7.   Interest Income

Table of Contents

    * Reminder
    * Introduction
    * Useful Items - You may want to see:
    * General Information
          o SSN for joint account.
          o Custodian account for your child.
          o Penalty for failure to supply SSN.
          o Reporting backup withholding.
          o Savings account with parent as trustee.
          o Interest not reported on Form 1099-INT.
          o Nominees.
          o Incorrect amount.
          o Information-reporting requirement.
    * Taxable Interest
          o Interest subject to penalty for early withdrawal.
          o Money borrowed to invest in certificate of deposit.
          o U.S. Savings Bonds
          o Education Savings Bond Program
          o U.S. Treasury Bills, Notes, and Bonds
          o Bonds Sold Between Interest Dates
          o Insurance
          o State or Local Government Obligations

          o Original Issue Discount (OID)
    * When To Report Interest Income
          o Constructive receipt.
    * How To Report Interest Income
          o Schedule B.
          o U.S. savings bond interest previously reported.

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.
Introduction

This chapter discusses:

    *

      Different types of interest income,
    *

      What interest is taxable and what interest is nontaxable,
    *

      When to report interest income, and
    *

      How to report interest income on your tax return.

In general, any interest that 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account and can be withdrawn is taxable income.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 chapter 28.
Useful Items - You may want to see:

Publication

    *

      537 Installment Sales
    *

      550 Investment Income and Expenses
    *

      1212 List of Original Issue Discount Instruments

Form (and Instructions)

    *

      Schedule B (Form 1040)
      Interest and Ordinary Dividends
    *

      Schedule 1 (Form 1040A)
      Interest and Ordinary Dividends for Form 1040A Filers
    *

      3115
      Application for Change in Accounting Method
    *

      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

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
interest received during the year. Also, keep the forms you receive that
show your interest income (Forms 1099-INT, for example) as an important
part of your records.
Tax on investment income of a child under age 14.   Part of a child's 2005
investment income may be taxed at the parent's tax rate. This may happen if
all the following are true.

   1.

      The child was under age 14 at the end of 2005. A child born on
January 1, 1992, is considered to be age 14 at the end of 2005.
   2.

      The child had more than $1,600 of investment income (such as taxable
interest and dividends) and has to file a tax return.
   3.

      Either parent was alive at the end of 2005.

If all these statements are true, Form 8615, Tax for Children Under Age 14
Who Have Investment Income of More Than $1,600, 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, Parents' Election To Report Child's Interest and Dividends, for this
purpose.

  For more information about the tax on investment income of children and
the parents' election, see chapter 31.

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 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.

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 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
social security number 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, 28% of the
amount you are paid.

  Backup withholding may also be required if the Internal Revenue Service
(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 that
indicates 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.

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.

   1.

      The savings account legally belongs to the child.
   2.

      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 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 S corporations. This interest is reported to you on Schedule K-1 (Form
1065) or 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 under How To Report
Interest Income in chapter 1 of Publication 550, or see the Schedule 1
(Form 1040A) or Schedule B (Form 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 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.) You will
receive a notice from the mutual fund telling you the amount of the
exempt-interest dividends that you received. Exempt-interest dividends are
not shown on Form 1099-DIV or 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.

Note.

Exempt-interest dividends paid from specified private activity bonds may be
subject to the alternative minimum tax. See Alternative Minimum Tax in
chapter 30 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 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 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 other 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 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 2005, 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 2005
showing the $575 interest you earned. The bank also gives you a statement
showing that you paid $310 interest for 2005. 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,
Installment Sales.

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:

   1.

      The financial institution is bankrupt or insolvent, or
   2.

      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:

   1.

      The net amount you withdrew from these deposits during the year, and
   2.

      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 2005, see Frozen deposits under How To Report Interest
Income in chapter 1 of Publication 550, 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 it
is received or accrued. See Bonds Sold Between Interest Dates, later, for
more information.

Below-market loans.   In general, a below-market loan is a loan on which no
interest is charged or on which interest is charged at a rate below the
applicable federal rate. See Below-Market Loans in chapter 1 of Publication
550 for more information.

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.

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

For series EE and I:
Bureau of the Public Debt
Accrual Services Division
P.O. Box 1328
Parkersburg, WV 26106-1328

For series HH/H:

Bureau of the Public Debt
Current Income Services Division
HH/H Assistance Branch
P.O. Box 2186
Parkersburg, WV 26106-2186

Access by computer
Or, on the Internet, visit:
www.publicdebt.treas.gov/sav/sav.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. Accrual methods of accounting are explained in chapter 1 under
Accounting Methods.

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. The cash method of accounting is explained in
chapter 1 under Accounting Methods.

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.

   Beginning in 2005, owners of paper series EE bonds are able to 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 they mature. (However,
see Savings bonds traded, later.)
      Note. Series E bonds issued in January through November 1965 and all
of 1975 matured in 2005. If you have used method 1, you generally must
report the interest on these bonds on your 2005 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 education 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 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
Room 4516
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 in chapter 1 of
Publication 550 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 7-1.   These rules are also shown in Table 7-1.

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.

Purchased jointly.   If you and a co-owner each contributed funds to buy
series E, series EE, or series I bonds jointly and later have the bonds
reissued in the co-owner's name alone, you must include in your gross
income for the year of reissue your share of all the interest earned on the
bonds that you have not previously reported. The former co-owner does not
have to include in gross income at the time of reissue his or her share of
the interest earned that was not reported before the transfer. This
interest, however, as well as all interest earned after the reissue, is
income to the former co-owner.

  This income-reporting rule also applies when the bonds are reissued in
the name of your former co-owner and a new co-owner. But the new co-owner
will report only his or her share of the interest earned after the transfer.

  If bonds that you and a co-owner bought jointly are reissued to each of
you separately in the same proportion as your contribution to the purchase
price, neither you nor your co-owner has to report at that time the
interest earned before the bonds were reissued.

  
Table 7-1. 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.

Example 1.

You and your spouse each spent an equal amount to buy a $1,000 series EE
savings bond. The bond was issued to you and your spouse as co-owners. You
both postpone reporting interest on the bond. You later have the bond
reissued as two $500 bonds, one in your name and one in your spouse's name.
At that time neither you nor your spouse has to report the interest earned
to the date of reissue.

Example 2.

You bought a $1,000 series EE savings bond entirely with your own funds.
The bond was issued to you and your spouse as co-owners. You both postpone
reporting interest on the bond. You later have the bond reissued as two
$500 bonds, one in your name and one in your spouse's name. You must report
half the interest earned to the date of reissue.
Transfer to a trust.   If you own series E, series EE, or series I bonds
and transfer them to a trust, giving up all rights of ownership, you must
include in your income for that year the interest earned to the date of
transfer if you have not already reported it. However, if you are
considered the owner of the trust and if the increase in value both before
and after the transfer continues to be taxable to you, you can continue to
defer reporting the interest earned each year. You must include the total
interest in your income in the year you cash or dispose of the bonds or the
year the bonds finally mature, whichever is earlier.

  The same rules apply to previously unreported interest on series EE or
series E bonds if the transfer to a trust consisted of series HH or series
H bonds you acquired in a trade for the series EE or series E bonds. See
Savings bonds traded, later.

Decedents.   The manner of reporting interest income on series E, series
EE, or series I bonds, after the death of the owner, depends on the
accounting and income-reporting method previously used by the decedent.
This is explained in chapter 1 of Publication 550.

Savings bonds traded.   If you postponed reporting the interest on your
series EE or series E bonds, you did not recognize taxable income when you
traded the bonds for series HH or series H bonds, unless you received cash
in the trade. (You cannot trade series I bonds for series HH bonds. After
August 31, 2004, you cannot trade any other series of bonds for series HH
bonds.) Any cash you received is income up to the amount of the interest
earned on the bonds traded. When your series HH or series H bonds mature,
or if you dispose of them before maturity, you report as interest the
difference between their redemption value and your cost. Your cost is the
sum of the amount you paid for the traded series EE or series E bonds plus
any amount you had to pay at the time of the trade.

Example.

In 2004, you traded series EE bonds (on which you postponed reporting the
interest) for $2,500 in series HH bonds and $223 in cash. You reported the
$223 as taxable income in 2004, the year of the trade. At the time of the
trade, the series EE bonds had accrued interest of $523 and a redemption
value of $2,723. You hold the series HH bonds until maturity, when you
receive $2,500. You must report $300 as interest income in the year of
maturity. This is the difference between their redemption value, $2,500,
and your cost, $2,200 (the amount you paid for the series EE bonds). (It is
also the difference between the accrued interest of $523 on the series EE
bonds and the $223 cash received on the trade.)
Choice to report interest in year of trade.   You could have chosen to
treat all of the previously unreported accrued interest on the series EE or
series E bonds traded for series HH bonds as income in the year of the
trade. If you made this choice, it is treated as a change from method 1.
See Change from method 1 under Series EE and series I bonds, earlier.

Form 1099-INT for U.S. savings bonds interest.   When you cash a bond, the
bank or other payer that redeems it must give you a Form 1099-INT if the
interest part of the payment you receive is $10 or more. Box 3 of your Form
1099-INT should show the interest as the difference between the amount you
received and the amount paid for the bond. However, your Form 1099-INT may
show more interest than you have to include on your income tax return. For
example, this may happen if any of the following are true.

    *

      You chose to report the increase in the redemption value of the bond
each year. The interest shown on your Form 1099-INT will not be reduced by
amounts previously included in income.
    *

      You received the bond from a decedent. The interest shown on your
Form 1099-INT will not be reduced by any interest reported by the decedent
before death, or on the decedent's final return, or by the estate on the
estate's income tax return.
    *

      Ownership of the bond was transferred. The interest shown on your
Form 1099-INT will not be reduced by interest that accrued before the transfer.
    *

      You were named as a co-owner and the other co-owner contributed funds
to buy the bond. The interest shown on your Form 1099-INT will not be
reduced by the amount you received as nominee for the other co-owner. (See
Co-owners, earlier in this chapter, for more information about the
reporting requirements.)
    *

      You received the bond in a taxable distribution from a retirement or
profit-sharing plan. The interest shown on your Form 1099-INT will not be
reduced by the interest portion of the amount taxable as a distribution
from the plan and not taxable as interest. (This amount is generally shown
on Form 1099-R, Distributions From Pensions, Annuities, Retirement or
Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year of
distribution.)

  For more information on including the correct amount of interest on your
return, see How To Report Interest Income, later. Publication 550 includes
examples showing how to report these amounts.

  
Tip
Interest on U.S. savings bonds is exempt from state and local taxes. The
Form 1099-INT you receive will indicate the amount that is for U.S. savings
bond interest in box 3.

Education Savings Bond Program

You may be able to exclude from income all or part of the interest you
receive on the redemption of qualified U.S. savings bonds during the year
if you pay qualified higher educational expenses during the same year. This
exclusion is known as the Education Savings Bond Program.

You do not qualify for this exclusion if your filing status is married
filing separately.
Form 8815.   Use Form 8815 to figure your exclusion. Attach the form to
your Form 1040 or Form 1040A.

Qualified U.S. savings bonds.   A qualified U.S. savings bond is a series
EE bond issued after 1989 or a series I bond. The bond must be issued
either in your name (sole owner) or in your and your spouse's names
(co-owners). You must be at least 24 years old before the bond's issue
date. For example, a bond bought by a parent and issued in the name of his
or her child under age 24 does not qualify for the exclusion by the parent
or child.

  
Caution
The issue date of a bond may be earlier than the date the bond is purchased
because the issue date assigned to a bond is the first day of the month in
which it is purchased.

Beneficiary.   You can designate any individual (including a child) as a
beneficiary of the bond.

Verification by IRS.   If you claim the exclusion, the IRS will check it by
using bond redemption information from the Department of the Treasury.

Qualified expenses.   Qualified higher educational expenses are tuition and
fees required for you, your spouse, or your dependent (for whom you can
claim an exemption) to attend an eligible educational institution.

  Qualified expenses include any contribution you make to a qualified
tuition program or to a Coverdell education savings account.

  Qualified expenses do not include expenses for room and board or for
courses involving sports, games, or hobbies that are not part of a degree
or certificate granting program.

Eligible educational institutions.   These institutions include most
public, private, and nonprofit universities, colleges, and vocational
schools that are accredited and are eligible to participate in student aid
programs run by the Department of Education.

Reduction for certain benefits.   You must reduce your qualified higher
educational expenses by all of the following tax-free benefits.

   1.

      Tax-free part of scholarships and fellowships (see Scholarships and
fellowships in chapter 12), and
   2.

      Expenses used to figure the tax-free portion of distributions from a
Coverdell ESA.
   3.

      Any tax-free payments (other than gifts or inheritances) received for
educational expenses, such as:
         1.

            Veterans' educational assistance benefits,
         2.

            Qualified tuition reductions, or
         3.

            Employer-provided educational assistance.
   4.

      Any expense used in figuring the Hope and lifetime learning credits.

Amount excludable.   If the total proceeds (interest and principal) from
the qualified U.S. savings bonds you redeem during the year are not more
than your adjusted qualified higher educational expenses for the year, you
may be able to exclude all of the interest. If the proceeds are more than
the expenses, you may be able to exclude only part of the interest.

  To determine the excludable amount, multiply the interest part of the
proceeds by a fraction. The numerator (top part) of the fraction is the
qualified higher educational expenses you paid during the year. The
denominator (bottom part) of the fraction is the total proceeds you
received during the year.

Example.

In February 2005, Mark and Joan, a married couple, cashed a qualified
series EE U.S. savings bond they bought in April 1996. They received
proceeds of $7,068, representing principal of $5,000 and interest of
$2,068. In 2005, they paid $4,000 of their daughter's college tuition. They
are not claiming an education credit for that amount, and their daughter
does not have any tax-free educational assistance. They can exclude $1,170
($2,068 × ($4,000 ÷ $7,068)) of interest in 2005. They must pay tax on the
remaining $898 ($2,068 - $1,170) interest.
Modified adjusted gross income limit.   The interest exclusion is limited
if your modified adjusted gross income (modified AGI) is:

    *

      $61,200 to $76,200 for taxpayers filing single or head of household, and
    *

      $91,850 to $121,850 for married taxpayers filing jointly or for a
qualifying widow(er) with dependent child.

You do not qualify for the interest exclusion if your modified AGI is equal
to or more than the upper limit for your filing status.

  Modified AGI, for purposes of this exclusion, is adjusted gross income
(Form 1040A, line 21 or Form 1040, line 37) figured before the interest
exclusion, and modified by adding back any:

   1.

      Foreign earned income exclusion,
   2.

      Foreign housing exclusion and deduction,
   3.

      Exclusion of income for bona fide residents of American Samoa,
   4.

      Exclusion for income from Puerto Rico,
   5.

      Exclusion for adoption benefits received under an employer's adoption
assistance program,
   6.

      Deduction for tuition and fees,
   7.

      Deduction for student loan interest, and
   8.

      Deduction for domestic production activities.

  Use the worksheet in the instructions for line 9, Form 8815, to figure
your modified AGI. If you claim any of the exclusion or deduction items
listed above (except items 6, 7, and 8), add the amount of the exclusion or
deduction (except any deduction for tuition and fees, student loan
interest, or domestic production activities) to the amount on line 5 of the
worksheet, and enter the total on Form 8815, line 9, as your modified AGI.

  If you have investment interest expense incurred to earn royalties and
other investment income, see Education Savings Bond Program in chapter 1 of
Publication 550.

Records you should keep
Recordkeeping. If you claim the interest exclusion, you must keep a written
record of the qualified U.S. savings bonds you redeem. Your record must
include the serial number, issue date, face value, and total redemption
proceeds (principal and interest) of each bond. You can use Form 8818,
Optional Form To Record Redemption of Series EE and I U.S. Savings Bonds
Issued After 1989, to record this information. You should also keep bills,
receipts, canceled checks, or other documentation that shows you paid
qualified higher educational expenses during the year.
U.S. Treasury Bills, Notes, and Bonds

Treasury bills, notes, and bonds are direct debts (obligations) of the U.S.
Government.
Taxation of interest.   Interest income from Treasury bills, notes, and
bonds is subject to federal income tax, but is exempt from all state and
local income taxes. You should receive Form 1099-INT showing the amount of
interest (in box 3) that was paid to you for the year.

  Payments of principal and interest generally will be credited to your
designated checking or savings account by direct deposit through the
TREASURY DIRECT system.

Treasury bills.   These 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 you pay
for the bills and the face value you receive at maturity is interest
income. Generally, you report this interest income when the bill is paid at
maturity.

Treasury notes and bonds.   Treasury notes have maturity periods of more
than 1 year, ranging up to 10 years. Maturity periods for Treasury bonds
are longer than 10 years. Both notes and bonds generally pay interest every
6 months. Generally, you report this interest for the year paid. For more
information, see U.S. Treasury Bills, Notes, and Bonds in chapter 1 of
Publication 550.

Address you may need
For other information on Treasury notes or bonds, write to:


Treasury Direct
Attn: Customer Information
P.O. Box 9150
Minneapolis, MN 55480-9150

Access by computer
Or, on the Internet, visit:
www. publicdebt.treas.gov

For information on series EE, series I, and series HH savings bonds, see
U.S. Savings Bonds, earlier.
Treasury inflation-protected securities (TIPS).   These securities pay
interest twice a year at a fixed rate, based on a principal amount that is
adjusted to take into account inflation and deflation. For the tax
treatment of these securities, see Inflation-Indexed Debt Instruments under
Original Issue Discount (OID), in Publication 550.

Bonds Sold Between Interest Dates

If you sell a bond between interest payment dates, part of the sales price
represents interest accrued to the date of sale. You must report that part
of the sales price as interest income for the year of sale.

If you buy a bond between interest payment dates, part of the purchase
price represents interest accrued before the date of purchase. When that
interest is paid to you, treat it as a return of your capital investment,
rather than interest income, by reducing your basis in the bond. See
Accrued interest on bonds under How To Report Interest Income in chapter 1
of Publication 550 for information on reporting the payment.
Insurance

Life insurance proceeds paid to you as beneficiary of the insured person
are usually not taxable. But if you receive the proceeds in installments,
you must usually report a part of each installment payment as interest income.

For more information about insurance proceeds received in installments, see
Publication 525, Taxable and Nontaxable Income.
Annuity.   If you buy an annuity with life insurance proceeds, the annuity
payments you receive are taxed as pension and annuity income from a
nonqualified plan, not as interest income. See chapter 10 for information
on pension and annuity income from nonqualified plans.

State or Local Government Obligations

Interest on a bond used to finance government operations generally is not
taxable if the bond is issued by a state, the District of Columbia, a
possession of the United States, or any of their political subdivisions.

Bonds issued after 1982 by an Indian tribal government are treated as
issued by a state. Interest on these bonds is generally tax exempt if the
bonds are part of an issue of which substantially all of the proceeds are
to be used in the exercise of any essential government function.

Interest on arbitrage bonds issued by state or local governments after
October 9, 1969, is taxable.

Interest on a private activity bond that is not a qualified bond is
taxable. For more information on whether such interest is taxable or tax
exempt, see State or Local Government Obligations in chapter 1 of
Publication 550.
Information reporting requirement.   If you must file a tax return, you are
required to show any tax-exempt interest you received on your return. This
is an information-reporting requirement only. It does not change tax-exempt
interest to taxable interest.

Original Issue Discount (OID)

Original issue discount (OID) is a form of interest. You generally include
OID in your income as it accrues over the term of the debt instrument,
whether or not you receive any payments from the issuer.

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 debt instruments that pay no interest before maturity are presumed to
be issued at a discount. Zero coupon bonds are one example of these
instruments.

The OID accrual rules generally do not apply to short-term obligations
(those with a fixed maturity date of 1 year or less from date of issue).
See Discount on Short-Term Obligations in chapter 1 of Publication 550.
De minimis OID.   You can treat the discount as zero 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. This small discount is known as “de minimis” OID.

Example 1.

You bought a 10-year bond with a stated redemption price at maturity of
$1,000, issued at $980 with OID of $20. One-fourth of 1% of $1,000 (stated
redemption price) times 10 (the number of full years from the date of
original issue to maturity) equals $25. Because the $20 discount is less
than $25, the OID is treated as zero. (If you hold the bond at maturity,
you will recognize $20 ($1,000 - $980) of capital gain.)

Example 2.

The facts are the same as in Example 1, except that the bond was issued at
$950. The OID is $50. Because the $50 discount is more than the $25 figured
in Example 1, you must include the OID in income as it accrues over the
term of the bond.
Debt instrument bought after original issue.   If you buy a debt instrument
with de minimis OID at a premium, the discount is not includible in income.
If you buy a debt instrument with de minimis OID at a discount, the
discount is reported under the market discount rules. See Market Discount
Bonds in chapter 1 of Publication 550.

Exceptions to reporting OID.   The OID rules discussed in this chapter do
not apply to the following debt instruments.

   1.

      Tax-exempt obligations. (However, see Stripped tax-exempt obligations
under Stripped Bonds and Coupons in chapter 1 of Publication 550).
   2.

      U.S. savings bonds.
   3.

      Short-term debt instruments (those with a fixed maturity date of not
more than 1 year from the date of issue).
   4.

      Obligations issued by an individual before March 2, 1984.
   5.

      Loans between individuals, if all the following are true.
         1.

            The lender is not in the business of lending money.
         2.

            The amount of the loan, plus the amount of any outstanding
prior loans between the same individuals, is $10,000 or less.
         3.

            Avoiding any federal tax is not one of the principal purposes
of the loan.

Form 1099-OID.   The issuer of the debt instrument (or your broker, if you
held the instrument through a broker) should give you Form 1099-OID,
Original Issue Discount, or a similar statement, if the total OID for the
calendar year is $10 or more. Form 1099-OID will show, in box 1, the amount
of OID for the part of the year that you held the bond. It also will show,
in box 2, the stated interest that you must include in your income. A copy
of Form 1099-OID will be sent to the IRS. Do not file your copy with your
return. Keep it for your records.

  In most cases, you must report the entire amount in boxes 1 and 2 of Form
1099-OID as interest income. But see Refiguring OID shown on Form 1099-OID,
later in this discussion, for more information.

Form 1099-OID not received.   If you had OID for the year but did not
receive a Form 1099-OID, see Publication 1212, which lists total OID on
certain debt instruments and has information that will help you figure OID.
If your debt instrument is not listed in Publication 1212, consult the
issuer for further information about the accrued OID for the year.

Nominee.   If someone else is the holder of record (the registered owner)
of an OID instrument that belongs to you and receives a Form 1099-OID on
your behalf, that person must give you a Form 1099-OID.

Refiguring OID shown on Form 1099-OID.   You must refigure the OID shown in
box 1 or box 6 of Form 1099-OID if either of the following apply.

    *

      You bought the debt instrument after its original issue and paid a
premium or an acquisition premium.
    *

      The debt instrument is a stripped bond or a stripped coupon
(including certain zero coupon instruments).

For information about figuring the correct amount of OID to include in your
income, see Figuring OID on Long-Term Debt Instruments in Publication 1212.

Refiguring periodic interest shown on Form 1099-OID.   If you disposed of a
debt instrument or acquired it from another holder during the year, see
Bonds Sold Between Interest Dates, earlier, for information about the
treatment of periodic interest that may be shown in box 2 of Form 1099-OID
for that instrument.

Certificates of deposit (CDs).   If you buy a CD with a maturity of more
than 1 year, you must include in income each year a part of the total
interest due and report it in the same manner as other OID.

  This also applies to similar deposit arrangements with banks, building
and loan associations, etc., including:

    *

      Time deposits,
    *

      Bonus plans,
    *

      Savings certificates,
    *

      Deferred income certificates,
    *

      Bonus savings certificates, and
    *

      Growth savings certificates.

Bearer CDs.   CDs issued after 1982 generally must be in registered form.
Bearer CDs are CDs that are not in registered form. They are not issued in
the depositor's name and are transferable from one individual to another.

  Banks must provide the IRS and the person redeeming a bearer CD with a
Form 1099-INT.

More information.   See chapter 1 of Publication 550 for more information
about OID and related topics, such as market discount bonds.

When To Report Interest Income

When to report your interest income depends on whether you use the cash
method or an accrual method to report income.
Cash method.   Most individual taxpayers use the cash method. If you use
this method, you generally report your interest income in the year in which
you actually or constructively receive it. However, there are special rules
for reporting the discount on certain debt instruments. See U.S. Savings
Bonds and Original Issue Discount, earlier.

Example.

On September 1, 2003, you loaned another individual $2,000 at 12%,

compounded annually. You are not in the business of lending money. The note
stated that principal and interest would be due on August 31, 2005. In
2005, you received $2,508.80 ($2,000 principal and $508.80 interest). If
you use the cash method, you must include in income on your 2005 return the
$508.80 interest you received in that year.
Constructive receipt.   You constructively receive income when it is
credited to your account or made available to you. You do not need to have
physical possession of it. For example, you are considered to receive
interest, dividends, or other earnings on any deposit or account in a bank,
savings and loan, or similar financial institution, or interest on life
insurance policy dividends left to accumulate, when they are credited to
your account and subject to your withdrawal. This is true even if they are
not yet entered in your passbook.

  You constructively receive income on the deposit or account even if you must:

    *

      Make withdrawals in multiples of even amounts,
    *

      Give a notice to withdraw before making the withdrawal,
    *

      Withdraw all or part of the account to withdraw the earnings, or
    *

      Pay a penalty on early withdrawals, unless the interest you are to
receive on an early withdrawal or redemption is substantially less than the
interest payable at maturity.

Accrual method.   If you use an accrual method, you report your interest
income when you earn it, whether or not you have received it. Interest is
earned over the term of the debt instrument.

Example.

If, in the previous example, you use an accrual method, you must include
the interest in your income as you earn it. You would report the interest
as follows: 2003, $80; 2004, $249.60; and 2005, $179.20.
Coupon bonds.   Interest on coupon bonds is taxable in the year the coupon
becomes due and payable. It does not matter when you mail the coupon for
payment.

How To Report Interest Income

Generally, you report all of your taxable interest income on Form 1040,
line 8a; Form 1040A, line 8a; or Form 1040EZ, line 2.

You cannot use Form 1040EZ if your interest income is more than $1,500.
Instead, you must use Form 1040A or Form 1040.
Form 1040A.   You must complete Schedule 1 (Form 1040A), Part I, if you
file Form 1040A and any of the following are true.

    *

      Your taxable interest income is more than $1,500.
    *

      You are claiming the interest exclusion under the Education Savings
Bond Program (discussed earlier).
    *

      You received interest from a seller-financed mortgage, and the buyer
used the property as a home.
    *

      You received a Form 1099-INT for tax-exempt interest.
    *

      You received a Form 1099-INT for U.S. savings bond interest that
includes amounts you reported before 2005.
    *

      You received, as a nominee, interest that actually belongs to someone
else.
    *

      You received a Form 1099-INT for interest on frozen deposits.

List each payer's name and the amount of interest income received from each
payer on line 1. If you received a Form 1099-INT or Form 1099-OID from a
brokerage firm, list the brokerage firm as the payer.

  You cannot use Form 1040A if you must use Form 1040, as described next.

Form 1040.   You must use Form 1040 instead of Form 1040A or Form 1040EZ if:

   1.

      You forfeited interest income because of the early withdrawal of a
time deposit,
   2.

      You received or paid accrued interest on securities transferred
between interest payment dates,
   3.

      You had a financial account in a foreign country, unless the combined
value of all foreign accounts was $10,000 or less during all of 2005 or the
accounts were with certain U.S. military banking facilities,
   4.

      You acquired taxable bonds after 1987 and choose to reduce interest
income from the bonds by any amortizable bond premium (see Bond Premium
Amortization in chapter 3 of Publication 550),
   5.

      You are reporting OID in an amount more or less than the amount shown
on Form 1099-OID, or
   6.

      You received tax-exempt interest from private activity bonds issued
after August 7, 1986.

Schedule B.   You must complete Schedule B (Form 1040), Part I, if you file
Form 1040 and any of the following apply.

    *

      Your taxable interest income is more than $1,500.
    *

      You are claiming the interest exclusion under the Education Savings
Bond Program (discussed earlier).
    *

      You had a foreign account or you received a distribution from, or
were a grantor of, or transferor to, a foreign trust.
    *

      You received interest from a seller-financed mortgage, and the buyer
used the property as a home.
    *

      You received a Form 1099-INT for tax-exempt interest.
    *

      You received a Form 1099-INT for U.S. savings bond interest that
includes amounts you reported before 2005.
    *

      You received, as a nominee, interest that actually belongs to someone
else.
    *

      You received a Form 1099-INT for interest on frozen deposits.
    *

      You received a Form 1099-INT for interest on a bond that you bought
between interest payment dates.
    *

      Statement (4) or (5) in the preceding list is true.

On Part I, line 1, list each payer's name and the amount received from
each. If you received a Form 1099-INT or Form 1099-OID from a brokerage
firm, list the brokerage firm as the payer.

Form 1099-INT.   Your taxable interest income, except for interest from
U.S. savings bonds and Treasury obligations, is shown in box 1 of Form
1099-INT. Add this amount to any other taxable interest income you
received. You must report all of your taxable interest income even if you
do not receive a Form 1099-INT.

  If you forfeited interest income because of the early withdrawal of a
time deposit, the deductible amount will be shown on Form 1099-INT in box
2. See Penalty on early withdrawal of savings in chapter 1 of Publication 550.

  Box 3 of Form 1099-INT shows the amount of interest income you received
from U.S. savings bonds, Treasury bills, Treasury notes, and Treasury
bonds. Add the amount shown in box 3 to any other taxable interest income
you received, unless part of the amount in box 3 was previously included in
interest income. If part of the amount shown in box 3 was previously
included in your interest income, see U.S. savings bond interest previously
reported, later.

  Box 4 of Form 1099-INT (federal income tax withheld) will contain an
amount if you were subject to backup withholding. Report the amount from
box 4 on Form 1040EZ, line 7, on Form 1040A, line 39, or on Form 1040, line
64 (federal income tax withheld).

  Box 5 of Form 1099-INT shows investment expenses you may be able to
deduct as an itemized deduction. See chapter 3 of Publication 550 for more
information about investment expenses.

U.S. savings bond interest previously reported.   If you received a Form
1099-INT for U.S. savings bond interest, the form may show interest you do
not have to report. See Form 1099-INT for U.S. savings bonds interest,
earlier, under U.S. Savings Bonds.

  On Schedule B (Form 1040), Part I, line 1, or on Schedule 1 (Form 1040A),
Part I, line 1, report all the interest shown on your Form 1099-INT. Then
follow these steps.

   1.

      Several lines above line 2, enter a subtotal of all interest listed
on line 1.
   2.

      Below the subtotal enter “U.S. Savings Bond Interest Previously
Reported” and enter amounts previously reported or interest accrued before
you received the bond.
   3.

      Subtract these amounts from the subtotal and enter the result on line 2.

More information.   For more information about how to report interest
income, see chapter 1 of Publication 550 or the instructions for the form
you must file.