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Pub. 550, Investment Income and Expenses 2006 Tax Year

1.   Investment Income

Table of Contents

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 Guide to Original Issue Discount (OID) 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 18 Who Have Investment Income of More Than $1,700

  • 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.

Records you should keep
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 18.   Part of a child's 2006 investment income may be taxed at the parent's tax rate. This may happen if all of the following are true.

  • The child was under age 18 at the end of 2006. A child born on January 1, 1989, is considered to be age 18 at the end of 2006.

  • The child had more than $1,700 of investment income (such as taxable interest and dividends) and has to file a tax return.

  • Either parent was alive at the end of 2006.


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:

  • Include your SSN on any return, statement, or other document,

  • Give your SSN to another person who has to include it on any return, statement, or other document, or

  • 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, 28% of the amount you are paid.

  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 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:

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

  • 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.

  • No underreporting occurred.

  • You have a bona fide dispute with the IRS about whether underreporting occurred.

  • Backup withholding will cause or is causing an undue hardship, and it is unlikely that you will underreport interest and dividends in the future.

  • 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.

  • The savings account legally belongs to the child.

  • The parents are not legally permitted to use any of the funds to support the child.

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

(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.)
Type of Income If you file Form 1040, report on ... If you can file Form 1040A, report on ... If you can file Form 1040EZ, report on ...
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
Taxable interest that totals more than $1,500 Line 8a; also use Schedule B Line 8a; 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  
Ordinary dividends that total $1,500 or less Line 9a (You may need to file Schedule B as well.) Line 9a (You may need to file Schedule 1 as well.)  
Ordinary dividends that total more than $1,500 Line 9a; also use Schedule B Line 9a; also use Schedule 1  
Qualified dividends (if you do not have to file Schedule D) Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet  
Qualified dividends (if you have to file Schedule D) Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet You cannot use Form 1040A.


You cannot use Form 1040EZ
Capital gain distributions (if you do not have to file Schedule D) Line 13; also use the Qualified Dividends and Capital Gain Tax Worksheet Line 10; also use the Qualified Dividends and Capital Gain Tax Worksheet  
Capital gain distributions (if you have to file Schedule D) Schedule D, line 13; also use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet    
Gain or loss from sales of stocks or bonds Line 13; also use Schedule D and the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet You cannot use Form 1040A  
Gain or loss from exchanges of like-kind investment property Line 13; also use Schedule D, Form 8824, and the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet    
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.

Interest Income

Terms you may need to know (see Glossary):

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

This section discusses the tax treatment of different types of interest income.

In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income. (It does not have to be entered in your passbook.) Exceptions to this rule are discussed later.

Form 1099-INT.   Interest income is generally reported to you on Form 1099-INT, or a similar statement, by banks, savings and loans, and other payers of interest. This form shows you the interest you received during the year. Keep this form for your records. You do not have to attach it to your tax return.

  Report on your tax return the total amount of interest income that you receive for the tax year.

Interest not reported on Form 1099-INT.   Even if you do not receive Form 1099-INT, you must still report all of your taxable interest income. For example, you may receive distributive shares of interest from partnerships or subchapter S corporations. This interest is reported to you on Schedule K-1 (Form 1065) and Schedule K-1 (Form 1120S).

Nominees.   Generally, if someone receives interest as a nominee for you, that person will give you a Form 1099-INT showing the interest received on your behalf.

  If you receive a Form 1099-INT that includes amounts belonging to another person, see the discussion on nominee distributions, later, under How To Report Interest Income.

Incorrect amount.   If you receive a Form 1099-INT that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. The new Form 1099-INT you receive will be marked “Corrected.”

Form 1099-OID.   Reportable interest income may also be shown on Form 1099-OID, Original Issue Discount. For more information about amounts shown on this form, see Original Issue Discount (OID), later in this chapter.

Exempt-interest dividends.   Exempt-interest dividends you receive from a regulated investment company (mutual fund) are not included in your taxable income. (However, see Information-reporting requirement, next.) Exempt-interest dividends should be shown in box 8 of Form 1099-INT.

Information-reporting requirement.   Although exempt-interest dividends are not taxable, you must show them on your tax return if you have to file. This is an information-reporting requirement and does not change the exempt-interest dividends into taxable income. See How To Report Interest Income, later.

Note.

Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. The exempt-interest dividends subject to the alternative minimum tax are shown in box 9 of Form 1099-INT. See Form 6251 and its instructions for more information about this tax. (Private activity bonds are discussed later under State or Local Government Obligations.)

Interest on VA dividends.   Interest on insurance dividends that you leave on deposit with the Department of Veterans Affairs (VA) is not taxable. This includes interest paid on dividends on converted United States Government Life Insurance policies and on National Service Life Insurance policies.

Individual retirement arrangements (IRAs).   Interest on a Roth IRA generally is not taxable. Interest on a traditional IRA is tax deferred. You generally do not include it in your income until you make withdrawals from the IRA. See Publication 590 for more information.

Taxable Interest — General

Taxable interest includes interest you receive from bank accounts, loans you make to others, and other sources. The following are some sources of taxable interest.

Dividends that are actually interest.   Certain distributions commonly called dividends are actually interest. You must report as interest so-called “dividends” on deposits or on share accounts in:

  • Cooperative banks,

  • Credit unions,

  • Domestic building and loan associations,

  • Domestic savings and loan associations,

  • Federal savings and loan associations, and

  • Mutual savings banks.

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

Certificates of deposit and other deferred interest accounts.   If you open any of these accounts, interest may be paid at fixed intervals of 1 year or less during the term of the account. You generally must include this interest in your income when you actually receive it or are entitled to receive it without paying a substantial penalty. The same is true for accounts that mature in 1 year or less and pay interest in a single payment at maturity. If interest is deferred for more than 1 year, see Original Issue Discount (OID), later.

Interest subject to penalty for early withdrawal.   If you withdraw funds from a deferred interest account before maturity, you may have to pay a penalty. You must report the total amount of interest paid or credited to your account during the year, without subtracting the penalty. See Penalty on early withdrawal of savings under How To Report Interest Income, later, for more information on how to report the interest and deduct the penalty.

Money borrowed to invest in certificate of deposit.   The interest you pay on money borrowed from a bank or savings institution to meet the minimum deposit required for a certificate of deposit from the institution and the interest you earn on the certificate are two separate items. You must report the total interest you earn on the certificate in your income. If you itemize deductions, you can deduct the interest you pay as investment interest, up to the amount of your net investment income. See Interest Expenses in chapter 3.

Example.

You deposited $5,000 with a bank and borrowed $5,000 from the bank to make up the $10,000 minimum deposit required to buy a 6-month certificate of deposit. The certificate earned $575 at maturity in 2006, but you received only $265, which represented the $575 you earned minus $310 interest charged on your $5,000 loan. The bank gives you a Form 1099-INT for 2006 showing the $575 interest you earned. The bank also gives you a statement showing that you paid $310 interest for 2006. You must include the $575 in your income. If you itemize your deductions on Schedule A (Form 1040), you can deduct $310, subject to the net investment income limit.

Gift for opening account.   If you receive noncash gifts or services for making deposits or for opening an account in a savings institution, you may have to report the value as interest.

  For deposits of less than $5,000, gifts or services valued at more than $10 must be reported as interest. For deposits of $5,000 or more, gifts or services valued at more than $20 must be reported as interest. The value is determined by the cost to the financial institution.

Example.

You open a savings account at your local bank and deposit $800. The account earns $20 interest. You also receive a $15 calculator. If no other interest is credited to your account during the year, the Form 1099-INT you receive will show $35 interest for the year. You must report $35 interest income on your tax return.

Interest on insurance dividends.   Interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable to you in the year it is credited to your account. However, if you can withdraw it only on the anniversary date of the policy (or other specified date), the interest is taxable in the year that date occurs.

Prepaid insurance premiums.   Any increase in the value of prepaid insurance premiums, advance premiums, or premium deposit funds is interest if it is applied to the payment of premiums due on insurance policies or made available for you to withdraw.

U.S. obligations.   Interest on U.S. obligations, such as U.S. Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes.

Interest on tax refunds.   Interest you receive on tax refunds is taxable income.

Interest on condemnation award.   If the condemning authority pays you interest to compensate you for a delay in payment of an award, the interest is taxable.

Installment sale payments.   If a contract for the sale or exchange of property provides for deferred payments, it also usually provides for interest payable with the deferred payments. That interest is taxable when you receive it. If little or no interest is provided for in a deferred payment contract, part of each payment may be treated as interest. See Unstated Interest and Original Issue Discount in Publication 537.

Interest on annuity contract.   Accumulated interest on an annuity contract you sell before its maturity date is taxable.

Usurious interest.   Usurious interest is interest charged at an illegal rate. This is taxable as interest unless state law automatically changes it to a payment on the principal.

Interest income on frozen deposits.   Exclude from your gross income interest on frozen deposits. A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because:

  • The financial institution is bankrupt or insolvent, or

  • The state in which the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent.

  The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of:

  • 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).

If you receive a Form 1099-INT for interest income on deposits that were frozen at the end of 2006, see Frozen deposits under How To Report Interest Income for information about reporting this interest income exclusion on your tax return.

  The interest you exclude is treated as credited to your account in the following year. You must include it in income in the year you can withdraw it.

Example.

$100 of interest was credited on your frozen deposit during the year. You withdrew $80 but could not withdraw any more as of the end of the year. You must include $80 in your income and exclude $20 from your income for the year. You must include the $20 in your income for the year you can withdraw it.

Bonds traded flat.    If you buy a bond at a discount when interest has been defaulted or when the interest has accrued but has not been paid, the transaction is described as trading a bond flat. The defaulted or unpaid interest is not income and is not taxable as interest if paid later. When you receive a payment of that interest, it is a return of capital that reduces the remaining cost basis of your bond. Interest that accrues after the date of purchase, however, is taxable interest income for the year received or accrued. See Bonds Sold Between Interest Dates, later in this chapter.

Below-Market Loans

If you make a below-market gift or demand loan, you must report as interest income any forgone interest (defined later) from that loan. The below-market loan rules and exceptions are described in this section. For more information, see section 7872 of the Internal Revenue Code and its regulations.

If you receive a below-market loan, you may be able to deduct the forgone interest as well as any interest that you actually paid, but not if it is personal interest.

Loans subject to the rules.   The rules for below-market loans apply to:

  • Gift loans,

  • Pay-related loans,

  • Corporation-shareholder loans,

  • Tax avoidance loans, and

  • Certain loans made to qualified continuing care facilities under a continuing care contract.

A pay-related loan is any below-market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services.

A tax avoidance loan is any below-market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement.

Forgone interest.   For any period, forgone interest is:

  • The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus

  • Any interest actually payable on the loan for the period.

Applicable federal rate.   Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. Some IRS offices have these bulletins available for research. See chapter 5 for other ways to get this information.

Rules for below-market loans.   The rules that apply to a below-market loan depend on whether the loan is a gift loan, demand loan, or term loan.

Gift and demand loans.   A gift loan is any below-market loan where the forgone interest is in the nature of a gift.

  A demand loan is a loan payable in full at any time upon demand by the lender. A demand loan is a below-market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate.

  A demand loan or gift loan that is a below-market loan is generally treated as an arm's-length transaction in which the lender is treated as having made:

  • A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and

  • An additional payment to the borrower in an amount equal to the forgone interest.

The borrower is generally treated as transferring the additional payment back to the lender as interest. The lender must report that amount as interest income.

  The lender's additional payment to the borrower is treated as a gift, dividend, contribution to capital, pay for services, or other payment, depending on the substance of the transaction. The borrower may have to report this payment as taxable income, depending on its classification.

These transfers are considered to occur annually, generally on December 31.

Term loans.   A term loan is any loan that is not a demand loan. A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan.

  A lender who makes a below-market term loan other than a gift loan is treated as transferring an additional lump-sum cash payment to the borrower (as a dividend, contribution to capital, etc.) on the date the loan is made. The amount of this payment is the amount of the loan minus the present value, at the applicable federal rate, of all payments due under the loan. An equal amount is treated as original issue discount (OID). The lender must report the annual part of the OID as interest income. The borrower may be able to deduct the OID as interest expense. See Original Issue Discount (OID), later.

Exceptions to the below-market loan rules.   Exceptions to the below-market loan rules are discussed here.

Exception for loans of $10,000 or less.   The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to:

  1. Gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and

  2. Pay-related loans or corporation-shareholder loans if the avoidance of federal tax is not a principal purpose of the interest arrangement.

This exception does not apply to a term loan described in (2) above that previously has been subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

Exception for loans to continuing care facilities.   Loans to qualified continuing care facilities under continuing care contracts are not subject to the rules for below-market loans for the calendar year if the lender or the lender's spouse is age 62 or older at the end of the year. For the definitions of qualified continuing care facility and continuing care contract, see Internal Revenue Code section 7872(h).

Exception for loans without significant tax effect.   Loans are excluded from the below-market loan rules if their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender. These loans include:

  1. Loans made available by the lender to the general public on the same terms and conditions that are consistent with the lender's customary business practice,

  2. Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public,

  3. Certain employee-relocation loans,

  4. Certain loans from a foreign person, unless the interest income would be effectively connected with the conduct of a U.S. trade or business and would not be exempt from U.S. tax under an income tax treaty,

  5. Gift loans to a charitable organization, contributions to which are deductible, if the total outstanding amount of loans between the organization and lender is $250,000 or less at all times during the tax year, and

  6. Other loans on which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower.

For a loan described in (6) above, all the facts and circumstances are used to determine if the interest arrangement has a significant effect on the federal tax liability of the lender or borrower. Some factors to be considered are:

  • Whether items of income and deduction generated by the loan offset each other,

  • The amount of these items,

  • The cost to you of complying with the below-market loan rules, if they were to apply, and

  • Any reasons other than taxes for structuring the transaction as a below-market loan.

If you structure a transaction to meet this exception, and one of the principal purposes of structuring the transaction in that way is the avoidance of federal tax, the loan will be considered a tax-avoidance loan and this exception will not apply.

Limit on forgone interest for gift loans of $100,000 or less.   For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of federal tax is one of the main purposes of the interest arrangement.

Effective dates.    These rules apply to term loans made after June 6, 1984, and to demand loans outstanding after that date.

U.S. Savings Bonds

This section provides tax information on U.S. savings bonds. It explains how to report the interest income on these bonds and how to treat transfers of these bonds.

U.S. savings bonds currently offered to individuals are the following.

  • Series EE bonds

  • Series I bonds

Address you may need
For other information on U.S. savings bonds, write to:

For Series HH/H:

Bureau of the Public Debt
Division of Customer Assistance
P.O. Box 2186
Parkersburg, WV 26106-2186.



For Series EE and I

Bureau of the Public Debt
Division of Customer Assistance
P.O. Box 7012
Parkersburg, WV 26106-7012.

Access by computer
Or, on the Internet, visit:
www.treasurydirect.gov/indiv/products/products.htm/.

Accrual method taxpayers.   If you use an accrual method of accounting, you must report interest on U.S. savings bonds each year as it accrues. You cannot postpone reporting interest until you receive it or until the bonds mature.

Cash method taxpayers.   If you use the cash method of accounting, as most individual taxpayers do, you generally report the interest on U.S. savings bonds when you receive it. But see Series EE and series I bonds, below.

Series HH bonds.   These bonds were issued at face value. Interest is paid twice a year by direct deposit to your bank account. If you are a cash method taxpayer, you must report interest on these bonds as income in the year you receive it.

  Series HH bonds were first offered in 1980; they were last offered in August 2004. Before 1980, series H bonds were issued. Series H bonds are treated the same as series HH bonds. If you are a cash method taxpayer, you must report the interest when you receive it.

  Series H bonds have a maturity period of 30 years. Series HH bonds mature in 20 years.

Series EE and series I bonds.   Interest on these bonds is payable when you redeem the bonds. The difference between the purchase price and the redemption value is taxable interest.

Series EE bonds.   Series EE bonds were first offered in July 1980. They have a maturity period of 30 years. Before July 1980, series E bonds were issued. The original 10-year maturity period of series E bonds has been extended to 40 years for bonds issued before December 1965 and 30 years for bonds issued after November 1965. Paper series EE and series E bonds are issued at a discount. The face value is payable to you at maturity. Electronic series EE bonds are issued at their face value. The face value plus accrued interest is payable to you at maturity.

   Owners of paper series E and EE bonds can convert them to electronic bonds. These converted bonds do not retain the denomination listed on the paper certificate but are posted at their purchase price (with accrued interest).

Series I bonds.   Series I bonds were first offered in 1998. These are inflation-indexed bonds issued at their face amount with a maturity period of 30 years. The face value plus all accrued interest is payable to you at maturity.

Reporting options for cash method taxpayers.   If you use the cash method of reporting income, you can report the interest on series EE, series E, and series I bonds in either of the following ways.

  1. Method 1. Postpone reporting the interest until the earlier of the year you cash or dispose of the bonds or the year in which they mature. (However, see Savings bonds traded, later.)
    Note. Series E bonds issued in 1976 matured in 2006. If you have used method 1, you generally must report the interest on these bonds on your 2006 return.

  2. Method 2. Choose to report the increase in redemption value as interest each year.


You must use the same method for all series EE, series E, and series I bonds you own. If you do not choose method 2 by reporting the increase in redemption value as interest each year, you must use method 1.

Tip
If you plan to cash your bonds in the same year that you will pay for higher educational expenses, you may want to use method 1 because you may be able to exclude the interest from your income. To learn how, see Education Savings Bond Program, later.

Change from method 1.   If you want to change your method of reporting the interest from method 1 to method 2, you can do so without permission from the IRS. In the year of change, you must report all interest accrued to date and not previously reported for all your bonds.

  Once you choose to report the interest each year, you must continue to do so for all series EE, series E, and series I bonds you own and for any you get later, unless you request permission to change, as explained next.

Change from method 2.   To change from method 2 to method 1, you must request permission from the IRS. Permission for the change is automatically granted if you send the IRS a statement that meets all the following requirements.

  1. You have typed or printed at the top, “Change in Method of Accounting Under Section 6.01 of the Appendix of Rev. Proc. 2002-9” (or later update).

  2. It includes your name and social security number under the label in (1).

  3. It identifies the savings bonds for which you are requesting this change.

  4. It includes your agreement to:

    1. Report all interest on any bonds acquired during or after the year of change when the interest is realized upon disposition, redemption, or final maturity, whichever is earliest, and

    2. Report all interest on the bonds acquired before the year of change when the interest is realized upon disposition, redemption, or final maturity, whichever is earliest, with the exception of the interest reported in prior tax years.

  5. It includes your signature.

You must attach this statement to your tax return for the year of change, which you must file by the due date (including extensions).

  You can have an automatic extension of 6 months from the due date of your return for the year of change (excluding extensions) to file the statement with an amended return. At the top of the statement, enter “Filed pursuant to section 301.9100-2.” To get this extension, you must have filed your original return for the year of the change by the due date (including extensions).

  
Address you may need
 By the date you file the original statement with your return, you must also send a copy to the address below.

  

Internal Revenue Service
Attention: CC: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 the address below.

Internal Revenue Service
Attention: CC:IT&A (Automatic Rulings Branch)
1111 Constitution Avenue, NW
Washington, DC 20224.

  Instead of filing this statement, you can request permission to change from method 2 to method 1 by filing Form 3115. In that case, follow the form instructions for an automatic change. No user fee is required.

Co-owners.   If a U.S. savings bond is issued in the names of co-owners, such as you and your child or you and your spouse, interest on the bond is generally taxable to the co-owner who bought the bond.

One co-owner's funds used.   If you used your funds to buy the bond, you must pay the tax on the interest. This is true even if you let the other co-owner redeem the bond and keep all the proceeds. Under these circumstances, since the other co-owner will receive a Form 1099-INT at the time of redemption, the other co-owner must provide you with another Form 1099-INT showing the amount of interest from the bond that is taxable to you. The co-owner who redeemed the bond is a “nominee.” See Nominee distributions under How To Report Interest Income, later, for more information about how a person who is a nominee reports interest income belonging to another person.

Both co-owners' funds used.   If you and the other co-owner each contribute part of the bond's purchase price, the interest is generally taxable to each of you, in proportion to the amount each of you paid.

Community property.   If you and your spouse live in a community property state and hold bonds as community property, one-half of the interest is considered received by each of you. If you file separate returns, each of you generally must report one-half of the bond interest. For more information about community property, see Publication 555, Community Property.

Table 1-2.   These rules are also shown in Table 1-2.

Child as only owner.   Interest on U.S. savings bonds bought for and registered only in the name of your child is income to your child, even if you paid for the bonds and are named as beneficiary. If the bonds are series EE, series E, or series I bonds, the interest on the bonds is income to your child in the earlier of the year the bonds are cashed or disposed of or the year the bonds mature, unless your child chooses to report the interest income each year.

Choice to report interest each year.   The choice to report the accrued interest each year can be made either by your child or by you for your child. This choice is made by filing an income tax return that shows all the interest earned to date, and by stating on the return that your child chooses to report the interest each year. Either you or your child should keep a copy of this return.

  Unless your child is otherwise required to file a tax return for any year after making this choice, your child does not have to file a return only to report the annual accrual of U.S. savings bond interest under this choice. However, see Tax on investment income of a child under age 18, earlier, under General Information. Neither you nor your child can change the way you report the interest unless you request permission from the IRS, as discussed earlier under Change from method 2.

Ownership transferred.   If you bought series E, series EE, or series I bonds entirely with your own funds and had them reissued in your co-owner's name or beneficiary's name alone, you must include in your gross income for the year of reissue all interest that you earned on these bonds and have not previously reported. But, if the bonds were reissued in your name alone, you do not have to report the interest accrued at that time.

  This same rule applies when bonds (other than bonds held as community property) are transferred between spouses or incident to divorce.

Example.

You bought series EE bonds entirely with your own funds. You did not choose to report the accrued interest each year. Later, you transfer the bonds to your former spouse under a divorce agreement. You must include the deferred accrued interest, from the date of the original issue of the bonds to the date of transfer, in your income in the year of transfer. Your former spouse includes in income the interest on the bonds from the date of transfer to the date of redemption.

Table 1-2. Who Pays the Tax on U.S. Savings Bond Interest

IF ... THEN the interest must be reported by ...
you buy a bond in your name and the name of another person as co-owners, using only your own funds you.
you buy a bond in the name of another person, who is the sole owner of the bond the person for whom you bought the bond.
you and another person buy a bond as co-owners, each contributing part of the purchase price both you and the other co-owner, in proportion to the amount each paid for the bond.
you and your spouse, who live in a community property state, buy a bond that is community property you and your spouse. If you file separate returns, both you and your spouse generally report one-half of the interest.

Purchased jointly.   If you and a co-owner each