Free Stipulation - District Court of Federal Claims - federal

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Publication 550
Cat. No. 15093R Department of the Treasury Internal Revenue Service

Contents
Introduction ........................................ Chapter 1. Investment Income .......... General Information ........................ Interest Income ............................... Discount on Debt Instruments ........ When To Report Interest Income ... How To Report Interest Income ..... Dividends and Other Corporate Distributions ............................. Stripped Preferred Stock ................ REMICs, FASITs, and Other CDOs S Corporations ................................ Investment Clubs ............................ Chapter 2. Tax Shelters ..................... Chapter 3. Investment Expenses ..... Limits on Deductions ...................... Interest Expenses ........................... Bond Premium Amortization ........... Expenses of Producing Income ...... Nondeductible Expenses ................ How To Report Investment Expenses ................................. When To Report Investment Expenses ................................. Chapter 4. Sales and Trades of Investment Property ................... What is a Sale or Trade? ............... Basis of Investment Property ......... How To Figure Gain or Loss .......... Nontaxable Trades ......................... Transfers Between Spouses .......... Related Party Transactions ............ Capital Gains and Losses .............. Holding Period ............................ Nonbusiness Bad Debts ............. Short Sales ................................. Wash Sales ................................. Options ........................................ Straddles ..................................... Rollover of Gain From Publicly Traded Securities ..................... Gains on Qualified Small Business Stock ........................ Reporting Capital Gains and Losses ...................................... Chapter 5. How To Get More Information ................................... Glossary .............................................. Index .................................................... 2 3 3 4 12 15 16 18 22 22 24 24 26 29 29 29 31 32 33 34 34 36 36 39 42 42 44 44 45 49 50 51 51 52 53 57 57 58 65 66 68

Investment Income and Expenses
(Including Capital Gains and Losses)
For use in preparing

1999

Returns

Important Changes for 1999
Reporting capital gain distributions. For 1999, if your only capital gains are capital gain distributions from mutual funds, you may not need to file Schedule D. Instead, the gains generally can be reported directly on Form 1040, line 13. A worksheet in the Form 1040 instructions is used to figure the tax. This simpler method of reporting is discussed in chapter 4 under Reporting Capital Gains and Losses.

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Photographs of missing children. The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1­800­THE­LOST (1­800­843­ 5678) if you recognize a child.

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Important Reminders
Reporting dividends on Schedule B. Report in Part II of Schedule B (Form 1040) only ordinary dividends, not capital gain distributions or nontaxable distributions. Reporting dividends is discussed in chapter 1 under How To Report Dividend Income. Investing in DC Zone assets. Beginning in 2003, investments in District of Columbia Enterprise Zone (DC Zone) assets held more than 5 years will qualify for a special tax benefit. If you sell or trade a DC Zone asset at a gain, you will not have to include any qualified capital gain in your gross income. This exclusion applies to an interest in, or property of, certain businesses operating in the District of Columbia. For more information, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities.

U.S. property acquired from a foreign person. If you acquire a U.S. real property interest from a foreign person or firm, you may have to withhold income tax on the amount you pay for the property (including cash, the fair market value of other property, and any assumed liability). Domestic or foreign corporations, partnerships, trusts, and estates may also have to withhold on certain distributions and other transactions involving U.S. real property interests. If you fail to withhold, you may be held liable for the tax, penalties that apply, and interest. For more information, see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Corporations. Foreign-source income. If you are a U.S. citizen with investment income from sources outside the United States (foreign income), you must report all 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. Alien's individual taxpayer identification number (ITIN). The IRS will issue an ITIN to a nonresident or resident alien who does not have and is not eligible to get a social security number (SSN). To apply for an ITIN, file Form W­7, Application for IRS Individual Taxpayer Identification Number, with the IRS. Enter your ITIN wherever an SSN is requested on a tax return. If you must include another

person's SSN on your return and that person does not have and cannot get an SSN, enter that person's ITIN. An ITIN is for tax use only. It does not entitle you to social security benefits or change your employment or immigration status under U.S. law.

Introduction
This publication provides information on the tax treatment of investment income and expenses. It explains what investment income is taxable and what investment expenses are deductible. It explains when and how to show these items on your tax return. It also explains how to determine and report gains and losses on the disposition of investment property and provides information on property trades and tax shelters. There is a glossary at the end of this publication that defines many of the terms used. Investment income. This generally includes interest, dividends, capital gains, and other types of distributions. Investment expenses. These include interest paid or incurred to acquire investment property and expenses to manage or collect income from investment property.

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1. Investment Income
Topics
This chapter discusses:

General Information
A few items of general interest are covered here. Recordkeeping. As an important part of your records, you should keep a list RECORDS showing sources and amounts of investment income that you receive during the year.

For example, you must give your child's SSN to the payer of dividends on stock owned by your child, even though the dividends are paid to you as custodian. Penalty for failure to supply SSN. You will be subject to a penalty if, when required, you fail to: 1) Include your SSN on any return, statement, or other document, 2) Give your SSN to another person who has to include it on any return, statement, or other document, or 3) Include the SSN of another person on any return, statement, or other document. The penalty is $50 for each failure up to a maximum penalty of $100,000 for any calendar year. You will not be subject to this penalty if you can show that your failure to provide the SSN was due to a reasonable cause and not to willful neglect. If you fail to supply an SSN, you may also be subject to backup withholding. Backup withholding. Your investment income is generally not subject to regular withholding. However, it may be subject to backup withholding to ensure that income tax is collected on this income. Under backup withholding, the bank, broker, or other payer of interest, original issue discount (OID), dividends, cash patronage dividends, or royalties must withhold, as income tax, 31% of the amount you are paid. Backup withholding applies if: 1) You do not give the payer your identification number (either a social security number or an employer identification number) in the required manner, 2) The Internal Revenue Service (IRS) notifies the payer that you gave an incorrect identification number, 3) The IRS notifies the payer that you are subject to backup withholding on interest or dividends because you have underreported interest or dividends on your income tax return, or 4) You are required, but fail, to certify that you are not subject to backup withholding for the reason described in (3). Certification. For new accounts paying interest or dividends, you must certify under penalties of perjury that your SSN is correct and that you are not subject to backup withholding. Your payer will give you a Form W­9, Request for Taxpayer Identification Number and Certification, or a similar form, to make this certification. If you fail to make this certification, backup withholding may begin immediately on your new account or investment. Underreported interest and dividends. You will be considered to have underreported your interest and dividends if the IRS has determined for a tax year that: 1) You failed to include any part of a reportable interest or dividend payment required to be shown on your return, or 2) You were required to file a return and to include a reportable interest or dividend payment on that return, but you failed to file the return. Chapter 1 Investment Income Page 3

· Interest income, · Dividends and other corporate distributions,

· Real estate mortgage investment
conduits (REMICs), financial asset securitization investment trusts (FASITs), and other collateralized debt obligations (CDOs),

Tax on investment income of a child under age 14. Part of a child's 1999 investment income may be taxed at the parent's tax rate. This may happen if all of the following are true. 1) The child was under age 14 on January 1, 2000. 2) The child had more than $1,400 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 1999. If all of these statements are true, Form 8615 must be completed and attached to the child's tax return. If any of these statements is not true, Form 8615 is not required and the child's income is taxed at his or her own tax rate. However, the parent can choose to include the child's interest and dividends on the parent's return if certain requirements are met. Use Form 8814 for this purpose. For more information about the tax on investment income of children and the parents' election, see Publication 929, Tax Rules for Children and Dependents. Beneficiary of an estate or trust. Interest, dividends, and other investment income you receive as a beneficiary of an estate or trust is generally taxable income. You should receive a Schedule K­1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc., from the fiduciary. Your copy of Schedule K­1 and its instructions will tell you where to report the items on your Form 1040. Social security number (SSN). You must give your name and SSN to any person required by federal tax law to make a return, statement, or other document that relates to you. This includes payers of interest and dividends. SSN for joint account. If the funds in a joint account belong to one person, list that person's name first on the account and give that person's SSN to the payer. (For information on who owns the funds in a joint account, see Joint accounts, later.) If the joint account contains combined funds, give the SSN of the person whose name is listed first on the account. These rules apply both to joint ownership by a married couple and to joint ownership by other individuals. For example, if you open a joint savings account with your child using funds belonging to the child, list the child's name first on the account and give the child's SSN. Custodian account for your child. If your child is the actual owner of an account that is recorded in your name as custodian for the child, give the child's SSN to the payer.

· S corporations, and · Investment clubs.

Useful Items
You may want to see: Publication 525 537 564 590 Taxable and Nontaxable Income Installment Sales Mutual Fund Distributions Individual Retirement Arrangements (IRAs) (including Roth IRAs and Education IRAs) Passive Activity and At-Risk Rules

925

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 1099 Instructions for Forms 1099, 1098, 5498, and W­2G 3115 Application for Change in Accounting Method 6251 Alternative Minimum Tax--Individuals 8582 Passive Activity Loss Limitations 8615 Tax for Children Under Age 14 Who Have Investment Income of More Than $1,400 8814 Parents' Election To Report Child's Interest and Dividends 8815 Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989 8818 Optional Form To Record Redemption of Series EE and I U.S. Savings Bonds Issued After 1989 See chapter 5 for information about getting these publications and forms.

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How to stop backup withholding due to underreporting. If you have been notified that you underreported interest or dividends, you can request a determination from the IRS to prevent backup withholding from starting or to stop backup withholding once it has begun. You must show that at least one of the following situations applies. 1) No underreporting occurred. 2) You have a bona fide dispute with the IRS about whether underreporting occurred. 3) Backup withholding will cause or is causing an undue hardship, and it is unlikely that you will underreport interest and dividends in the future. 4) You have corrected the underreporting by filing a return if you did not previously file one and by paying all taxes, penalties, and interest due for any underreported interest or dividend payments. If the IRS determines that backup withholding should stop, it will provide you with a certification and will notify the payers who were sent notices earlier. How to stop backup withholding due to an incorrect identification number. If you have been notified by a payer that you are subject to backup withholding because you have provided an incorrect SSN or employer identification number, you can stop it by following the instructions the payer must give you. Other payments subject to backup withholding. Transactions made by brokers or barter exchanges may be subject to backup withholding. Backup withholding may also apply to certain other reportable payments made in the course of the payer's trade or business. It applies if you do not give the payer your identification number (or the IRS notifies the payer that you gave an incorrect number) and:

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Penalties. There are civil and criminal penalties for giving false information to avoid backup withholding. The civil penalty is $500. The criminal penalty, upon conviction, is a fine of up to $1,000, or imprisonment of up to 1 year, or both. Where to report investment income. Table 1­1 gives an overview of the forms and schedules to use to report some common types of investment income. But, see the rest of this publication for detailed information about reporting investment income. Joint accounts. In a joint account, two or more persons hold property as joint tenants, tenants by the entirety, or tenants in common. That property can include a savings account, bonds, or stock. Each person may receive a share of any interest or dividends from the property. Each person's share is determined by local law. Example. You and your husband have a joint money market account. Under state law, half the income from the account belongs to you, and half belongs to your husband. If you file separate returns, you each report half of the income. Income from property given to a child. Property you give as a parent to your child under the Model Gifts of Securities to Minors Act, the Uniform Gifts to Minors Act, or any similar law, becomes the child's property. Income from the property is taxable to the child unless it is used in any way to satisfy a legal obligation to support that child. The income is taxable to the person having the legal obligation to support the child (the parent or guardian) to the extent that it is used for the child's support. 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. Accuracy-related penalty. A 20% accuracyrelated penalty can be charged for underpayments of tax due to negligence or disregard of rules or regulations or substantial understatement of tax. For information on the penalty and any interest that applies, see Penalties in chapter 2.

Private activity bond Term loan This section discusses the tax treatment of different types of interest income. In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income. (It does not have to be entered in your passbook.) Exceptions to this rule are discussed later. Form 1099­INT. Interest income is generally reported to you on Form 1099­INT 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 is shown on any Form 1099­INT that you receive for the tax year. You must also report all of your interest income for which you did not receive a Form 1099­INT. Nominees. Generally, if someone receives interest as a nominee for you, that person will give you a Form 1099­INT showing the interest received on your behalf. If you receive a Form 1099­INT that includes amounts belonging to another person, see the discussion on nominee distributions, later, under How To Report Interest Income. Incorrect amount. If you receive a Form 1099­INT that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. The new Form 1099­INT you receive will be marked "CORRECTED." Form 1099­OID. Reportable interest income may also be shown on Form 1099­OID, Original Issue Discount. For more information about amounts shown on this form, see Original Issue Discount (OID) later in this chapter. Exempt-interest dividends. Exemptinterest 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 1099­DIV or Form 1099­INT. 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 to taxable income. See How To Report Interest Income, later. Note. Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. See Form 6251 and its instructions for more information about this tax. (Private activity bonds are discussed later under State or Local Government Obligations.) Interest on VA dividends. Interest on insurance dividends that you leave on deposit with the Department of Veterans Affairs (VA) is not taxable. This includes interest paid on dividends on converted United States Government Life Insurance policies and on National Service Life Insurance policies.

· You are paid $600 or more during the
year,

· The payer had to file an information return for you for the prior year, or

· The payer had to impose backup withholding on payments to you in the prior year. Reporting backup withholding. If backup withholding is deducted from your interest or dividend income or other reportable payment, the bank or other business must give you an information return for the year (for example, a Form 1099­INT, Interest Income) that indicates the amount withheld. The information return will show any backup withholding as "Federal income tax withheld." Nonresident aliens. Generally, payments made to nonresident aliens are not subject to backup withholding. You can use Form W­8, Certificate of Foreign Status, or Form W­8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, to certify exempt status. However, this does not exempt you from the 30% (or lower treaty) withholding rate that may apply to your investment income. For information on the 30% rate, see Publication 519, U.S. Tax Guide for Aliens. Page 4 Chapter 1 Investment Income

Interest Income
Terms you may need to know (see Glossary):
Accrual method Below-market loan Cash method Demand loan Forgone interest Gift loan Interest Nominee Original issue discount

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Table 1­1. Where To Report Common Types of Investment Income (For detailed information about reporting investment income, see the rest of this publication, especially How To Report Interest Income and How To Report Dividend Income in chapter 1.)
Income Taxable interest that totals $400 or less Ordinary dividends that total $400 or less Taxable interest that totals more than $400 Ordinary dividends that total more than $400 Savings bond interest you will exclude because of higher education expenses Gain or loss from sale of stocks and bonds Gain or loss from exchanges of like investment property Capital gain distributions (if you have to file Schedule D) Capital gain distributions (if you do not have to file Schedule D) If you file Form 1040 Line 8a (You may need to file Schedule B as well.) Line 9 (You may need to file Schedule B as well.) Line 8a; also use Schedule B If you file Form 1040A Line 8a (You may need to file Schedule 1 as well.) Line 9 (You may need to file Schedule 1 as well.) Line 8a; also use Schedule 1 If you file Form 1040EZ Line 2

Line 9; also use Schedule B

Line 9; also use Schedule 1

Schedule B; also use Form 8815 Line 13; also use Schedule D Line 13; also use Schedule D and Form 8824

Schedule 1; also use Form 8815 You can't use Form 1040EZ.

You can't use Form 1040A. Schedule D, line 13 Line 13

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

Taxable Interest -- General
Taxable interest includes interest you receive from bank accounts, loans you make to others, and interest from most 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

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 made a deposit in a deferred interest account that has a term of 1 year or less, and you paid a penalty because you withdrew funds before the end of the term, you must include in income all the interest shown in box 1 of the Form 1099­INT you receive. You can deduct the entire penalty shown in box 2 on line 30 of Form 1040, even if it is more than your interest income. Money borrowed to invest in money market certificate. The interest you pay on money borrowed from a bank or savings institution to meet the minimum deposit required for a money market certificate from the institution and the interest you earn on the certificate are two separate items. You must report the total interest you earn on the certificate in your income. If you itemize deductions, you can deduct the interest you pay as investment interest, up to the amount of your net investment income. See Interest Expenses in chapter 3. Example. You deposited $5,000 with a bank and borrowed $5,000 from the bank to make up the $10,000 minimum deposit required to buy a 6-month money market certificate. The certificate earned $575 at maturity in 1999, 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 1099­INT for 1999 showing the $575 interest you earned. The bank also gives you a statement showing that you paid $310 interest for 1999. 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. The fair market value of gifts or services you receive for making long-term deposits or for opening an account in a savings institution is interest. Report it in income in the year you receive it. Example. You open a savings account at your local bank. The account earns $20 interest. You also receive a $10 calculator. If no other interest is credited to your account during the year, the Form 1099­INT you receive will show $30 interest income for the year. 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 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. Chapter 1 Investment Income Page 5

· Mutual savings banks.
Money market funds. Generally, amounts you receive from money market funds should be reported as dividends, not as interest. Money market certificates, savings certificates, and other deferred interest accounts. If you open any of these accounts, and interest is 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

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Interest on condemnation award. If the condemning authority pays you interest to compensate you for a delay in payment of an award, the interest is taxable. Installment sale payments. If a contract for the sale or exchange of property provides for deferred payments, it also usually provides for interest payable with the deferred payments. That interest is taxable when you receive it. If little or no interest is provided for in a deferred payment contract, part of each payment may be treated as interest. See Unstated Interest and Original Issue Discount in Publication 537. Interest on annuity contract. Accumulated interest on an annuity contract you sell before its maturity date is taxable. Usurious interest. Usurious interest is interest charged at an illegal rate. Usurious interest is taxable unless state law automatically changes it to a payment on the principal. Interest income on frozen deposits. Exclude from your gross income interest credited 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 in which the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent. The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of: 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 1099­INT for interest income on deposits that were frozen at the end of 1999, see Frozen deposits under How To Report Interest Income for information about reporting this interest income exclusion on your 1999 tax return. The interest you exclude must be reported in the later tax year when you can withdraw it from your account. 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. Your net amount withdrawn was $80. You must exclude $20. You must include $80 in your income for the year. Bonds traded flat. If you buy a bond 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 you receive a payment of that interest, it is a return of capital that reduces the remaining cost basis. Interest that accrues after the date of purchase, however, is taxable interest income for the year received or accrued. See Bonds Sold Between Interest Dates, later in this chapter. Page 6 Chapter 1 Investment Income

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Below-Market Loans
If you make a below-market gift or demand loan, you must report as interest income any forgone interest (defined next) from that loan. The below-market loan rules and exceptions are described in this section. For more information, see section 7872 of the Internal Revenue Code and its regulations. If you receive a below-market loan, you may be able to deduct the forgone interest, as well as any interest that you actually paid, but only if it is not personal interest. Forgone interest. For any period, forgone interest is: 1) The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus 2) Any interest actually payable on the loan for the period. Applicable federal rate. Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. You can also contact the IRS to get these rates. See chapter 5 for the telephone number to call. Rules for below-market loans. The rules that apply to a below-market loan depend on whether the loan is a gift loan, demand loan, or term loan. Gift and demand loans. A gift loan is any below-market loan where the forgone interest is in the nature of a gift. A demand loan is a loan payable in full at any time upon demand by the lender. A demand loan is a below-market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate. A demand loan or gift loan that is a below-market loan is generally treated as an arm's-length transaction in which the lender is treated as having made: 1) A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and 2) An additional payment to the borrower in an amount equal to the foregone interest. The borrower is generally treated as transferring the additional payment back to the lender as interest. The lender must report that amount as interest income. The lender's additional payment to the borrower is treated as a gift, dividend, contribution to capital, pay for services, or other payment, depending on the substance of the transaction. The borrower may have to report this payment as taxable income, depending on its classification. These transfers are considered to occur annually, generally on December 31. Term loans. A term loan is any loan that is not a demand loan. A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan. A lender who makes a below-market term loan other than a gift loan is treated as transferring an additional lump-sum cash payment to the borrower (as a dividend, contribution to capital, etc.) on the date the loan is made. The amount of this payment is the amount of the loan minus the present value,

at the applicable federal rate, of all payments due under the loan. An equal amount is treated as original issue discount (OID). The lender must report the annual part of the OID as interest income. The borrower may be able to deduct the OID as interest expense. See Original Issue Discount (OID), later. Loans subject to the rules. The rules for below-market loans apply to:

· · · · ·

Gift loans, Pay-related loans, Corporation-shareholder loans, Tax avoidance loans, and Loans to qualified continuing care facilities (made after October 11, 1985) under a continuing care contract.

A pay-related loan is any below-market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services. A tax avoidance loan is any below-market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement. Exception for loans of $10,000 or less. The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to: 1) Gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and 2) Pay-related loans or corporationshareholder loans if the avoidance of federal tax is not a principal purpose of the interest arrangement. This exception does not apply to a term loan described in (2) above that previously has been subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less. Age exception for loans to continuing care facilities. Loans to qualified continuing care facilities under continuing care contracts are not subject to the rules for below-market loans for the calendar year if the lender or the lender's spouse is 65 or older at the end of the year. For 1999, this exception applies only to the part of the total outstanding loan balance that is $137,000 or less. Exception for loans without significant tax effect. Loans are excluded from the below-market loan rules if their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender. These loans include: 1) Loans made available by the lender to the general public on the same terms and conditions that are consistent with the lender's customary business practice, 2) Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public, 3) Certain employee-relocation loans, 4) Certain loans from a foreign person, unless the interest income would be effectively connected with the conduct of a

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U.S. trade or business and would not be exempt from U.S. tax under an income tax treaty, 5) Gift loans to a charitable organization, contributions to which are deductible, if the total outstanding amount of loans between the organization and lender is $250,000 or less at all times during the tax year, and 6) Other loans on which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower. For a loan described in (6) above, all the facts and circumstances are used to determine if the interest arrangement has a significant effect on the federal tax liability of the lender or borrower. Some factors to be considered are:

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as it accrues. You cannot postpone reporting interest until you receive it or until the bonds mature. Cash method taxpayers. If you use the cash method of accounting, as most individual taxpayers do, you generally report the interest on U.S. savings bonds when you receive it. But see the discussion of Series EE and series I bonds, below. Series HH bonds. These bonds are 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. 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 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 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. Series EE and series E bonds are issued at a discount. The face value is payable to you at maturity. 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 accrued interest is payable to you at maturity. If you use the cash method of reporting income, you can report the interest on series EE, series E, and series I bonds in either of the following ways. 1) Method 1. Postpone reporting the interest until the earlier of the year you cash or dispose of the bonds or the year in which they mature. (However, see Savings bonds traded, later.) Note. Series E bonds issued in 1959 and 1969 matured in 1999. If you have used method 1, you generally must report the interest on these bonds on your 1999 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. If you plan to cash your bonds in the

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. 98­60" (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: a) 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 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.

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

· The amount of these items, · The cost to you of complying with the
below-market loan rules, if they were to apply, and

· Any reasons other than taxes for structuring the transaction as a below-market loan. If you structure a transaction to meet this exception, and one of the principal purposes of structuring the transaction in that way is the avoidance of federal tax, the loan will be considered a tax-avoidance loan and this exception will not apply. Limit on forgone interest for gift loans of $100,000 or less. For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of federal tax is one of the main purposes of the interest arrangement. Effective dates. These rules apply to term loans made after June 6, 1984, and to demand loans outstanding after that date.

b)

5) It includes a statement that you agree to all the terms and conditions of Revenue Procedure 98­60 (or later update). 6) 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 (including extensions) to file the statement with an amended return. To get this extension, you must have filed your original return by the due date (including extensions). At the top of the statement, write "Filed Pursuant to Reg. 301.9100­2." By the date you file the original statement, you must also send a copy to the address below. Commissioner of Internal Revenue Attn: CC:DOM: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 Commissioner of Internal Revenue, CC:DOM:IT&A (Automatic Rulings Branch), 1111 Constitution Avenue, NW, Washington, DC 20224.) Instead of filing this statement, you can request permission to change from method 2 to method 1 by filing Form 3115. In that case, follow the form instructions for an automatic change. No user fee is required. Chapter 1 Investment Income Page 7

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. For other information on U.S. savings bonds, write to: Bureau of the Public Debt Attn: Customer Information P.O. Box 1328 Parkersburg, WV 26106­1328 Or, on the Internet, visit: www. publicdebt.treas.gov

TIP same year that you will pay for higher
educational expenses, you may want to use method 1 because you may be able to exclude the interest from your income. To learn how, see Education Savings Bond Program, later. Change from method 1. If you want to change your method of reporting the interest from method 1 to method 2, you can do so

Accrual method taxpayers. If you use an accrual method of accounting, you must report interest on U.S. savings bonds each year

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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 coowner 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 1099­INT at the time of redemption, the other co-owner must provide you with another Form 1099­INT 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, later, under How To Report Interest Income, 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 purchase price, interest on the bond 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 must report one-half of the bond interest. For more information about community property, see Publication 555, Community Property. Table 1­2. These rules are also shown in Table 1­2. Child as only owner. Interest on U.S. savings bonds bought for and registered only in the name of your child is income to your child, even if you paid for the bonds and are named as beneficiary. If the bonds are series EE, series E, or series I bonds, the interest on the bonds is income to your child in the earlier of the year the bonds are cashed or disposed of or the year the bonds mature, unless your child chooses to report the interest income each year. Choice to report interest each year. The choice to report the accrued interest each year can be made either by your child or by you for your child. This choice is made by filing an income tax return that shows all the interest earned to date, and by stating on the return that your child chooses to report the interest each year. Either you or your child should keep a copy of this return. Unless your child is otherwise required to file a tax return for any year after making this choice, your child does not have to file another return only to report the annual accrual of U.S. savings bond interest under this choice. However, see Tax on investment income of a child under age 14, earlier, under General Information. Neither you nor your child can change the way you report the interest unless you request permission from the IRS, as discussed earlier under Change from method 2. Ownership transferred. If you bought series E, series EE, or series I bonds entirely with your own funds and had them reissued in your co-owner's name or beneficiary's name alone, you must include in your gross income for the year of reissue all interest that you earned on these bonds and have not previously reported. But, if the bonds were reissued in your name alone, you do not have to report the interest accrued at that time. Page 8 Chapter 1 Investment Income

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Table 1­2. Who Pays Tax on U.S. Savings Bond Interest
IF . . . You use your funds to buy a bond in your name and the name of another person as co-owners You buy a bond in the name of another person, who is the sole owner of the bond You and another person buy a bond as co-owners, each contributing part of the purchase price You and your spouse, who live in a community property state, buy a bond that is community property THEN tax on the bond interest must be paid by . . . You.

The person for whom you bought the bond. Both you and the other co-owner, in proportion to the amount each paid for the bond. You and your spouse. If you file separate returns, both you and your spouse generally pay tax on one-half.

This same rule applies when bonds (other than bonds held as community property) are transferred between spouses or incident to divorce. Example. You bought series EE bonds entirely with your own funds and had not chosen to report the accrued interest each year. You transfer the bonds to your former spouse under a divorce agreement. You must include the deferred accrued interest, from the date of the original issuance of the bonds to the date of transfer, in your income in the year of transfer. Your former spouse includes in income the interest on the bonds from the date of transfer to the date of redemption. 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. At the time of reissue, the former co-owner does not have to include in gross income 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 coowner has to report at that time the interest earned before the bonds were reissued. 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 postponed 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. Decedent who reported interest each year. If the bonds transferred because of death were owned by a person who used an accrual method, or who used the cash method and had chosen to report the interest each year, the interest earned in the year of death up to the date of death must be reported on that person's final return. The person who acquires the bonds includes in income only interest earned after the date of death. Decedent who postponed reporting interest. If the transferred bonds were owned by a decedent who had used the cash method and had not chosen to report the interest each year, and who had bought the bonds entirely with his or her own funds, all interest earned before death must be reported in one of the following ways. 1) The surviving spouse or personal representative (executor, administrator, etc.) who files the final income tax return of the decedent can choose to include on that return all of the interest earned on the bonds before the decedent's death. The person who acquires the bonds then

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includes in income only interest earned after the date of death. 2) If the choice in (1) is not made, the interest earned up to the date of death is income in respect of the decedent. It should not be included in the decedent's final return. All of the interest earned both before and after the decedent's death is income to the person who acquires the bonds. If that person uses the cash method and does not choose to report the interest each year, he or she can postpone reporting any of it until the year the bonds are cashed or disposed of or the year they finally mature, whichever is earlier. In the year that person reports the interest, he or she can claim a deduction for any federal estate tax paid that was for the part of the interest included in the decedent's estate. For more information on income in respect of the decedent, see Publication 559, Survivors, Executors, and Administrators. Example 1. Your uncle, a cash method taxpayer, died and left you a $1,000 series EE bond. He had bought the bond for $500 and had not chosen to report the interest each year. At the date of death, interest of $200 had accrued on the bond and its value of $700 was included in your uncle's estate. Your uncle's executor chose not to include the $200 accrued interest in your uncle's final income tax return. The $200 is income in respect of the decedent. You are a cash method taxpayer and do not choose to report the interest each year as it is earned. If you cash the bond when it reaches maturity value of $1,000, you report $500 interest income--the difference between maturity value of $1,000 and the original cost of $500. For that year, you can deduct (as a miscellaneous itemized deduction not subject to the 2% AGI limit) any federal estate tax paid because the $200 interest was included in your uncle's estate. Example 2. If, in Example 1, the executor had chosen to include the $200 accrued interest in your uncle's final return, you would report only $300 as interest when you cashed the bond at maturity. This $300 is the interest earned after your uncle's death. Example 3. If, in Example 1, you make or have made the choice to report the increase in redemption value as interest each year, you include in gross income for the year you acquire the bond all of the unreported increase in value of all series E, series EE, and series I bonds you hold, including the $200 on the bond you inherited from your uncle. Example 4. When your aunt died, she owned series H bonds that she had acquired in a trade for series E bonds. You were the beneficiary of these bonds. Your aunt used the cash method and did not choose to report the interest on the series E bonds each year as it accrued. Your aunt's executor chose not to include any interest earned before your aunt's death on her final return. The income in respect of the decedent is the sum of the unreported interest on the series E bonds and the interest, if any, payable on the series H bonds but not received as of the date of your aunt's death. You must report any interest received during the year as in-

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come on your return. The part of the interest that was payable but not received before your aunt's death is income in respect of the decedent and may qualify for the estate tax deduction. For information on when to report the interest on the series E bonds traded, see Savings bonds traded, later. Savings bonds distributed from a retirement or profit-sharing plan. If you acquire a U.S. savings bond in a taxable distribution from a retirement or profit-sharing plan, your income for the year of distribution includes the bond's redemption value (its cost plus the interest accrued before the distribution). When you redeem the bond (whether in the year of distribution or later), your interest income includes only the interest accrued after the bond was distributed. To figure the interest reported as a taxable distribution and your interest income when you redeem the bond, see Worksheet for savings bonds distributed from a retirement or profit-sharing plan under How To Report Interest Income, later. 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.) Any cash you received is income to the extent 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 1. You own series E bonds with accrued interest of $523 and a redemption value of $2,723 and have postponed reporting the interest. You trade the bonds for $2,500 in series HH bonds and $223 in cash. You must report the $223 as taxable income in the year of the trade. Example 2. The facts are the same as in Example 1. 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 E bonds). (It is also the difference between the accrued interest of $523 on the series E bonds and the $223 cash received on the trade.) Choice to report interest in year of trade. You can choose to treat all of the previously unreported accrued interest on series EE or series E bonds traded for series HH bonds as income in the year of the trade. If you make 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 1099­INT for U.S. savings bond interest. When you cash a bond, the bank or other payer that redeems it must give you a Form 1099­INT if the interest part of the payment you receive is $10 or more. Box 3 of your Form 1099­INT should show the interest as the difference between the amount you received and the amount paid for the bond. However, your Form 1099­INT 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. 1) You chose to report the increase in the redemption value of the bond each year. The interest shown on your Form 1099­INT will not be reduced by amounts previously included in income. 2) You received the bond from a decedent. The interest shown on your Form 1099­INT 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. 3) Ownership of the bond was transferred. The interest shown on your Form 1099­INT will not be reduced by interest that accrued before the transfer. 4) You were named as a co-owner and the other co-owner contributed funds to buy the bond. The interest shown on your Form 1099­INT will not be reduced by the amount you received as nominee for the other co-owner. (See Co-owners, earlier in this section, for more information about the reporting requirements.) 5) You received the bond in a taxable distribution from a retirement or profitsharing plan. The interest shown on your Form 1099­INT 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 1099­R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year of distribution.) You must report your interest income even if you did not get a Form 1099­INT. For information on including the correct amount of interest on your return, see U.S. savings bond interest previously reported or Nominee distributions under How To Report Interest Income, later. Interest on U.S. savings bonds is ex-

TIP empt from state and local taxes. The
Form 1099­INT you receive will indicate the amount that is for U.S. savings bonds interest in box 3. Do not include this income on your state or local income tax return.

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. If you are married, you can qualify for this exclusion only if you file a joint return with your spouse. 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 (coowners). You must be at least 24 years old before the bond's issue date. Chapter 1 Investment Income Page 9

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The date a bond is issued may be earlier than the date the bond is purCAUTION chased because bonds are issued as of the first day of the month in which they are purchased.

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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 1999, Mark and Joan, a married couple, cashed a qualified series EE U.S. savings bond they bought in November 1992. They received proceeds of $7,132, representing principal of $5,000 and interest of $2,132. In 1999, they paid $4,000 of their daughter's college tuition. They are not claiming an education credit for that amount, and they do not have an education IRA. They can exclude $1,196 ($2,132 × ($4,000 ÷ $7,132)) of interest in 1999. They must pay tax on the remaining $936 ($2,132 - $1,196) interest. Figuring the interest part of the proceeds (Form 8815, line 6). To figure the amount of interest to report on Form 8815, line 6, use the Line 6 Worksheet in the Form 8815 instructions. If you previously reported any interest from savings bonds cashed during 1999, use the Alternate Line 6 Worksheet below instead.
Alternate Line 6 Worksheet 1. Enter the amount from Form 8815, line 5 ............................................................ 2. Enter the face value of all post-1989 series EE bonds cashed in 1999 ......... 3. Multiply line 2 by 50% (.50) .................. 4. Enter the face value of all series I bonds cashed in 1999 ..................................... 5. Add lines 3 and 4 ................................. 6. Subtract line 5 from line 1. ................... 7. Enter the amount of interest reported as income in previous years ................ 8. Subtract line 7 from line 6. Enter the result here and on Form 8815, line 6 ..

Beneficiary. You can designate any individual (including a child) as a beneficiary of the bond (payable on death). Verification by IRS. If you claim the exclusion, IRS will check it by using bond redemption information from Department of the Treasury records. Qualified expenses. Qualified higher educational expenses are tuition and fees required for you, your spouse, or your dependent (for whom you claim an exemption) to attend an eligible educational institution. Qualified expenses include any contribution you make to a qualified state tuition program or to an education IRA. For information about state tuition programs and education IRAs, see Publication 970, Tax Benefits for Higher Education. 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 program. Eligible educational institutions. These institutions include most public and nonprofit universities and colleges and certain vocational schools that are eligible to participate in student aid programs. Reduction for certain benefits. You must reduce your qualified higher educational expenses by certain benefits the student may have received. These benefits include: 1) Qualified scholarships that are exempt from tax (see Publication 520, Scholarships and Fellowships, for information on qualified scholarships), and 2) Any other nontaxable payments (other than gifts, bequests, or inheritances) received for educational expenses, such as: a) b) c) Veterans' educational assistance benefits, Benefits under a qualified state tuition program, or Certain employer-provided educational assistance benefits.

worksheet, and enter the total on Form 8815, line 9, as your modified AGI. Royalties included in modified AGI. Because the deduction for interest expenses attributable to royalties and other investments is limited to y