Interest income

06 Dec, 2015 TAX LAW 0

Chapter 7
Interest income

Introduction

Interest income is a significant portion of all income earned by many Americans. The government takes pains to make sure that all such income is reported by taxpayers. That’s why payers of interest, like banks, are required to report to the government the amounts of interest they pay out and to whom. If you do not supply your proper tax identification number–usually your social security number–to a payer of interest, tax will automatically be withheld.

Some investments permit you to defer reporting interest income. Such investments may boost the after-tax rate of return on your money, because you may pay tax on the income in a year–a retirement year, for example–when your tax rate is lower. This chapter outlines several tax planning ideas for deferring taxes on interest income.

What’s New

Income limits for excluding education savings bond interest increased. In order to exclude interest, your modified adjusted gross income (MAGI) must be less than $91,000 ($143,950 if married filing jointly or qualifying widow(er)).

Reminder

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

TAXALERT

Form 8938, Statement of Specified Foreign Financial Assets, must be filed with your annual income tax return if you have an interest in specified foreign financial assets with an aggregate value of over $50,000. If a specified foreign financial asset was sold during the year, you must take the asset sold into consideration when calculating the aggregate value of specified foreign financial assets you held during the year.

While most tax forms report income you receive, Form 8938 is different; it is an informational disclosure that is not used to calculate any part of your tax liability. It is used to provide information to the IRS on a range of foreign accounts and assets that may or may not actually generate taxable income.

Reportable specified foreign financial assets include, but are not limited to, financial accounts located at foreign financial institutions; interests in foreign mutual funds, hedge funds, and private equity funds; directly owned foreign stock or foreign partnership interests; and beneficial interests in foreign trusts or estates. Reportable assets also include financial instruments or contracts with a foreign issuer or counterparty, a category which may include derivatives offered by non-U.S. persons, foreign deferred compensation, or pension plans and insurance contracts purchased from a foreign insurance company.

If you fail to report foreign financial assets on Form 8938, you may be subject to a penalty of $10,000, and potentially an additional $50,000 penalty for continued failure to report after receiving IRS notification to file. In addition, underpayments of tax attributable to nondisclosed foreign financial assets are subject to a substantial understatement penalty of 40%.

You may also have a U.S. Treasury Department filing obligation to report your financial interest in or signature authority over any financial accounts in a foreign country, if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year. It is important to note that this rule applies to any financial accounts that you hold as an individual or through a partnership in which you have a greater than 50% ownership interest. You must report that relationship each calendar year by electronically filing a Financial Crimes Enforcement Network (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts (often referred to as the “FBAR”). FinCEN Form 114 supersedes TD F 90-22.1 (the FBAR form that was used in prior years) and is only available online through the BSA E-Filing System website. The system allows the filer to enter the calendar year reported, including past years, on the online FinCEN Form 114. It also offers an option to “explain a late filing,” or to select “Other” to enter up to 750-characters within a text box where the filer can provide a further explanation of the late filing or indicate whether the filing is made in conjunction with an IRS compliance program.

On July 29, 2013, FinCEN posted a notice on their internet site that introduced a new form to filers who submit FBARs jointly with spouses or who wish to have a third-party preparer file their FBARs on their behalf. The new FinCEN Form 114a, Record of Authorization to Electronically File FBARs, is not submitted with the filing but, instead, is maintained with the FBAR records by the filer and the account owner, and made available to FinCEN or the IRS on request.

Previous IRS guidance clarified that, although foreign mutual funds remain reportable financial accounts for the purpose of this reporting obligation, interests in private equity funds, hedge funds, and other “commingled funds” are not subject to reporting.

The FBAR is not filed with your income tax return. Rather, this form must be electronically filed separately with the Department of the Treasury on or before June 30 of the succeeding year. A substantial penalty may apply if you fail to completely disclose your foreign accounts or file the FBAR on time. Therefore, you should file a complete and accurate FBAR as early in June as possible in order to allow adequate time for electronic submission.

This chapter discusses the following topics.

Different types of interest income.
What interest is taxable and what interest is nontaxable.
When to report interest income.
How to report interest income on your tax return.

In general, any interest you receive or that is credited to your account and can be withdrawn is taxable income. Exceptions to this rule are discussed later in this chapter.

You may be able to deduct expenses you have in earning this income on Schedule A (Form 1040) if you itemize your deductions. See Money borrowed to invest in certificate of deposit, later, and chapter 29.

Useful Items

You may want to see:

Publication

537 Installment Sales
550 Investment Income and Expenses
1212 Guide to Original Issue Discount (OID) Instruments

Form (and Instructions)

Schedule B (Form 1040A or 1040) Interest and Ordinary 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
8960 Net Investment Income Tax—Individuals, Estates, and Trusts

General Information

A few items of general interest are covered here.

TAXALERT

Net Investment Income Tax (NIIT). The NIIT applies at a rate of 3.8% on the lesser of certain “Net Investment Income” (NII) of individuals or (2) the excess of modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly or qualifying widow(er) with dependent child; $125,000 if married filing separately). Generally, NII includes interest income.

NII subject to the tax is defined as investment income reduced by allocable deductions. Investment income generally includes interest income, as well as dividends and other items. The NIIT is assessed in addition to income taxes due on interest and other net investment income, and is payable regardless of whether you otherwise pay any regular income tax or are subject to the alternative minimum tax on your income. For more information, see Net Investment Income Tax (NIIT) in chapter 31, How to figure your tax, and Form 8960.

Recordkeeping. You should keep a list showing sources and interest amounts received during the year. Also, keep the forms you receive showing your interest income (Forms 1099-INT, for example) as an important part of your records.

Tax on unearned income of certain children. Part of a child’s 2014 unearned income may be taxed at the parent’s tax rate. If so, Form 8615, Tax for Certain Children Who Have Unearned Income, must be completed and attached to the child’s tax return. If not, Form 8615 is not required and the child’s income is taxed at his or her own tax rate.

Tax Breaks and Deductions You Can Use Checklist

Interest income. Interest income that is subject to federal tax is taxed as ordinary income and is subject to tax at your marginal tax rate (currently as high as 39.6%). (Interest paid on most municipal bonds is exempt from federal income tax. See Government Bond Interest, discussed later.) You should compare federally taxable interest income to qualified dividend income, which is currently subject to a 20% tax rate for taxpayers who are otherwise in the 39.6% bracket on their other ordinary income, 15% rate for taxpayers who are otherwise in the 25%, 28%, 33%, or 35% tax brackets and 0% rate for taxpayers who are otherwise in the 10% or 15% tax brackets. Although you may think that some items are dividend income, they may actually be interest–such as interest paid on a bank money market account. (Dividends on money market funds, like those sold by mutual fund companies, are dividends but are not qualified dividends.)

Withholding on interest income. Interest income is usually not subject to income tax withholding. But the payer may be required to withhold tax and you may be subject to a penalty if you don’t provide your correct social security number. So make sure you provide the correct information when you open an account or buy a bond. Certain interest income paid to nonresident aliens may be subject to withholding at a 30% rate under the tax law. However, there may be a tax treaty in place between the United States and the nonresident alien’s home country that may reduce the withholding to a lower rate.

Government bond interest. Interest on federal bonds is subject to federal taxation but not to state and local tax. Although the interest on most municipal bonds is not subject to federal income taxation, the amount of that interest earned must be reported on page 1, Line 8b, of your Form 1040. Interest on municipal “private activity” bonds is not subject to regular federal income tax but is subject to the alternative minimum tax.

Family loans. If you make a loan to a member of your family (or anyone else) without charging interest, you may have to recognize interest income anyway. There are exceptions based on the size of the loan and other factors, so make sure you check out the discussion in this chapter before you make such a loan.

Series E, Series EE, and Series I bonds. If you own these bonds, and are a cash method taxpayer, you can choose whether or not to report the increase in value of the bonds as income each year or instead report the interest income when the bonds are cashed in or when they reach final maturity (whichever is earlier). This enables you to control when the income is recognized. If you decide to hold off on recognizing interest earned until you redeem your bonds, consider cashing them in a year when you are subject to a low tax rate in order to minimize the tax you’ll need to pay on the bonds.

Some parents can choose to include the child’s interest and dividends on the parent’s return. If you can, use Form 8814, Parents’ Election To Report Child’s Interest and Dividends, for this purpose.

For more information about the tax on unearned income of children and the parents’ election, see chapter 32.

Beneficiary of an estate or trust. Interest 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 (Form 1041) 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 or individual tax identification number (ITIN) 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. If you do not give your SSN or ITIN to the payer of interest, you may have to pay a penalty.

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. This is because only one name and SSN can be shown on Form 1099.

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 interest on an account owned by your child, even though the interest is paid to you as custodian.

Penalty for failure to supply SSN. If you do not give your SSN to the payer of interest, you may have to pay a penalty. See Failure to supply SSN under Penalties in chapter 1. Backup withholding also may apply.

Backup withholding. Your interest 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 payer of interest must withhold, as income tax, on the amount you are paid, applying the appropriate withholding rate.

Backup withholding may also be required if the IRS has determined that you underreported your interest or dividend income. For more information, see Backup Withholding in chapter 4.

Reporting backup withholding. If backup withholding is deducted from your interest income, the payer must give you a Form 1099-INT for the year indicating the amount withheld. The Form 1099-INT will show any backup withholding as “Federal income tax withheld.”

Joint accounts. If two or more persons hold property (such as a savings account or bond) as joint tenants, tenants by the entirety, or tenants in common, each person’s share of any interest from the property is determined by local law.

EXPLANATION

Whether or not a person receives a share of any interest from a property depends on state law and the intentions of the parties.

Many people open a joint bank account with a friend or a relative so that the friend or relative may inherit the property more easily upon the owner’s death. In such cases, no immediate transfer of property interest is intended. In these circumstances, the interest income should be reported solely by the owner who contributed the money.

If a parent does not transfer bonds to his or her child but uses joint tenancy so that ownership of the bonds will pass automatically to the child in case of his or her death, the income belongs to the parent. The parent’s social security number should be used, and all income should be reported on the parent’s return. The same applies to joint savings accounts, other bank accounts, and certificates of deposit.

If a parent does intend to transfer during his or her lifetime some or all of his or her bonds to a child, a proportionate amount of interest should be included in both of their tax returns. Either person’s social security number may be used.

Note: Bonds, savings accounts, and the like that are in the name of a parent or other adult as custodian under a state’s Uniform Gifts or Transfers to Minors Act should use the child’s social security number.

TAXPLANNER

Since only one social security number will be recorded by the payer of interest, the IRS’s document-matching program may issue deficiency notices when interest income is split between two or more returns. This situation arises because the tax return with the social security number shown on the payer’s records may not include the full amount of the interest paid. To reduce the chance of receiving an IRS deficiency notice, show both the full amount of the interest paid and a subtraction for “amount attributable to others,” or “held as nominee for xx(insert name),” including their social security numbers, on Schedule B (Form 1040 or Form 1040A) in the section used for reporting distributions of income.

The person who receives the other part of the interest need not worry. Although that person includes on his or her return an amount for which he or she does not receive a Form 1099-INT, the IRS rarely questions returns where income in excess of that computed by the government is reported.

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 minor child, 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.

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 interest income you receive for the tax year.

TAXSAVER

The IRS contends that the figures shown on Form 1099 represent the correct amount of interest income paid to you. You have the burden of proof to demonstrate otherwise. If you have a valid reason for claiming that the correct amount is different, write on your return the amount shown on Form 1099 and then immediately show a subtraction (or addition) with an explanation for the adjustment. If you notice an error in the amount of interest stated, you should request that the payer issue a corrected Form 1099.

Example

You buy a bond on May 29, 2014, which pays interest once a year on December 31. Because you bought the bond between the interest payment dates, you pay, in addition to the cost of the bond, $1,000 for “purchased interest” (i.e., money to reimburse the seller for the interest that accrued between January 1, 2014, and May 28, 2014). On December 31, 2014, you receive a $3,000 interest payment, which represents interest for the period January 1, 2014, through December 31, 2014. Since you did not earn the interest from January 1, 2014, through May 28, 2014, you should not have to pay income tax on this amount. Therefore, on Schedule B (Form 1040 or Form 1040A), you should report as follows:

XYZ Corporation interest	$3,000
Less amount of purchased interest	($1,000)

See Bonds Sold Between Interest Dates, later in this chapter.

Interest not reported on Form 1099-INT. Even if you do not receive Form 1099-INT, you must still report all of your interest income. For example, you may receive distributive shares of interest from partnerships or S corporations. This interest is reported to you on Schedule K-1 (Form 1065), Partner’s Share of Income, Deduction, Credits, etc., or Schedule K-1 (Form 1120S), Shareholder’s Share of Income, Deductions, Credits, etc.

Nominees. Generally, if someone receives interest as a nominee for you, that person must 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 under How To Report Interest Income in chapter 1 of Publication 550, or Schedule B (Form 1040A or 1040) instructions.

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 also may 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 mutual fund or other regulated investment company, including those received from a qualified fund of funds in any tax year beginning after December 22, 2010, are not included in your taxable income. (However, see Information reporting requirement, next.) Exempt-interest dividends should be shown in box 10 of Form 1099-DIV. You do not reduce your basis for distributions that are exempt-interest dividends.

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.

Note. Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. See Alternative Minimum Tax (AMT) in chapter 31 for more information. Chapter 1 of Publication 550 contains a discussion on private activity bonds under State or Local Government Obligations.

Interest on VA dividends. Interest on insurance dividends left 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 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 chapter 17.

Taxable Interest

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.

The “dividends” will be shown as interest income on Form 1099-INT.

Money market funds. Money market funds pay dividends and are offered by nonbank financial institutions, such as mutual funds and stock brokerage houses. 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 in chapter 1 of Publication 550 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 of Publication 550.

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 2014, 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 2014 showing the $575 interest you earned. The bank also gives you a statement showing that you paid $310 interest for 2014. 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.

TAXPLANNER

Note in the previous example, the $310 of interest is deductible only if you itemize your deductions and may be further limited if you do not have net investment income (see chapter 24, Interest expense). If you are not able to fully deduct the interest you pay, you may want to reconsider the investment arrangement.

Example

Assuming the same facts as in the previous example, if you are in the top tax bracket, paying 43.4% (39.6% top marginal rate plus 3.8% Net Investment Income tax), $250 of the $575 interest you earned will go to the IRS, leaving you with only $325. Since you paid $310 in interest charges (for which you receive no tax benefit if you do not itemize) to earn that $325, you have only $15 of after-tax gain on your $5,000 investment, for an after-tax rate of return of 0.3% on this investment. The impact of state income taxes should also be factored to calculate your overall after-tax rate of return.

TAXSAVER

You should be very interested in the after-tax rate of return on your investments. If your interest income is fully taxable, you may determine your after-tax rate of return in the following manner. First, determine from the Tax Rate Schedules (see chapter 48) what you expect your highest marginal tax rate to be by calculating your total taxable income and then determining the highest rate at which it will be taxed. If the rate is, say, 33%, then the IRS gets 33% of your interest income on any investment, and you keep 67%. Thus, if you earn 10% on a bank deposit, your after-tax rate of return is really 6.7% (10% × 67%). See the chart later in this chapter in the State or Local Government Obligations section for a comparison of after-tax yields with the yield of municipal bonds. As the chart indicates, you should remember to include your state and local taxes when computing your marginal tax rate.

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, Installment Sales.

EXPLANATION

Congress has clamped down on a transaction structure that was once used with great success. The idea was to sell a piece of real estate at an inflated price in order to receive a larger long-term capital gain and, in turn, agree to accept deferred payments carrying a low interest rate. The strategy was to give up interest income taxed at ordinary rates and replace it with a larger long-term capital gain taxed at a lower rate.

Under legislation effective for debt instruments issued after December 31, 1984, payments must be made on a current basis, and certain tests are applied to determine if the interest rate is appropriate. If it isn’t, a portion of each payment is recharacterized as interest. Because the rules are very complex, you should obtain professional assistance when you are negotiating a deal and making the necessary computations.

The rules are not applicable to sales of less than $250,000, the sale of your principal residence, or sales for less than $1 million of a farm used by the seller as a farm.

However, in these situations, the IRS has the authority to recharacterize a transaction if the stipulated interest rate falls below the published federal rate. In such cases, the IRS would reduce the amount of the capital gain and increase the interest income.

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 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).

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