Interest Income
63 Interest Income
Taxable interest includes interest received from bank accounts, certificate of deposits, loans to others and other sources. The following are sources of taxable interest:
1. Dividends that are actually interest must be reported as interest on accounts in:
Cooperative banks
Credit Unions
Domestic building and loan associations
Domestic savings and loan associations
Federal savings and loan associations
Mutual savings banks
2. Money market certificates, savings certificates and other deferred interest accounts.
3. Interest subject to penalty for early withdrawal – report the full amount of interest without subtracting the penalty on early withdrawal. The penalty is reported as an adjustment to income.
4. Gifts for opening an account - Gifts or services for deposits less than $5,000 valued at more than $10 or for deposits of $5,000 or more valued at $20 or more must be reported as interest. The value is determined by the financial institution and included on Form 1099-INT.
5. Interest on insurance dividends is taxable in the year the interest is received.
6. Interest on U.S. obligations is taxable for federal income tax purposes.
7. Municipal bonds or interest on obligations used to finance government is not taxable if issued by a state, the District of Columbia, a U.S. possession or any of their subdivisions.
8. Treasury Bills generally have a 4-week, 13-week, or 26-week maturity period. They are issued at a discount in the amount of $1,000 and multiples of $1,000. The difference between the discounted price paid for the bills and the face value received at maturity is interest income. The interest is generally reported at maturity.
9. Money market interest is taxable in the year it is received or credited to the taxpayers account and can be withdrawn without substantial penalty. Interest on the money market account is not taxable if the interest is not credited to the taxpayer's account until maturity and withdrawal or redemption would result in a substantial penalty.
10. OID - When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called original issue discount (OID). Interest is reported on 1099-OID.
Adjustments are sometimes needed for OID interest because the issuing company does not track the activity of the bond.
11. Interest on tax refunds.
12. Interest on installment sale payments is taxable when received. Refer to Pub 537
13. The interest from a bearer and coupon bond is taxable the year the bonds are due and payable regardless of when they are presented for collection.
14. Interest paid on money borrowed to invest is a separate transaction from the money earned on the investment. The interest paid on the money borrowed is deductible if the taxpayer itemizes. Report investment interest expense on Form 4952.
Excerpt from Pub 17
64 Usurious Interest
Usurious interest is interest charged at an illegal rate. This is taxable interest unless state law automatically changes it to a payment on the principal
Interest on an IRA
Interest on a Roth IRS is generally not taxable. Interest on a traditional IRA is tax deferred, and generally not included in income until withdrawals are from the IRA.
When to Report Interest
Interest is reported depending on the method of accounting. Most individuals use the cash method of accounting. Generally under this method the interest is reported in the year it is actually or constructively received. When interest is credited to an account or made available to the taxpayer it is constructively received. If the taxpayer is using an accrual method of accounting the interest is taxable when it is accrued, whether or not the taxpayer has received it.
How Interest is Reported to the Taxpayer?
Taxable interest is reported to the taxpayer on Form 1099-INT in Box 1 except for U.S. savings bonds and Treasury obligations, and OID. All taxable interest must be reported whether or not Form 1099 is received.
Which Form is used to Report Interest Income?
The taxpayer may only use Form 1040EZ if the interest income is less than $1,500.
If the taxpayer is filing form 1040 or 1040A, Schedule B (1040) must be completed if any of the following are true:
1. Taxable interest income exceeds $1,500.
2. The taxpayer is claiming the interest exclusion under the Education Savings Bond Program.
3. Seller-financed mortgage interest and the buyer used the property as a home.
4. The taxpayer received a 1099-INT for savings bond interest (Box 3).
5. The taxpayer received a 1099-INT for tax exempt interest.
6. The taxpayer received as a nominee interest that was reported by someone else.
If the taxpayer had interest from or authority over a foreign bank account they must file Form 1040 and use Schedule B to report the interest.
Interest is considered nominee interest when the registered owner receives a 1099-INT with interest income in his/her name, but the interest actually belongs to someone else. The full amount of interest must be reported. On a separate line below the total of all interest reported label the nominee interest received as "Nominee Distribution" and subtract it from the total.
Note: Form 1099-INT must be issued by the taxpayer (using the name of the taxpayer as the payer) reporting the nominee distribution to the actual owner of the interest.
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The Education Savings Bond Program allows interest received on Series EE Bonds issued after 1989 or a Series I Bond to a taxpayer over the age of 24 may exclude the interest income from that bond if during the year the taxpayer paid qualified higher education expenses to an eligible educational institution. Refer to Form 8815 for instructions and limitations.
Dividend Income
Dividends are distributions of money, stock or other property paid to the taxpayer by a corporation.
Dividends may be received by a taxpayer through a partnership, an estate, a trust, or an association that is taxed as a corporation.
Ordinary dividends are the most common type of dividends and are paid out of earnings and profits of a corporation.
Ordinary dividends are reported on Form 1099-DIV box 1a.
Ordinary dividends that are not ―qualified‖ are taxed as ordinary income.
Excerpt from 2010 Pub 17.
Qualified Dividends are shown in box 1b of Form 1099-DIV.
The dividends must have been paid by a U.S. Corporation or a qualified foreign corporation. The dividends must meet the holding period. dividends are reported on 9b. Qualified dividends are carried to page 2 of Schedule D, line 23. If the total interest and dividends are less than $1,500, Schedule B is not required.
Ordinary dividends reinvested into stock through a dividend reinvestment plan must be reported in income.
Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions.
These capital gain distributions are reported in Box 2a of Form 1099-DIV. If 1099-DIV has only capital gain distributions in Box 2a and 2b the amount can be reported on line 13a and 13b of the 1040 and check the box on the line.
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When Schedule D is required in the return the capital gain distributions will net with the other capital gains on the Schedule D.
Nontaxable Distributions
A nontaxable distribution is a return of capital or a tax-free distribution of shares of stock or stock rights. It is a return of the investment in the stock of the company. Distributions by a corporation of its own stock are commonly known as stock dividends. Stock rights or options are distributions by a corporation of rights to acquire the corporation stock. Generally these nontaxable distributions are not reported on the tax return.
Dividends Used to Buy More Stock
The corporation in which the taxpayer owns stock may have a dividend reinvestment plan. The dividend reinvestment plan purchases more stock at the fair market value with the dividends. Dividends used in a dividend reinvestment plan must be reported as the fair market value of the additional stock on the dividend payment date.
How to Report Dividend Income
Dividends are reported to the taxpayer on Form 1099-DIV if you received more than $10 in dividends. Ordinary and qualified dividends are included in adjusted gross income.
Taxpayers report dividends on Form 1040 or 1040A. Ordinary dividends are reported on Line 9a and qualified dividends on line 9b. Dividends are reported on Schedule B, Part II if the dividends earned are more than $1500 or if the taxpayer received dividends as a nominee.
Expenses related to dividend income may be deducted on Schedule A as a miscellaneous deduction subject to 2% of the adjusted gross income.
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Chapter 6 - Sample Questions
1. Which of the following is not taxable interest received?
A. Interest on a bank account B. Interest on loans to others C. Capital gain distributions
D. Interest from certificate of deposits
2. The taxpayer must complete Schedule B if filing Form 1040 and any of the following apply, except:
A. Taxable interest of more than $1500 B. Taxable interest of $500
C. Interest received as a nominee, that belongs to someone else
D. The taxpayer is claiming an exclusion under the Education Savings Bond Program
3. Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes
A. True B. False
4. Taxable interest from U.S. savings bonds are reported to the taxpayer using this form:
A. Form 1099-DIV, box 4a B. Form Schedule B, box 2b C. Form 1098, box 3
D. Form 1099-INT box 3
5. Which of the following is an acceptable maturity period for Treasury Bills?
A. 4-week, B. 15-week, C. 30-week
D. None of the above
6. Dividends that really are interest come from the following sources, except A. Cooperative banks
B. Credit Unions
C. Domestic building and loan associations D. Mutual fund accounts
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7. The difference between the discounted price the taxpayer pays for the bills and the ________
received at maturity is interest income.
A. Face value
B. Original issue discount C. Cooperative amount D. None of the above
8. When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called which of the following?
A. Capital loss B. Discounted debt C. Original issue discount D. Ordinary dividend
9. The taxpayer is allowed to use Form 1040EZ if interest income is less than _______.
A. $400 B. $1500 C. $1200
D. None of the above
10. $100 of interest was credited on the taxpayer’s frozen deposit during 2010. The taxpayer withdrew
$80 but could not withdraw any more as of the end of the year. The taxpayer must include ____ in their income.
A. $100.
B. $20 C. $80 D. $0
11. When the registered owner receives a 1099-INT, but the interest actually belongs to someone else it is considered:
A. A mistake
B. Nominee Interest C. Mortgage Interest D. None of the above
12. _______ are distributions of money, stock or other property paid to the taxpayer by a corporation.
A. Dividends B. Stocks C. Bonds D. Interest
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13. Which of the following are not ways dividends may be received?
A. Partnership B. Estate C. Corporation D. Fringe Benefits
14. The most common type of dividends paid out of earnings and profits of a corporation are called:
A. Qualified Dividends B. Ordinary Dividends C. Standard Dividends D. Bank Dividends
15. A nondividend distribution reduces the basis of the stock. It is not taxed until the basis in the stock is fully recovered.
A. True B. False
16. Tax on ______________is taxed at the same rate as long-term capital gains received in 2010.
A. Qualified Dividends B. Ordinary Dividends C. Adjusted Gross Income D. Schedule D
17. Ordinary dividends reinvested into stock through a dividend reinvestment plan must be reported as:
A. Adjustment to income B. Income
C. Credit on tax due D. Deduction
18. Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions.
A. True B. False
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Chapter 6 – Answers to Sample Questions
1. C – Capital gain distributions are reported either on Schedule D or on line 13 of Form 1040 and check the box. (Form 1040 inst., page 22)
2. B - The taxpayer must complete Schedule B if filing Form 1040 and any of the following apply:
(Pub 17, Pg 57)
3. A - Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes is a true statement. (Pub 17, pg 56)
4. Taxable interest from U.S. savings bonds are reported to the taxpayer using Form 1099-INT box 3.
(Pub 17, pg 59)
5. A - Treasury Bills generally have a 4-week, 13-week, 26-week, or 52-week maturity period. (Pub 17, pg 60)
6. D - Mutual fund dividends are dividends. (Pub 17, pg 56)
7. A - The difference between the discounted price the taxpayer pays for the bills and the face value received at maturity is interest income. (Pub 17, pg 60)
8. C - When a long-term debt instrument is issued at a price that is lower than its stated redemption value, the difference is called original issue discount. (Pub 17, pg 56)
9. B - The taxpayer is allowed to use Form 1040EZ if interest income is less than $1500. (Pub 17, pg 61)
10. C - $100 of interest was credited on the taxpayer’s frozen deposit during 2010. The taxpayer withdrew $80 but could not withdraw any more as of the end of the year. The taxpayer must include $80 in their income
A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because:
The financial institution is bankrupt or insolvent, or
The state where the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent.
The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of:
The net amount you withdrew from these deposits during the year, and
The amount you could have withdrawn as of the end of the year (not reduced by any penalty for premature withdrawals of a time deposit). (Pub 17, pg 57)
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11. When the registered owner receives a 1099-INT, but the interest actually belongs to someone else it is considered nominee interest. (Pub 17, pg 62)
12. A - Dividends are distributions of money, stock or other property paid to the taxpayer by a corporation. (Pub 17, pg 63)
13. D- is incorrect. Dividends may be received from a partnership, an estate, or a corporation. (Pub 17, pg 63)
14. B - The most common type of dividends paid out of earnings and profits of a corporation are called ordinary dividends. (Pub 17, pg 63)
15. A -A nondividend distribution reduces the basis of the stock. It is not taxed until the basis in the stock is fully recovered. This is a true statement. (Pub 17, pg 65)
16. A - Tax on qualified dividends is taxed at the same rate as long-term capital gains received in 2010. (Pub 17, pg 63)
17. B - Ordinary dividends reinvested to buy more stock at the fair market value into through a dividend reinvestment plan must be reported as income. (Pub 17, pg 64)
18. A - Regulated investment companies (mutual funds) and real estate investment trusts (REITs) pay capital gain distributions is a true statement. (Pub 17, pg 65)
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