Categories

Need help selecting a firm?

Tell us about your project and get introduced to the best accounting and tax firm for your needs.

Get Started

Interest Income and Taxes

There are many different types of interest income a taxpayer may have. Learn how the IRS treats various sorts of interest income below:

Private Activity Bond Interest

Tax-exempt interest on certain private activity bonds is a tax preference item. Private activity bonds include those which finance mass-transit facilities, sewage and solid waste disposal facilities and certain multi-family dwellings. Tax-exempt interest, and the portion of it that is private activity interest, is required to be included on Form 1099-INT, boxes 8 and 9, respectively. The tax preference amount is the private activity interest income reduced by the related expenses not allowed for regular tax purposes because the income is nontaxable.

The Housing Assistance Act of 2008 exempts from the AMT three special classes of bonds issued after July 30, 2008:

(1) Certain exempt facility bonds used at least 95% for qualifying residential rental projects;

(2) Qualifying mortgage bonds; and

(3) Qualifying veterans' mortgage bonds.

Tax-exempt interest on specified private activity bonds issued in 2009 or 2010 is not an item of tax preference and therefore is not subject to the AMT. This provision also applies to a private activity bond issued in 2009 or 2010 to currently refund a private activity bond issued in 2004 through 2008. For bonds that refund bonds issued in 2009 or later years, the refunding bond is treated as being issued on the date of the issuance of the refunded bond or, in the case of a series of refundings, the original bond. (IRC Sec. 57(a)(5(C)(vi), as added by ARRA of 2009)

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.

Dividends That are Actually Interest

Certain distributions commonly called dividends are actually interest and should be reported as such. These include payments from:

  • Cooperative banks,
  • Credit unions,
  • Domestic building and loan associations,
  • Domestic savings and loan associations, 
  • Federal savings and loan associations, and
  • Mutual savings banks.

Interest on Insurance Dividends

Interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable in the year it is credited to the account.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

Bonds Traded Flat

If a bond is purchased when interest has been defaulted or when the interest has accrued but has not been paid, that interest is not income and is not taxable as interest if paid later. When payment of that interest is received, it is a return of capital that reduces the remaining cost basis. Interest that accrues after the date of purchase is taxable interest income for the year it is received or accrued.

Bond Premium

Generally, bond premium occurs when the stated interest rate on the bond is higher than the market yield for the bond when it is purchased. The bond premium amount is the excess of the holder’s basis in the bond immediately after its acquisition over the sum of all amounts payable on the bond after its purchase (other than payments of qualified stated interest) – in other words, face value of the bond. Special rules (not covered here) apply for convertible bonds, variable rate debt instruments and bonds subject to contingencies. The tax treatment of the premium depends on whether the bond pays tax-exempt or taxable interest.

  • Tax Exempt Bonds – Any premium on tax-exempt bonds cannot be deducted but must be amortized, and the basis of the bond must be reduced by the nondeductible amount. (IRC Sec 171(a)(2); IRC Sec. 1016(a)(5)) As a result, even though no deduction is allowed of the amortized premium, no loss is available when a tax-exempt bond is acquired at a premium and held to maturity.,
  • Taxable Bonds – At the bondholder’s election, a premium may be amortized, and a deduction is allowed for the year’s amortized amount. (IRC Sec. 171(a)(1); Sec. 171(b)(3)) The bond premium is computed under a constant-yield method based on yield to maturity. (Sec. 171(b)(3)(A)) The deduction is an offset on Schedule B to the stated interest allocable to the same period. When the amortization election has been made, the basis of the bond is reduced by the offset amount. The amortization deduction amount in any one year cannot exceed the income reported from the bond during the year. However, excess premium amortization can be carried forward to the next accrual period to offset that period's interest income. (Reg §1.171-2(a)(4))
  • Making the election - The amortization election is made by (1) offsetting the interest income with the bond premium on a timely filed return for the first tax year to which the bond holder wishes the election to apply, and (2) attaching an election statement to the return. Unless revoked with IRS consent, the election, once made, is binding for the year made and all future years for all taxable bonds held by the taxpayer at the beginning of the election year and to all taxable bonds subsequently acquired by the taxpayer.

Example - Amortizing the PremiumDuring the year Jack purchased a bond maturing in 5 years for which he paid a $6,000 premium. The 1099-INT he received for the year reported $10,000 of taxable interest from the bond and in box 11 showed $600, which is the premium amortization allocable to the year’s interest payments. He has not advised the payer that he doesn’t want to amortize the bond premium. The $600 was figured by dividing the premium amount by the number of months to maturity and multiplying the result by 6 months, the period he owned the bond during the year ($6,000/60 x 6 = $600). See the 1099-INT instructions for Box 11.

-
  • Reporting the Amortization - Report the bond's interest on Schedule B (Form 1040), line 1. Under your last entry on line 1, put a subtotal of all interest listed on line 1. Below this subtotal, enter the amortizable bond premium allocable to the interest payments for the year and label this amount “ABP Adjustment”. Subtract this amount from the subtotal and enter the result on line 2. (Pub 550 (2021) Page 33)
  • No Election - If the election is not made, the premium is recovered when the bond is redeemed or sold. Because the election provides a current offset to interest income, generally making the election is preferable to having a future capital loss deduction. But each taxpayer’s situation needs to be analyzed before making an election.

CAUTION

Most debt instruments are considered covered securities either as of Jan. 1, 2014, or Jan. 1, 2016, so brokers are required to report on Form 1099-B (or substitute statement) not only the gross proceeds from sales or maturities of these bonds, but also the adjusted basis of the debt instrument (and  whether any gain or loss is short-term, long-term, or ordinary). However, in certain circumstances, an adjusted basis different from the one reported by the broker will need to be used to arrive at the correct amount of gain or loss. This will be the case, for example, with market discount or premium amortization for taxable bonds if the taxpayer’s and broker’s treatments aren’t the same. The regulations specify which elections the brokers are to assume for basis reporting purposes, but these elections can be overridden by the taxpayer if the broker is timely notified. Taxpayers need to inform their broker in writing (an email is acceptable) by no later than December 31 of the year for which they want the broker to begin to apply or cease to apply the applicable election.

Bonds Traded Between Interest Dates

  • Bond Sold - If a bond is sold between interest payment dates, part of the sales price represents interest accrued to the date of sale.  The part of the sales price that represents interest must be reported as interest income for the year of sale.
  • Bond Purchased - If a bond is purchased between interest payment dates, part of the purchase price represents interest accrued before the date of purchase; this interest belongs to the seller of the bond. At the next interest payment date after the purchase, the buyer will receive interest from the bond issuer that includes both the accrued interest at purchase and post-purchase interest. Only the interest in excess of the amount paid to the seller for the accrued interest is taxable. The buyer purchased the interest that had accrued up to the purchase date, so the interest payment equal to that amount is a return of capital. There is no effect on the cost basis of the bond since the purchase of the interest was not included in the basis of the bond. On Schedule B, report the full amount of interest received for the year (so as to match the 1099-INT), subtotal all interest income, enter the accrued interest paid as a negative amount on the next line, and then enter the net total of line 1 on line 2. If the first interest payment after purchasing the bond does not occur until the following tax year, deduct the accrued interest paid on the following year’s return, not on the return for the year the bond was purchased.  

Example – On May 25, in the secondary market, Chuck purchased a bond with a face value of $10,000 for $9,810. The coupon rate on the bond is 5%, which is payable semi-annually on April 15 and October 15. At the time of the purchase, interest of $58.91 had accrued, which Chuck paid the seller, thus making his total cost for the purchase $9,868.91. On October 15 he receives an interest payment of $250, which he offsets with the $58.91 of accrued interest he purchased, leaving $191.09 as taxable interest and a zero basis in the purchased interest (original basis $58.91 – return of principal 58.91 = 0). His basis in the bond is $9,810.  

-
  • Original Issue Discount (OID) - A debt instrument generally has OID when the instrument is issued for a price that is less than its stated redemption price at maturity. OID is the difference between the stated redemption price at maturity and the issue price., All instruments that pay no interest before maturity are presumed to be issued at a discount. Zero coupon bonds are one example of these instruments.

Original issue discount (OID) is a form of interest and is generally included in income as it accrues over the term of the debt instrument, whether or not the taxpayer receives any payments from the issuer. The discount or OID is treated as zero (“de minimis” OID) if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity.

  • State or Local Government Obligations - Generally, interest on obligations used to finance government operations is not taxable if the obligations are issued by a state, the District of Columbia, a possession of the United States, or any of their political subdivisions. This includes interest on certain obligations issued after 1982 by an Indian tribal government treated as a state., Interest on arbitrage bonds issued by state or local governments and interest on private activity bonds generally is taxable.

CAUTION

If a taxpayer is required to file a tax return, they are required to show any tax-exempt interest and exempt interest dividends received during the year (line 2a of 2021 Form 1040 or 1040-SR).

Bond and Acquisition Premium Broker Reporting Final Regs 

These regulations relate to information reporting by brokers for bond premium and acquisition premium, as well as final and temporary regulations relating to brokers’ information reporting for transactions involving debt instruments and options. The regulations address the reporting of original issue discount (OID) on tax-exempt obligations, the treatment of certain holder elections for reporting a taxpayer’s adjusted basis in a debt instrument, and transfer reporting for Code Sec. 1256 options and debt instruments. These regulations adopt, with certain clarifications and one change, the 2013 proposed interest reporting regulations (NPRM REG-154563-12, I.R.B. 2013-20, 1097). The text of the temporary regulations also serves as the text of the proposed regulations (NPRM REG-143040-14). The regulations are effective on March 13, 2015.     

TaxBuzz Guides