferred interest accounts.If you open any of these accounts, interest may be paid at fixedintervals of 1 year or less during the term of the account. Yougenerally must include this interest in your income when you actuallyreceive it or are entitled to receive it without paying a substantialpenalty. The same is true for accounts that mature in 1 year or lessand pay interest in a single payment at maturity. If interest isdeferred 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 beforematurity, you may have to pay a penalty. You must report the totalamount of interest paid or credited to your account during the year,without subtracting the penalty. See Penalty on early withdrawalof savings under How To Report Interest Income,later, for more information on how to report the interest anddeduct the penalty. Money borrowed to invest in money market certificate.The interest you pay on money borrowed from a bank or savingsinstitution to meet the minimum deposit required for a money marketcertificate from the institution and the interest you earn on thecertificate are two separate items. You must report the total interestyou earn on the certificate in your income. If you itemize deductions,you can deduct the interest you pay as investment interest, up to theamount of your net investment income. See Interest Expensesin chapter 3. Example.You deposited $5,000 with a bank and borrowed $5,000 from the bankto make up the $10,000 minimum deposit required to buy a 6-monthmoney market certificate. The certificate earned $575 at maturity in2000, but you received only $265, which represented the $575 youearned minus $310 interest charged on your $5,000 loan. The bank givesyou a Form 1099-INT for 2000 showing the $575 interest youearned. The bank also gives you a statement showing that you paid $310interest for 2000. You must include the $575 in your income. If youitemize 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 foropening an account in a savings institution, you may have to reportthe value as interest. For deposits of less than $5,000, gifts or services valued at morethan $10 must be reported as interest. For deposits of $5,000 or more,gifts or services valued at more than $20 must be reported asinterest. The value is determined by the cost to the financialinstitution. Example.You open a savings account at your local bank and deposit $800. Theaccount earns $20 interest. You also receive a $15 calculator. If noother interest is credited to your account during the year, the Form1099-INT you receive will show $35 interest for the year. Youmust report $35 interest income on your tax return. Interest on insurance dividends.Interest on insurance dividends left on deposit with an insurancecompany that can be withdrawn annually is taxable to you in the yearit is credited to your account. However, if you can withdraw it onlyon the anniversary date of the policy (or other specified date), theinterest is taxable in the year that date occurs. Prepaid insurance premiums.Any increase in the value of prepaid insurance premiums, advancepremiums, or premium deposit funds is interest if it is applied to thepayment of premiums due on insurance policies or made available foryou to withdraw. U.S. obligations.Interest on U.S. obligations, such as U.S. Treasury bills, notesand bonds, issued by any agency or instrumentality of the UnitedStates 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 fora delay in payment of an award, the interest is taxable. Installment sale payments.If a contract for the sale or exchange of property provides fordeferred payments, it also usually provides for interest payable withthe deferred payments. That interest is taxable when you receive it.If little or no interest is provided for in a deferred paymentcontract, part of each payment may be treated as interest. SeeUnstated Interest in Publication 537. Interest on annuity contract.Accumulated interest on an annuity contract you sell before itsmaturity date is taxable. Usurious interest.Usurious interest is interest charged at an illegal rate. Thisinterest is taxable unless state law automatically changes it to apayment on the principal. Interest income on frozen deposits.Exclude from your gross income interest on frozen deposits. Adeposit is frozen if, at the end of the year, you cannot withdraw anypart of the deposit because: The financial institution is bankrupt or insolvent, or The state in which the institution is located has placedlimits on withdrawals because other financial institutions in thestate are bankrupt or insolvent. The amount of interest you must exclude is the interest that wascredited on the frozen deposits minus the sum of: The net amount you withdrew from these deposits during theyear, and The amount you could have withdrawn as of the end of theyear (not reduced by any penalty for premature withdrawals of a timedeposit). If you receive a Form 1099-INT for interest income ondeposits that were frozen at the end of 2000, see Frozen depositsunder How To Report Interest Income for informationabout reporting this interest income exclusion on your 2000 taxreturn. The interest you exclude must be reported in the later tax yearwhen you can withdraw it from your account. Example.$100 of interest was credited on your frozen deposit during theyear. You withdrew $80 but could not withdraw any more as of the endof the year. You must include $80 in your income for the year. Youmust exclude $20. Bonds traded flat.If you buy a bond when interest has been defaulted or when theinterest has accrued but has not been paid, that interest is notincome and is not taxable as interest if paid later. When you receivea payment of that interest, it is a return of capital that reduces theremaining cost basis. Interest that accrues after the date ofpurchase, however, is taxable interest income for the year received oraccrued. See Bonds Sold Between Interest Dates, later inthis chapter. Below-Market Loans If you make a below-market gift or demand loan, you must report asinterest income any forgone interest (defined later) from that loan.The below-market loan rules and exceptions are described in thissection. For more information, see section 7872 of the InternalRevenue Code and its regulations. If you receive a below-market loan, you may be able to deduct theforgone interest, as well as any interest that you actually paid, butnot 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 afterOctober 11, 1985) under a continuing care contract. A pay-related loan is any below-market loan between an employer andan employee or between an independent contractor and a person for whomthe contractor provides services. A tax avoidance loan is any below-market loan where the avoidanceof federal tax is one of the main purposes of the interestarrangement. Forgone interest.For any period, forgone interest is: The amount of interest that would be payable for that periodif interest accrued on the loan at the applicable federal rate and waspayable annually on December 31, minus Any interest actually payable on the loan for theperiod. Applicable federal rate.Applicable federal rates are published by the IRS each month in theInternal Revenue Bulletin. You can also contact the IRS toget these rates. See chapter 5for the telephone number to call. Rules for below-market loans. The rules that apply to a below-market loan depend on whether theloan 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 isin the nature of a gift. A demand loan is a loan payable in full at any time upon demand bythe lender. A demand loan is a below-market loan if no interest ischarged or if interest is charged at a rate below the applicablefederal rate. A demand loan or gift loan that is a below-market loan is generallytreated as an arm's-length transaction in which the lender is treatedas having made: A loan to the borrower in exchange for a note that requiresthe payment of interest at the applicable federal rate, and An additional payment to the borrower in an amount equal tothe forgone interest. The borrower is generally treated as transferring theadditional payment back to the lender as interest. The lender mustreport that amount as interest income. The lender's additional payment to the borrower is treated as agift, dividend, contribution to capital, pay for services, or otherpayment, depending on the substance of the transaction. The borrowermay have to report this payment as taxable income, depending on itsclassification. These transfers are considered to occur annually, generally onDecember 31. Term loans.A term loan is any loan that is not a demand loan. A term loan is abelow-market loan if the amount of the loan is more than the presentvalue of all payments due under the loan. A lender who makes a below-market term loan other than a gift loanis treated as transferring an additional lump-sum cash payment to theborrower (as a dividend, contribution to capital, etc.) on the datethe loan is made. The amount of this payment is the amount of the loanminus the present value, at the applicable federal rate, of allpayments due under the loan. An equal amount is treated as originalissue discount (OID). The lender must report the annual part of theOID as interest income. The borrower may be able to deduct the OID asinterest 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 whichthe total outstanding amount of loans between the borrower and lenderis $10,000 or less. This exception applies only to: Gift loans between individuals if the gift loan is notdirectly used to buy or carry income-producing assets, and Pay-related loans or corporation-shareholder loans if theavoidance of federal tax is not a principal purpose of the interestarrangement. This exception does not apply to a term loan described in (2) abovethat previously has been subject to the below-market loan rules. Thoserules will continue to apply even if the outstanding balance isreduced to $10,000 or less. accommodation in CascaisAge exception for loans to continuing care facilities.Loans to qualified continuing care facilities under continuing carecontracts are not subject to the rules for below-market loans for thecalendar year if the lender or the lender's spouse is 65 or older atthe end of the year. For 2000, this exception applies only to the partof the total outstanding loan balance that is $139,700 or less. Exception for loans without significant tax effect.Loans are excluded from the below-market loan rules if theirinterest arrangements do not have a significant effect on the federaltax liability of the borrower or the lender. These loans include: Loans made available by the lender to the general public onthe same terms and conditions that are consistent with the lender'scustomary business practice, Loans subsidized by a federal, state, or municipalgovernment that are made available under a program of generalapplication to the public, Certain employee-relocation loans, Certain loans from a foreign person, unless the interestincome would be effectively connected with the conduct of a U.S. tradeor business and would not be exempt from U.S. tax under an income taxtreaty, Gift loans to a charitable organization, contributions towhich are deductible, if the total outstanding amount of loans betweenthe organization and lender is $250,000 or less at all times duringthe tax year, and Other loans on which the interest arrangement can be shownto have no significant effect on the federal tax liability of thelender or the borrower. For a loan described in (6) above, all the facts and circumstancesare used to determine if the interest arrangement has a significanteffect on the federal tax liability of the lender or borrower. Somefactors to be considered are: Whether items of income and deduction generated by the loanoffset each other, The amount of these items, The cost to you of complying with the below-market loanrules, if they were to apply, and Any reasons other than taxes for structuring the transactionas a below-market loan. If you structure a transaction to meet this exception, and one ofthe principal purposes of structuring the transaction in that way isthe avoidance of federal tax, the loan will be considered atax-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 loansbetween the lender and borrower total $100,000 or less, the forgoneinterest to be included in income by the lender and deducted by theborrower is limited to the amount of the borrower's net investmentincome for the year. If the borrower's net investment income is $1,000or less, it is treated as zero. This limit does not apply to a loan ifthe avoidance of federal tax is one of the main purposes of theinterest arrangement. Effective dates.These rules apply to term loans made after June 6, 1984, and todemand loans outstanding after that date. U.S. Savings Bonds This section provides tax information on U.S. savings bonds. Itexplains how to report the interest income on these bonds and how totreat transfers of these bonds. Envelope: For other information on U.S. savings bonds, write to:   Bureau of the Public Debt Attn: Customer Information P.O. Box 1328 Parkersburg, WV 26106-1328. Computer: Or, on the Internet, visit: www. publicdebt.treas.gov Accrual method taxpayers.If you use an accrual method of accounting, you must reportinterest on U.S. savings bonds each year as it accrues. You cannotpostpone reporting interest until you receive it or until the bondsmature. Cash method taxpayers.If you use the cash method of accounting, as most individualtaxpayers do, you generally report the interest on U.S. savings bondswhen you receive it. But see the discussion of Series EE andseries I bonds, below. Series HH bonds.These bonds are issued at face value. Interest is paid twice a yearby direct deposit to your bank account. If you are a cash methodtaxpayer, you must report interest on these bonds as income in theyear you receive it. Series HH bonds were first offered in 1980. Before 1980,series H bonds were issued. Series H bonds are treated thesame as series HH bonds. If you are a cash method taxpayer, you mustreport the interest when you receive it. Series H bonds have a maturity period of 30 years. Series HH bondsmature in 20 years. Series EE and series I bonds.Interest on these bonds is payable when you redeem the bonds. Thedifference between the purchase price and the redemption value istaxable interest. Series EE bonds were first offered in July 1980. They have amaturity period of 30 years. Before July 1980, series E bondswere issued. The original 10-year maturity period of series Ebonds has been extended to 40 years for bonds issued before December1965 and 30 years for bonds issued after November 1965. Series EE andseries E bonds are issued at a discount. The face value is payable toyou at maturity. Series I bonds were first offered in 1998. These areinflation-indexed bonds issued at their face amount with a maturityperiod of 30 years. The face value plus accrued interest is payable toyou at maturity. If you use the cash method of reporting income, you can report theinterest on series EE, series E, and series I bonds in either of thefollowing ways. Method 1. Postpone reporting the interest untilthe earlier of the year you cash or dispose of the bonds or the yearin which they mature. (However, see Savings bonds traded,later.) Note. Series E bonds issued in 1960 and 1970matured in 2000. If you have used method 1, you generally must reportthe interest on these bonds on your 2000 return. Method 2. Choose to report the increase inredemption value as interest each year. You must use the same method for all series EE, series E, andseries I bonds you own. If you do not choose method 2 by reporting theincrease in redemption value as interest each year, you must usemethod 1. TaxTip: If you plan to cash your bonds in the same year that you will payfor higher educational expenses, you may want to use method 1 becauseyou may be able to exclude the interest from your income. To learnhow, see Education Savings Bond Program, later. Change from method 1.If you want to change your method of reporting the interest frommethod 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 andnot previously reported for all your bonds. Once you choose to report the interest each year, you must continueto do so for all series EE, series E, and series I bonds you own andfor any you get later, unless you request permission to change, asexplained next. Change from method 2.To change from method 2 to method 1, you must request permissionfrom the IRS. Permission for the change is automatically granted ifyou send the IRS a statement that meets all the followingrequirements. You have typed or printed at the top, "Change inMethod of Accounting Under Section 6.01 of the Appendix of Rev. Proc.99-49" (or later update). It includes your name and social security number under thelabel in (1). It identifies the savings bonds for which you are requestingthis change. It includes your agreement to: Report all interest on any bonds acquired during or afterthe year of change when the interest is realized upon disposition,redemption, or final maturity, whichever is earliest, and Report all interest on the bonds acquired before the year ofchange when the interest is realized upon disposition, redemption, orfinal maturity, whichever is earliest, with the exception of theinterest reported in prior tax years. It includes your signature. You must attach this statement to your tax return for the yearof change, which you must file by the due date (including extensions). You can have an automatic extension of 6 months from the due dateof your return (including extensions) to file the statement with anamended return. To get this extension, you must have filed youroriginal return by the due date (including extensions). At the top ofthe statement, write "Filed Pursuant to Reg.301.9100-2." Envelope: By the date you file the original statement, you must also send acopy to the address below. Commissioner of Internal Revenue Attention: CC:DOM:IT&A (Automatic Rulings Branch) P.O. Box 7604 Benjamin Franklin Station Washington, DC 20044. If you use a private delivery service, send the copy to theCommissioner of Internal Revenue, Attention: CC:DOM:IT&A(Automatic Rulings Branch), 1111 Constitution Avenue, NW, Washington,DC 20224. Instead of filing this statement, you can request permission tochange from method 2 to method 1 by filing Form 3115. Inthat case, follow the form instructions for an automatic change. Nouser fee is required. Co-owners.If a U.S. savings bond is issued in the names of co-owners, such asyou and your child or you and your spouse, interest on the bond isgenerally taxable to the co-owner who bought the bond. Table 1-2 Who Pays Tax on U.S. Savings Bond Interest One co-owner's funds used.If you used your funds to buy the bond, you must pay the tax on theinterest. This is true even if you let the other co-owner redeem thebond and keep all the proceeds. Under these circumstances, since theother co-owner will receive a Form 1099-INT at the time ofredemption, the other co-owner must provide you with another Form1099-INT showing the amount of interest from the bond that istaxable to you. The co-owner who redeemed the bond is a "nominee."See Nominee distributions under How To Report InterestIncome, later, for more information about how a person who is anominee 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'spurchase price, the interest is generally taxable to each of you, inproportion to the amount each of you paid. Community property.If you and your spouse live in a community property state and holdbonds as community property, one-half of the interest is consideredreceived by each of you. If you file separate returns, each of yougenerally must report one-half of the bond interest. For moreinformation 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 inthe name of your child is income to your child, even if you paid forthe 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 toyour child in the earlier of the year the bonds are cashed or disposedof or the year the bonds mature, unless your child chooses to reportthe interest income each year. Choice to report interest each year.The choice to report the accrued interest each year can be madeeither by your child or by you for your child. This choice is made byfiling an income tax return that shows all the interest earned todate, and by stating on the return that your child chooses to reportthe interest each year. Either you or your child should keep a copy ofthis return. Unless your child is otherwise required to file a tax return forany year after making this choice, your child does not have to file areturn only to report the annual accrual of U.S. savings bond interestunder this choice. However, see Tax on investment income of achild under age 14, earlier, under General Information.Neither you nor your child can change the way you report the interestunless you request permission from the IRS, as discussed earlier underChange from method 2. Ownership transferred.If you bought series E, series EE, or series I bonds entirelywith your own funds and had them reissued in your co-owner'sname or beneficiary's name alone, you must include in your grossincome for the year of reissue all interest that you earned on thesebonds and have not previously reported. But, if the bonds werereissued in your name alone, you do not have to report the interestaccrued at that time. This same rule applies when bonds (other than bonds held ascommunity property) are transferred between spouses or incident todivorce. Example.You bought series EE bonds entirely with your own funds. You didnot choose to report the accrued interest each year. Later, youtransfer the bonds to your former spouse under a divorce agreement.You must include the deferred accrued interest, from the date of theoriginal issue of the bonds to the date of transfer, in your income inthe year of transfer. Your former spouse includes in income theinterest on the bonds from the date of transfer to the date ofredemption. 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 thebonds reissued in the co-owner's name alone, you must include in yourgross income for the year of reissue your share of all the interestearned on the bonds that you have not previously reported. At the timeof reissue, the former co-owner does not have to include in grossincome his or her share of the interest earned that was not reportedbefore the transfer. This interest, however, as well as all interestearned after the reissue, is income to the former co-owner. This income-reporting rule also applies when the bonds are reissuedin the name of your former co-owner and a new co-owner. But the newco-owner will report only his or her share of the interest earnedafter the transfer. If bonds that you and a co-owner bought jointly arereissued to each of you separately in the same proportion as yourcontribution to the purchase price, neither you nor your co-owner hasto report at that time the interest earned before the bonds werereissued. Example 1.You and your spouse each spent an equal amount to buy a $1,000series EE savings bond. The bond was issued to you and your spouse asco-owners. You both postpone reporting interest on the bond. You laterhave the bond reissued as two $500 bonds, one in your name and one inyour spouse's name. At that time neither you nor your spouse has toreport the interest earned to the date of reissue. Example 2.You bought a $1,000 series EE savings bond entirely with your ownfunds. The bond was issued to you and your spouse as co-owners. Youboth postponed reporting interest on the bond. You later have the bondreissued as two $500 bonds, one in your name and one in your spouse'sname. 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 themto a trust, giving up all rights of ownership, you must include inyour income for that year the interest earned to the date of transferif you have not already reported it. However, if you are consideredthe owner of the trust and if the increase in value both before andafter the transfer continues to be taxable to you, you can continue todefer reporting the interest earned each year. You must include thetotal interest in your income in the year you cash or dispose of thebonds or the year the bonds finally mature, whichever is earlier. The same rules apply to previously unreported interest on series EEor series E bonds if the transfer to a trust consisted of series HH orseries H bonds you acquired in a trade for the series EE or series Ebonds. See Savings bonds traded, later. Decedents.The manner of reporting interest income on series E, series EE, orseries I bonds, after the death of the owner, depends on theaccounting and income-reporting method previously used by thedecedent. Decedent who reported interest each year.If the bonds transferred because of death were owned by a personwho used an accrual method, or who used the cash method and had chosento report the interest each year, the interest earned in the year ofdeath up to the date of death must be reported on that person's finalreturn. The person who acquires the bonds includes in income onlyinterest earned after the date of death. Decedent who postponed reporting interest.If the transferred bonds were owned by a decedent who had used thecash method and had not chosen to report the interest each year, andwho had bought the bonds entirely with his or her own funds, allinterest earned before death must be reported in one of the followingways. The surviving spouse or personal representative (executor,administrator, etc.) who files the final income tax return of thedecedent can choose to include on that return all of the interestearned on the bonds before the decedent's death. The person whoacquires the bonds then includes in income only interest earned afterthe date of death. If the choice in (1) is not made, the interest earned up tothe date of death is income in respect of the decedent. It should notbe included in the decedent's final return. All of the interest earnedboth before and after the decedent's death is income to the person whoacquires the bonds. If that person uses the cash method and does notchoose to report the interest each year, he or she can postponereporting it until the year the bonds are cashed or disposed of or theyear they mature, whichever is earlier. In the year that personreports the interest, he or she can claim a deduction for any federalestate tax that was paid on the part of the interest included in thedecedent's estate. For more information on income in respect of a decedent, seePublication 559, Survivors, Executors, and Administrators. Example 1.Your uncle, a cash method taxpayer, died and left you a $1,000series EE bond. He had bought the bond for $500 and had not chosen toreport the interest each year. At the date of death, interest of $200had accrued on the bond and its value of $700 was included in youruncle's estate. Your uncle's executor chose not to include the $200accrued interest in your uncle's final income tax return. The $200 isincome in respect of the decedent. You are a cash method taxpayer and do not choose to report theinterest each year as it is earned. If you cash the bond when itreaches maturity value of $1,000, you report $500 interestincome--the difference between maturity value of $1,000 and theoriginal cost of $500. For that year, you can deduct (as amiscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit) any federal estate tax paid because the $200interest 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 reportonly $300 as interest when you cashed the bond at maturity. $300 isthe interest earned after your uncle's death. Example 3.If, in Example 1, you make or have made the choice toreport the increase in redemption value as interest each year, youinclude in gross income for the year you acquire the bond all of theunreported increase in value of all series E, series EE, and series Ibonds you hold, including the $200 on the bond you inherited from youruncle. Example 4.When your aunt died, she owned series H bonds that she had acquiredin a trade for series E bonds. You were the beneficiary of thesebonds. Your aunt used the cash method and did not choose to report theinterest on the series E bonds each year as it accrued. Your aunt'sexecutor chose not to include any interest earned before your aunt'sdeath on her final return. The income in respect of the decedent is the sum of the unreportedinterest on the series E bonds and the interest, if any, payable onthe series H bonds but not received as of the date of your aunt'sdeath. You must report any interest received during the year as incomeon your return. The part of the interest that was payable but notreceived before your aunt's death is income in respect of the decedentand may qualify for the estate tax deduction. For information on whento report the interest on the series E bonds traded, see Savingsbonds traded, later. Savings bonds distributed from a retirement or profit-sharingplan.If you acquire a U.S. savings bond in a taxable distribution from aretirement or profit-sharing plan, your income for the year ofdistribution includes the bond's redemption value (its cost plus theinterest accrued before the distribution). When you redeem the bond(whether in the year of distribution or later), your interest incomeincludes only the interest accrued after the bond was distributed. Tofigure the interest reported as a taxable distribution and yourinterest income when you redeem the bond, see Worksheet forsavings bonds distributed from a retirement or profit-sharing planunder How To Report Interest Income, later. Savings bonds traded.If you postponed reporting the interest on your series EE or seriesE bonds, you did not recognize taxable income when you traded thebonds for series HH or series H bonds, unless you received cash in thetrade. (You cannot trade series I bonds for series HH bonds.) Any cashyou received is income up to the amount of the interest earned on thebonds traded. When your series HH or series H bonds mature, or if youdispose of them before maturity, you report as interest the differencebetween their redemption value and your cost. Your cost is the sum ofthe amount you paid for the traded series EE or series E bonds plusany amount you had to pay at the time of the trade. Example 1.You own series E bonds with accrued interest of $523 and aredemption 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 theseries HH bonds until maturity, when you receive $2,500. You mustreport $300 as interest income in the year of maturity. This is thedifference between their redemption value, $2,500, and your cost,$2,200 (the amount you paid for the series E bonds). (It is also thedifference between the accrued interest of $523 on the series E bondsand 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 accruedinterest on series EE or series E bonds traded for series HH bonds asincome in the year of the trade. If you make this choice, it istreated as a change from method 1. See Change from method 1under 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 mustgive you a Form 1099-INT if the interest part of the payment youreceive is $10 or more. Box 3 of your Form 1099-INT should showthe interest as the difference between the amount you received and theamount paid for the bond. However, your Form 1099-INT may showmore interest than you have to include on your income tax return. Forexample, this may happen if any of the following are true. You chose to report the increase in the redemption value ofthe bond each year. The interest shown on your Form 1099-INTwill not be reduced by amounts previously included in income. You received the bond from a decedent. The interest shown onyour Form 1099-INT will not be reduced by any interest reportedby the decedent before death, or on the decedent's final return, or bythe estate on the estate's income tax return. Ownership of the bond was transferred. The interest shown onyour Form 1099-INT will not be reduced by interest that accruedbefore the transfer. You were named as a co-owner and the other co-ownercontributed funds to buy the bond. The interest shown on your Form1099-INT will not be reduced by the amount you received asnominee for the other co-owner. (See Co-owners, earlier inthis section, for more information about the reporting requirements.) You received the bond in a taxable distribution from aretirement or profit-sharing plan. The interest shown on your Form1099-INT will not be reduced by the interest portion of theamount taxable as a distribution from the plan and not taxable asinterest. (This amount is generally shown on Form 1099-R,Distributions From Pensions, Annuities, Retirement orProfit-Sharing Plans, IRAs, Insurance Contracts, etc., for theyear of distribution.) For more information on including the correct amount of interest onyour return, see U.S. savings bond interest previously reportedor Nominee distributions under How To ReportInterest Income, later. TaxTip: Interest on U.S. savings bonds is exempt from state and localtaxes. The Form 1099-INT you receive will indicate the amountthat is for U.S. savings bonds interest in box 3. Do not include thisincome 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 interestyou receive on the redemption of qualified U.S. savings bonds duringthe year if you pay qualified higher educational expenses during thesame year. This exclusion is known as the Education Savings BondProgram. If you are married, you can qualify for this exclusion only if youfile 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 after1989 or a series I bond. The bond must be issued either in yourname (sole owner) or in your and your spouse's names (co-owners). Youmust be at least 24 years old before the bond's issue date. Caution: The date a bond is issued may be earlier than the date the bond ispurchased because bonds are issued as of the first day of the month inwhich they are purchased. Beneficiary.You can designate any individual (including a child) as abeneficiary of the bond. Verification by IRS.If you claim the exclusion, the IRS will check it by using bondredemption information from the Department of Treasury. Qualified expenses.Qualified higher educational expenses are tuition and fees requiredfor you, your spouse, or your dependent (for whom you claim anexemption) to attend an eligible educational institution. Qualified expenses include any contribution you make to a qualifiedstate tuition program or to an education IRA. For information aboutstate tuition programs and education IRAs, see Publication 970,Tax Benefits for Higher Education. Qualified expenses do not include expenses for room and board orfor courses involving sports, games, or hobbies that are not part of adegree program. Eligible educational institutions.These institutions include most public, private, and nonprofituniversities, colleges, and vocational schools that are accredited andare eligible to participate in student aid programs run by theDepartment of Education. albergo con colazione SopotReduction for certain benefits.You must reduce your qualified higher educational expenses bycertain benefits the student may have received. These benefitsinclude: Qualified scholarships that are exempt from tax (seePublication 520, Scholarships and Fellowships, forinformation on qualified scholarships), and Any other nontaxable payments (other than gifts, bequests,or inheritances) received for educational expenses, such as: Veterans' educational assistance benefits, Benefits under a qualified state tuition program, or Certain employer-provided educational assistancebenefits. Effect of other tax benefits.Do not include in your qualified expenses any expense used to: Figure an education credit on Form 8863, or Figure how much of a distribution from an education IRA youcan exclude from your income. For information about education credits or education IRAs, seePublication 970. Amount excludable.If the total proceeds (interest and principal) from the qualifiedU.S. savings bonds you redeem during the year are not more than yourqualified higher educational expenses for the year, you can excludeall of the interest. If the proceeds are more than the expenses, youcan exclude only part of the interest. To determine the excludable amount, multiply the interest part ofthe proceeds by a fraction. The numerator (top part) of the fractionis the qualified higher educational expenses you paid during the year.The denominator (bottom part) of the fraction is the total proceedsyou received during the year. Example.In February 2000, Mark and Joan, a married couple, cashed aqualified series EE U.S. savings bond they bought in November 1992.They received proceeds of $7,564, representing principal of $5,000 andinterest of $2,564. In 2000, they paid $4,000 of their daughter'scollege tuition. They are not claiming an education credit for thatamount, and they do not have an education IRA. They can exclude $1,356($2,564 ($4,000 $7,564)) of interest in 2000. Theymust pay tax on the remaining $1,208 ($2,564 - $1,356) interest. Figuring the interest part of the proceeds (Form 8815, line6).To figure the amount of interest to report on Form 8815, line 6,use the Line 6 Worksheet in the Form 8815 instructions. Pencil: If you previously reported any interest from savings bonds cashedduring 2000, use the Alternate Line 6 Worksheet belowinstead. Alternate Line 6Worksheet 1. Enter the amount from Form 8815, line 5            2. Enter the face value of all post-1989 series EEbonds cashed in 2000            3. Multiply line 2 above by 50% (.50)            4. Enter the face value of all series I bondscashed in 2000.            5. Add lines 3 and 4            6. Subtract line 5 from line 1            7. Enter the amount of interest reported as incomein previous years            8. Subtract line 7 from line 6. Enter the resulthere and on Form 8815, line 6            Modified adjusted gross income limit.The interest exclusion is limited if your modified adjusted grossincome (modified AGI) is: $54,100 to $69,100 for taxpayers filing single or head ofhousehold, and $81,100 to $111,100 for married taxpayers filing jointly, orfor a qualifying widow(er) with dependent child. You do not qualify for the interest exclusion if your modifiedAGI is equal to or more than the upper limit for your filing status. Modified AGI.Modified AGI, for purposes of this exclusion, is adjusted grossincome (line 20 of Form 1040A or line 34 of Form 1040) figured beforethe interest exclusion, and modified by adding back any: Foreign earned income exclusion, Foreign housing exclusion or deduction, Exclusion of income for bona fide residents of AmericanSamoa, Exclusion for income from Puerto Rico, Exclusion for adoption benefits received under an employer'sadoption assistance program, and Deduction for student loan interest. Use the worksheet in the instructions for line 9, Form 8815, tofigure your modified AGI. If you claim any of the items (1) -(6) listed above, add the amount of the exclusion or deduction to theamount 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 toroyalties and other investments is limited to your net investmentincome (see Investment Interest in chapter 3),you cannotfigure the deduction until you have figured this interest exclusion.Therefore, if you had interest expenses attributable to royalties anddeductible on Schedule E (Form 1040), you must make a specialcomputation of your deductible interest without regard to thisexclusion to figure the net royalty income included in your modifiedAGI. You can use a "dummy" Form 4952, Investment InterestExpense Deduction, to make the special computation. On thisform, include in your net investment income your total interest incomefor the year from series EE and I U.S. savings bonds. Use thedeductible interest amount from this form only to figure your modifiedAGI. Do not attach this form to your tax return. After you figure this interest exclusion, use a separate Form 4952to figure your actual deduction for investment interest expenses, andattach that form to your return. Files: Recordkeeping.If you claim the interestexclusion, 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 andinterest) of each bond. You can use Form8818, Optional Form ToRecord Redemption of Series EE and I U.S. Savings Bonds Issued After1989, to record this information. You should also keep bills,receipts, canceled checks, or other documentation that shows you paidqualified higher educational expenses during the year. U.S. Treasury Bills,Notes, and Bonds Treasury bills, notes, and bonds are direct debts (obligations) ofthe U.S. Government. Interest income from Treasury bills, notes, and bonds is subject tofederal income tax, but is exempt from all state and local incometaxes. You should receive Form 1099-INT showing the amount ofinterest (in box 3) that was paid to you for the year. Payments of principal and interest generally will be credited toyour designated checking or savings account by direct deposit throughthe TREASURY DIRECT system. Treasury bills.These bills generally have a 13-week, 26-week, or 52-week maturityperiod. They are issued at a discount in the amount of $1,000 andmultiples of $1,000. The difference between the discounted price youpay for the bills and the face value you receive at maturity isinterest income. Generally, you report this interest income when thebill is paid at maturity. See Discount on Short-Term Obligationsunder Discount on Debt Instruments, later. If you reinvest your Treasury bill at its maturity in a newTreasury bill, note, or bond, you will receive payment for thedifference between the proceeds of the maturing bill (par amount lessany tax withheld) and the purchase price of the new Treasury security.However, you must report the full amount of the interest income oneach of your Treasury bills at the time it reaches maturity. Treasury notes and bonds.Treasury notes have maturity periods of more than 1 year, rangingup to 10 years. Maturity periods for Treasury bonds are longer than 10years. Both of these Treasury issues generally are issued indenominations of $1,000 to $1 million. Both notes and bonds generallypay interest every 6 months. Generally, you report this interest forthe year paid. When the notes or bonds mature, you can redeem thesesecurities for face value. Treasury notes and bonds are usually sold by auction withcompetitive bidding. If, after compiling the competitive bids, adetermination is made that the purchase price is less than the facevalue, you will receive a refund for the difference between thepurchase price and the face value. This amount is considered originalissue discount. However, the original issue discount rules (discussedlater) 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 fromthe date of original issue to maturity. See De minimis OIDunder Original Issue Discount (OID), later. If thepurchase price is determined to be more than the face amount, thedifference is a premium. (See Bond Premium Amortization inchapter 3.) Envelope: For other information on these notes or bonds, write to: Bureau of the Public Debt Attn: Customer Information P.O. Box 1328 Parkersburg, WV 26106-1328. Computer: Or, on the Internet, visit: www. publicdebt.treas.gov Treasury Inflation-Indexed Securities.These securities pay interest twice a year at a fixed rate, basedon a principal amount that is adjusted to take into account inflationand deflation. For the tax treatment of these securities, seeInflation-Indexed Debt Instruments under OriginalIssue 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 Lossin chapter 4.Also see Nontaxable Trades in chapter 4for information about trading U.S. Treasury obligations for certainother designated issues. Bonds Sold Between Interest Dates If you sell a bond between interest payment dates, part of thesales price represents interest accrued to the date of sale. You mustreport that part of the sales price as interest income for the year ofsale. If you buy a bond between interest payment dates, part of thepurchase price represents interest accrued before the date ofpurchase. When that interest is paid to you, treat it as a return ofyour capital investment, rather than interest income, by reducing yourbasis in the bond. See Accrued interest on bonds underHow To Report Interest Income, later in this chapter, forinformation on reporting the payment. Insurance Life insurance proceeds paid to you as beneficiary of the insuredperson are usually not taxable. But if you receive the proceeds ininstallments, you must usually report part of each installment paymentas interest income. For more information about insurance proceeds received ininstallments, see Publication 525. Interest option on insurance.If you leave life insurance proceeds on deposit with an insurancecompany under an agreement to pay interest only, the interest paid toyou is taxable. Annuity.If you buy an annuity with life insurance proceeds, the annuitypayments you receive are taxed as pension and annuity income, not asinterest income. See Publication 939, General Rule for Pensionsand Annuities, for information on taxation of pension andannuity income. State or LocalGovernment Obligations Interest you receive on an obligation issued by a state or localgovernment is generally not taxable. The issuer should be able to tellyou whether the interest is taxable. The issuer should also give you aperiodic (or year-end) statement showing the tax treatment of theobligation. If you invested in the obligation through a trust, a fund,or other organization, that organization should give you thisinformation. Caution: 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 also apply to other dispositionsof the obligation. Tax-Exempt Interest Interest on a bond used to finance government operations generallyis not taxable if the bond is issued by a state, the District ofColumbia, 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 certainobligations issued after 1980). There are other requirements for tax-exempt bonds. Contact theissuing state or local government agency or see sections 103 and 141through 150 of the Internal Revenue Code and the related regulations. TaxTip: Obligations that are not bonds. Interest on a state orlocal government obligation may be tax exempt even if the obligationis not a bond. For example, interest on a debt evidenced only by anordinary written agreement of purchase and sale may be tax exempt.Also, interest paid by an insurer on default by the state or politicalsubdivision may be tax exempt. Registration requirement.A bond issued after June 30, 1983, generally must be in registeredform for the interest to be tax exempt. Indian tribal government.Bonds issued after 1982 by an Indian tribal government are treatedas issued by a state. Interest on these bonds is generally tax exemptif the bonds are part of an issue of which substantially all of theproceeds are to be used in the exercise of any essential governmentfunction. However, interest on private activity bonds (other thancertain bonds for tribal manufacturing facilities) is taxable. Original issue discount.Original issue discount (OID) on tax-exempt state or localgovernment bonds is treated as tax-exempt interest. For information on the treatment of OID when you dispose of atax-exempt bond, see Tax-exempt state and local government bondsunder 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 IssueDiscount (OID), later. Information reporting requirement.If you must file a tax return, you are required to show anytax-exempt interest you received on your return. This is aninformation-reporting requirement only. It does not change tax-exemptinterest to taxable interest. See Reporting tax-exempt interestunder How To Report Interest Income, later in this chapter. That discussion also explains what to do if you receive a Form1099-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 issuedafter 1983 is generally taxable. This rule does not applyto interest on obligations guaranteed by the following U.S. Governmentagencies. Bonneville Power Authority (if the guarantee was under theNorthwest 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 forhomebuyers. Generally, interest on state or local government homemortgage bonds issued after April 24, 1979, is taxable unless thebonds are qualified mortgage bonds or qualified veterans' mortgagebonds. Arbitrage bonds. Interest on arbitrage bonds issued by state or local governmentsafter October 9, 1969, is taxable. An arbitrage bond is a bond, anyportion of the proceeds of which is expected to be used to buy (or toreplace funds used to buy) higher yielding investments. A bond istreated as an arbitrage bond if the issuer intentionally uses any partof 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 partof a state or local government bond issue that meets both of thefollowing requirements. More than 10% of the proceeds of the issue is to be used fora private business use. More than 10% of the payment of the principal or interestis: Secured by an interest in property to be used for a privatebusiness use (or payments for this property), or Derived from payments for property (or borrowed money) usedfor a private business use. Also, a bond is generally considered a private activity bond ifthe amount of the proceeds to be used to make or finance loans topersons 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 taxexempt. A qualified bond is an exempt-facility bond (including anenterprise zone facility bond), qualified student loan bond, qualifiedsmall issue bond (including a tribal manufacturing facility bond),qualified redevelopment bond, qualified mortgage bond, qualifiedveterans' mortgage bond, or qualified 501(c)(3) bond (a bond issuedfor the benefit of certain tax-exempt organizations). Interest that you receive on these tax-exempt bonds (exceptqualified 501(c)(3) bonds), if issued after August 7, 1986, generallyis a "tax preference item" and may be subject to the alternativeminimum tax. See Form 6251 and its instructions for more information. Enterprise zone facility bonds. Interest on certain private activity bonds issued by a state orlocal government to finance a facility used in an empowerment zone orenterprise 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 youbought the bond after April 30, 1993, you can choose to accrue themarket discount over the period you own the bond and include it inyour income currently, as taxable interest. See Market DiscountBonds under Discount on Debt Instruments, later. Ifyou 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 thebond. For more information on the treatment of market discount when youdispose of a tax-exempt bond, see Discounted Debt Instrumentsunder Capital or Ordinary Gain or Loss in chapter 4.