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Miscellaneous Income

This section discusses various types of income. You may have taxable income from certain transactions even if no money changes hands. For example, you may have taxable income if you lend money at a below-market interest rate or have a debt you owe cancelled.

Bartering

Bartering is an exchange of property or services. You must include in your income, at the time received, the fair market value of property or services you receive in bartering. If you exchange services with another person and you both have agreed ahead of time as to the value of the services, that value will be accepted as fair market value unless the value can be shown to be otherwise.

Generally, you report this income on Schedule C (Form 1040) or Schedule C-EZ (Form 1040). But if the barter involves an exchange of something other than services, such as in Example 4 below, you may have to use another form or schedule instead.

Example 1. You are a self-employed attorney who performs legal services for a client, a small corporation. The corporation gives you shares of its stock as payment for your services. You must include the fair market value of the shares in your income on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) in the year you receive them.

Example 2. You are a self-employed accountant. You and a house painter are members of a barter club. Members get in touch with each other directly and bargain for the value of the services to be performed. In return for accounting services you provided, the house painter painted your home. You must report as your income on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) the fair market value of the house painting services you received. The house painter must include in income the fair market value of the accounting services you provided.

Example 3. You are self-employed and a member of a barter club. The club uses credit units as a means of exchange. It adds credit units to your account for goods or services you provide to members, which you can use to purchase goods or services offered by other members of the barter club. The club subtracts credit units from your account when you receive goods or services from other members. You must include in your income the value of the credit units that are added to your account, even though you may not actually receive goods or services from other members until a later tax year.

Example 4. You own a small apartment building. In return for 6 months rent-free use of an apartment, an artist gives you a work of art she created. You must report as rental income on Schedule E (Form 1040) the fair market value of the artwork, and the artist must report as income on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) the fair rental value of the apartment.

Form 1099-B from barter exchange. If you exchanged property or services through a barter exchange, you should receive Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, or a similar statement from the barter exchange by January 31, 2002. It should show the value of cash, property, services, credits, or scrip you received from exchanges during 2001. The IRS will also receive a copy of Form 1099-B.

Backup withholding. The income you receive from bartering is generally not subject to regular income tax withholding. However, backup withholding will apply in certain circumstances to ensure that income tax is collected on this income.

Under backup withholding, the barter exchange must withhold, as income tax, 31% of the income if:

  • You do not give the barter exchange your taxpayer identification number (generally a social security number or an employer identification number), or
  • The IRS notifies the barter exchange that you gave it an incorrect identification number.

If you join a barter exchange, you must certify under penalties of perjury that your taxpayer identification number is correct and that you are not subject to backup withholding. If you do not make this certification, backup withholding may begin immediately. The barter exchange will give you a Form W-9, Request for Taxpayer Identification Number and Certification, or a similar form, for you to make this certification.

The barter exchange will withhold tax only up to the amount of any cash paid to you or deposited in your account and any scrip or credit issued to you (and converted to cash).

TaxTip: If tax is withheld from your barter income, the barter exchange will report the amount of tax withheld on Form 1099-B, or similar statement.

Canceled Debts

Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold.

If the debt is a nonbusiness debt, report the canceled amount on line 21 of Form 1040. If it is a business debt, report the amount on Schedule C (Form 1040) or C-EZ (Form 1040) (or on Schedule F (Form 1040), Profit or Loss From Farming, if you are a farmer).

Form 1099-C. If a federal government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2.

Interest included in canceled debt. If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest will also be shown in box 3. Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible if you paid it. See Deductible debt under Exceptions, later.

If the interest would not be deductible (such as interest on a personal loan), include in your income the amount from box 2 of Form 1099-C. If the interest would be deductible (such as on a business loan), include in your income the net amount of the canceled debt (the amount shown in box 2 less the interest amount shown in box 3).

Discounted mortgage loan. If your financial institution offers a discount for the early payment of your mortgage loan, the amount of the discount is canceled debt. You must include the canceled amount in your income.

Stockholder debt. If you are a stockholder in a corporation and the corporation cancels or forgives your debt to it, the canceled debt is dividend income to you.

If you are a stockholder in a corporation and you cancel a debt owed to you by the corporation, you generally do not realize income. This is because the canceled debt is considered as a contribution to the capital of the corporation equal to the amount of debt principal that you canceled.

Exceptions

There are several exceptions to the inclusion of canceled debt in income. These are explained next.

Nonrecourse debt. If you are not personally liable for the debt (nonrecourse debt), different rules apply. You may have a gain or loss if a nonrecourse debt is canceled or forgiven in conjunction with the foreclosure or repossession of property to which the debt attaches. See Publication 544 for more information.

Student loans. Certain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers.

You do not have income if your student loan is canceled after you agreed to this provision and then performed the services required. To qualify, the loan must have been made by:

  1. The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof,
  2. A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or
  3. An educational institution:
    1. Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or
    2. As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization.

A loan to refinance a qualified student loan will also qualify if it was made by an educational institution or a tax-exempt section 501(a) organization under its program designed as described in (3)(b) above.

An educational institution is an organization with a regular faculty and curriculum and a regularly enrolled body of students in attendance at the place where the educational activities are carried on.

A section 501(c)(3) organization is any corporation, community chest, fund, or foundation organized and operated exclusively for one or more of the following purposes.

  • Charitable.
  • Educational.
  • Fostering national or international amateur sports competition (but only if none of the organization's activities involve providing athletic facilities or equipment).
  • Literary.
  • Preventing cruelty to children or animals.
  • Religious.
  • Scientific.
  • Testing for public safety.

Exception. You do have income if your student loan was made by an educational institution and is canceled because of services you performed for the institution or other organization that provided the funds.

Deductible debt. You do not have income from the cancellation of a debt if your payment of the debt would be deductible. This exception applies only if you use the cash method of accounting. For more information, see chapter 5 of Publication 334.

Price reduced after purchase. Generally, if the seller reduces the amount of debt you owe for property you purchased, you do not have income from the reduction. The reduction of the debt is treated as a purchase price adjustment and reduces your basis in the property.

Excluded debt. Do not include a canceled debt in your gross income in the following situations.

  • The debt is canceled in a bankruptcy case under title 11 of the U.S. Code. See Publication 908, Bankruptcy Tax Guide.
  • The debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent. See Publication 908.
  • The debt is qualified farm debt and is canceled by a qualified person. See chapter 4 of Publication 225, Farmer's Tax Guide.
  • The debt is qualified real property business debt. See chapter 5 of Publication 334.

Life Insurance Proceeds

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract.

Proceeds not received in installments. If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person's death. If the benefit payable at death is not specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.

Proceeds received in installments. If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.

To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.

Example. The face amount of the policy is $75,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 120), or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is interest income to you.

Installments for life. If, as the beneficiary under an insurance contract, you are entitled to receive the proceeds in installments for the rest of your life without a refund or period-certain guarantee, you figure the excluded part of each installment by dividing the amount held by the insurance company by your life expectancy. If there is a refund or period-certain guarantee, the amount held by the insurance company for this purpose is reduced by the actuarial value of the guarantee.

Surviving spouse. If your spouse died before October 23, 1986, and insurance proceeds paid to you because of the death of your spouse are received in installments, you can exclude up to $1,000 a year of the interest included in the installments. If you remarry, you can continue to take the exclusion.

Interest option on insurance. If an insurance company pays you interest only on proceeds from life insurance left on deposit, the interest you are paid is taxable.

If you chose to receive only the interest from your insurance proceeds, the $1,000 interest exclusion for a surviving spouse does not apply. If you later decide to receive the proceeds from the policy in installments, you can take the interest exclusion from the time you begin to receive the installments.

Surrender of policy for cash. If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. In general, your cost (or investment in the contract) is the total of premiums that you paid for the life insurance policy, less any refunded premiums, rebates, dividends or unrepaid loans that were not included in your income.

You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 16a and 16b of Form 1040, or on lines 12a and 12b of Form 1040A.

Endowment proceeds. Endowment proceeds paid in a lump sum to you at maturity are taxable only if the proceeds are more than the cost of the policy. To determine your cost, add the aggregate amount of premiums (or other consideration) paid for the contract and subtract any amount that you previously received under the contract and excluded from your income. Include the part of the lump sum payment that is more than your cost in your income.

Endowment proceeds that you choose to receive in installments instead of a lump-sum payment at the maturity of the policy are taxed as an annuity. This is explained in Publication 575. For this treatment to apply, you must choose to receive the proceeds in installments before receiving any part of the lump sum. This election must be made within 60 days after the lump-sum payment first becomes payable to you.

Accelerated Death Benefits

Certain amounts paid as accelerated death benefits under a life insurance contract or viatical settlement before the insured's death are excluded from income if the insured is terminally or chronically ill.

Viatical settlement. This is the sale or assignment of any part of the death benefit under a life insurance contract to a viatical settlement provider. A viatical settlement provider is a person who regularly engages in the business of buying or taking assignment of life insurance contracts on the lives of insured individuals who are terminally or chronically ill and who meets the requirements of section 101(g)(2)(B) of the Internal Revenue Code.

Exclusion for terminal illness. Accelerated death benefits are fully excludable if the insured is a terminally ill individual. This is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months from the date of the certification.

Exclusion for chronic illness. If the insured is a chronically ill individual who is not terminally ill, accelerated death benefits paid on the basis of costs incurred for qualified long-term care services are fully excludable. Accelerated death benefits paid on a per diem or other periodic basis are excludable up to a limit. This limit applies to the total of the accelerated death benefits and any periodic payments received from long-term care insurance contracts. For information on the limit and the definitions of chronically ill individual, qualified long-term care services, and long-term care insurance contracts, see Long-Term Care Insurance Contracts under Sickness and Injury Benefits, earlier.

Exception. The exclusion does not apply to any amount paid to a person (other than the insured) who has an insurable interest in the life of the insured because the insured:

  • Is a director, officer, or employee of the person, or
  • Has a financial interest in the person's business.

Form 8853. To claim an exclusion for accelerated death benefits made on a per diem or other periodic basis, you must file Form 8853 with your return. You do not have to file Form 8853 to exclude accelerated death benefits paid on the basis of actual expenses incurred.

Recoveries

A recovery is a return of an amount you deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of deductions itemized on Schedule A (Form 1040). You may also have recoveries of non-itemized deductions (such as payments on previously deducted bad debts) and recoveries of items for which you previously claimed a tax credit.

Tax benefit rule. You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from the deduction or credit is considered to have reduced your tax in the earlier year.

Federal income tax refund. Refunds of federal income taxes are not included in your income because they are never allowed as a deduction from income.

State income tax refund. If you received a state or local income tax refund (or credit or offset) in 2001, you generally must include it in income if you deducted the tax in an earlier year. You should receive Form 1099-G, Certain Government and Qualified State Tuition Program Payments, from the payer by January 31, 2002. The IRS will also receive a copy of the Form 1099-G. Use the worksheet in the 2001 Form 1040 instructions for line 10 to figure the amount (if any) to include in your income.

Mortgage interest refund. If you received a refund or credit in 2001 of mortgage interest paid in an earlier year, the amount should be shown in box 3 of your Form 1098, Mortgage Interest Statement. Do not subtract the refund amount from the interest you paid in 2001. You may have to include it in your income under the rules explained in the following discussions.

Interest on recovery. Interest on any of the amounts you recover must be reported as interest income in the year received. For example, report any interest you received on state or local income tax refunds on line 8a of Form 1040.

Recovery and expense in same year. If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and is not reported as income.

Recovery for 2 or more years. If you receive a refund or other recovery that is for amounts you paid in 2 or more separate years, you must allocate, on a pro rata basis, the recovered amount between the years in which you paid it. This allocation is necessary to determine the amount of recovery from any earlier years and to determine the amount, if any, of your allowable deduction for this item for the current year.

Example. You paid 2000 estimated state income tax of $4,000 in four equal payments. You made your fourth payment in January 2001. You had no state income tax withheld during 2000. In 2001, you received a $400 tax refund based on your 2000 state income tax return. You claimed itemized deductions each year on your federal income tax return.

You must allocate the $400 refund between 2000 and 2001, the years in which you paid the tax on which the refund is based. Since you paid 75% ($3,000 $4,000) of the estimated tax in 2000, 75% of the $400 refund, or $300, is for amounts you paid in 2000 and is a recovery item. If all of the $300 is a taxable recovery item, you will include $300 on line 10, Form 1040, for 2001, and attach a copy of your computation showing why that amount is less than the amount shown on the Form 1099-G you received from the state.

The balance ($100) of the $400 refund is for your January 2001 estimated tax payment. When you figure your deduction for state and local income taxes paid during 2001, you will reduce the $1,000 paid in January by $100. Your deduction for state and local income taxes paid during 2001 will include the January net amount of $900 ($1,000 - $100), plus any estimated state income taxes paid in 2001 for 2001, and any state income tax withheld during 2001.

Deductions not itemized. If you did not itemize deductions for the year for which you received the recovery of an expense that was deductible only if you itemized, do not include any of the recovery amount in your income.

Example. You filed your 2000 federal income tax return on Form 1040A. In 2001 you received a refund of your 2000 state income tax. Do not report any of the refund as income because you did not itemize deductions for 2000.

Itemized Deduction Recoveries

The following discussion explains how to determine the amount to include in your income from a recovery of an amount deducted in an earlier year as an itemized deduction. However, you generally do not need to use this discussion if the recovery is for state or local income taxes paid in 2000. Instead, use the worksheet in the 2001 Form 1040 instructions for line 10 to figure the amount (if any) to include in your income.

You cannot use the Form 1040 worksheet and must use this discussion if any of the following statements is true.

  • The recovery is for a tax year other than 2000.
  • The recovery is for a deducted item other than state or local income taxes, such as real property taxes.
  • Your 2000 taxable income was less than zero.
  • You made your last payment of 2000 state or local estimated tax in 2001.
  • You owed alternative minimum tax for 2000.
  • You could not deduct all your tax credits for 2000 because their total was more than the amount of tax shown on line 42 of your 2000 Form 1040 minus any foreign tax credit shown on line 43 of that form.
  • You could be claimed as a dependent by someone else in 2000.

Caution: If you also recovered an amount deducted as a non-itemized deduction, figure the amount of that recovery to include in your income and add it to your adjusted gross income before applying the rules explained here. See Non-Itemized Deduction Recoveries, later.

Total recovery included in income. If you recover any amount that you deducted in an earlier year on Schedule A (Form 1040), you generally must include the full amount of the recovery in your income in the year you receive it. This rule applies if, for the earlier year, all of the following statements are true.

  1. Your itemized deductions exceeded the standard deduction by at least the amount of the recovery. (If your itemized deductions did not exceed the standard deduction by at least the amount of the recovery, see Standard deduction limit, later.)
  2. You had taxable income. (If you had no taxable income, see Negative taxable income, later.)
  3. Your deduction for the item recovered equals or exceeds the amount recovered. (If your deduction was less than the amount recovered, see Recovery limited to deduction, later.)
  4. Your itemized deductions were not subject to the limit on itemized deductions. (If your deductions were limited, see Itemized deductions limited, later.)
  5. You had no unused tax credits. (If you had unused tax credits, see Unused tax credits, later.)
  6. You were not subject to alternative minimum tax. (If you were subject to alternative minimum tax, see Subject to alternative minimum tax, later.)

If any of the above statements is not true, see Total recovery not included in income, later.

Where to report. Enter your state or local income tax refund on line 10 of Form 1040, and the total of all other recoveries as other income on line 21 of Form 1040. You cannot use Form 1040A or Form 1040EZ.

Example. For 2000, you filed a joint return. Your taxable income was $20,000 and you were not entitled to any tax credits. Your standard deduction was $7,350, and you had itemized deductions of $9,000. In 2001, you received the following recoveries for amounts deducted on your 2000 return:

Medical expenses $200
State and local income tax refund 400
Refund of mortgage interest   325   
Total recoveries $925

None of the recoveries were more than the deductions taken for 2000.

Because your total recoveries are less than the amount by which your itemized deductions exceeded the standard deduction ($9,000 - $7,350 = $1,650), you must include your total recoveries in your income for 2001. Report the state and local income tax refund of $400 on line 10 of Form 1040, and the balance of your recoveries, $525, on line 21 of Form 1040.

Total recovery not included in income. If one or more of the six statements listed in the preceding discussion is not true, you may be able to exclude at least part of the recovery from your income. If statements (4), (5), and (6) are true (your itemized deductions were not limited, you had no unused tax credits, and you were not subject to the alternative minimum tax), you can use Table 1 to determine the part of your recovery of amounts deducted after 1986 to include in your income.

Table 1 Worksheet for Recoveries of Itemized Deductions - Deducted After 1986

Table 2 - 2000 standard deduction

Table 3 - 1999 standard deduction

Table 4 - 1998 standard deduction

Allocating the included part. If you are not required to include all of your recoveries in your income, and you have both a state income tax refund and other itemized deduction recoveries, you must allocate the taxable recoveries between the state tax refund you report on line 10 of Form 1040 and the amount you report as other income on line 21 of Form 1040. If you do not use Table 1, make the allocation as follows.

  1. Divide your state income tax refund by the total of all your itemized deduction recoveries.
  2. Multiply the amount of taxable recoveries by the percentage in (1). This is the amount you report as a state income tax refund.
  3. Subtract the result in (2) above from the amount of taxable recoveries. This is the amount you report as other income.

Example. In 2001 you recovered $2,500 of your 2000 itemized deductions, but the recoveries you must include in your 2001 income are only $1,500. Of the $2,500 you recovered, $500 was due to your state income tax refund. The amount you report as a state tax refund on line 10 of Form 1040 is $300 [($500 $2,500) $1,500]. The balance of the taxable recoveries, $1,200, is reported as other income on line 21 of Form 1040.

Standard deduction limit. You are generally allowed to claim the standard deduction if you do not itemize your deductions. Only your itemized deductions that are more than your standard deduction are subject to the recovery rule (unless you are required to itemize your deductions). If your total deductions on the earlier year return were not more than your income for that year, include in your income this year the lesser of:

  1. Your recoveries, or
  2. The amount by which your itemized deductions exceeded the standard deduction.

Standard deduction for earlier years. To determine if amounts recovered in 2001 must be included in your income, you must know the standard deduction for your filing status for the year the deduction was claimed. The standard deduction tables for 2000, 1999, and 1998 are shown in Tables 2, 3, and 4. If you need the standard deduction amounts for years before 1998, see the copy of your return for that year.

Example. You filed a joint return for 2000 with a taxable income of $25,000. Your itemized deductions were $8,700. The standard deduction that you could have claimed was $7,350. In 2001, you recovered $2,400 of your 2000 itemized deductions. None of the recoveries were more than the actual deductions for 2000. Include $1,350 of the recoveries in your 2001 income. This is the smaller of your recoveries ($2,400) or the amount by which your itemized deductions were more than the standard deduction ($8,700 - $7,350 = $1,350).

Negative taxable income. If your taxable income was a negative amount, reduce the recovery you must otherwise include in your income by the negative amount.

Example. The facts are the same as in the previous example except you had a negative taxable income of $200 in 2000. You must include $1,150 in your 2001 income, rather than $1,350.

Recovery limited to deduction. You do not include in your income any amount of your recovery that is more than the amount you deducted in the earlier year. The amount you include in your income is limited to the smaller of:

  • The amount deducted on Schedule A (Form 1040), or
  • The amount recovered.

Example. During 2000, you paid $1,700 for medical expenses. From this amount you subtracted $1,500, which was 7.5% of your adjusted gross income. Your actual medical expense deduction was $200. In 2001, you received a $500 reimbursement from your medical insurance for your 2000 expenses. The only amount of the $500 reimbursement that must be included in your income for 2001 is $200--the amount actually deducted.

Itemized deductions limited. You were subject to the limit on itemized deductions in the earlier year if your adjusted gross income (AGI) was more than a base amount. For example, this amount was:

  • For 2000, $128,950 ($64,475 if married filing separately),
  • For 1999, $126,600 ($63,300 if married filing separately), and
  • For 1998, $124,500 ($62,250 if married filing separately).

If the limit applied, your itemized deductions were reduced by the smaller of the following amounts.

  • 3% of the amount by which your AGI exceeded the base amount.
  • 80% of your otherwise allowable deductions other than medical and dental expenses, investment interest expense, nonbusiness casualty and theft losses, and gambling losses.

If the amount you recovered was deducted in a year in which your itemized deductions were limited, you must include it in income up to the difference between the amount of itemized deductions actually allowed that year and the amount you would have been allowed (the greater of your itemized deductions or your standard deduction) if you had figured your deductions using only the net amount of the recovery item.

To determine the part of the recovery you must include in income, follow the four steps below. If your earlier tax year does not involve negative taxable income or an unused tax credit, skip steps 1 and 2 and start with step 3.

  1. If your taxable income for the earlier year was a negative amount, reduce your recovery by the negative amount.
  2. If your tax for the earlier year was reduced to zero by a tax credit that was not fully used in that year, and if reducing your deduction for that year by the recovery would result in tax for that year, reduce your recovery to an amount equal to your recovery multiplied by the following fraction:
    1. Your tax for the earlier year, determined after reducing your deductions by the recovery and applying the credit, over
    2. The total increase in your tax for the earlier year, determined by subtracting your actual tax before applying the credit from the tax in (a) before applying the credit.
  3. Figure the greater of:
    1. The standard deduction for the earlier year, or
    2. The amount of itemized deductions you would have been allowed for the earlier year (after taking into account the limit on itemized deductions) if you had figured them using only the net amount of the recovery item. The net amount is the amount you actually paid reduced by the recovery amount (as reduced in steps 1 and 2, if they apply).

    Note. If you were required to itemize your deductions in the earlier year, use step 3(b) and not step 3(a).

  4. Subtract the amount in step 3 from the amount of itemized deductions actually allowed in the earlier year after applying the limit on itemized deductions.

The result of step 4 is the amount of the recovery to include in your income for the year you receive the recovery.

For more information on this computation, see Revenue Ruling 93-75. This ruling is in Cumulative Bulletin 1993-2.

Example. Eileen Martin is single. She had an AGI of $1,128,950 and itemized her deductions on her federal income tax return for 2000. She was not subject to alternative minimum tax and was not entitled to any credit against income tax. Her only allowable deduction was $40,000 of state income taxes. However, Eileen deducted only $10,000 in 2000 because her otherwise allowable deductions of $40,000 were reduced by $30,000. In 2001, she received a $5,000 refund of her state income taxes for 2000.

The following table shows how Eileen figured the $30,000 reduction and other amounts from the Itemized Deduction Worksheet in the 2000 Schedule A (Form 1040) instructions. These amounts are needed to figure the part of the $5,000 refund that Eileen must include in her income for 2001.

AGI for 2000 $1,128,950
State income taxes paid in 2000 $40,000
3% reduction (amount on line 8 of  2000 Itemized Deduction Worksheet)   [($1,128,950 - $128,950) 3%] $30,000
80% reduction not applied (amount  on line 4 of 2000 Itemized Deduction  Worksheet) ($40,000 80%) $32,000
2000 deduction (amount on line 10 of  2000 Itemized Deduction Worksheet)  ($40,000 - $30,000) $10,000
Refund received in 2001 of 2000 state  income tax $5,000
Net amount of 2000 state income  tax ($40,000 - $5,000) $35,000

If Eileen had used the $35,000 net amount of state income tax to figure her itemized deductions for 2000, the deduction allowed would have been $7,000. This is her otherwise allowable deduction of $35,000 reduced by $28,000 ($35,000 80%). By deducting the full $10,000 paid in 2000, she derived a tax benefit of $3,000 ($10,000 - $7,000). Therefore, only $3,000 of the $5,000 refund is included in her income for 2001.

Unused tax credits. If you recover an item deducted in an earlier year in which you had unused tax credits, you must refigure the earlier year's tax to determine if you must include the recovery in your income. To do this, add the amount of the recovery to your earlier year's taxable income and refigure the tax and the credits on the recomputed amount. If the recomputed tax, after application of the credits, is more than the actual tax in the earlier year, include the recovery in your income up to the amount by which it reduced the tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year. If the recovery is for an itemized deduction claimed in a year in which the deductions were limited, see Itemized deductions limited, earlier.

If your tax, after application of the credits, does not change, you did not have a tax benefit from the deduction. Do not include the recovery in your income.

Example. In 2000, Jean Black filed as head of household and itemized her deductions. Her taxable income was $5,260 and her tax was $791. She claimed a child care credit of $1,200. The credit reduced her tax to zero and she had an unused tax credit of $409 ($1,200 - $791). In 2001, Jean recovered $1,000 of her itemized deductions. She reduces her 2000 itemized deductions by $1,000 and recomputes that year's tax on taxable income of $6,260. However, the child care credit exceeds the recomputed tax of $941. Jean's tax liability for 2000 is not changed by reducing her deductions by the recovery. She did not have a tax benefit from the recovered deduction and does not include any of the recovery in her income for 2001.

Subject to alternative minimum tax. If you were subject to the alternative minimum tax in the year of the deduction, you will have to recompute your tax for the earlier year to determine if the recovery must be included in your income. This will require a recomputation of your regular tax, as shown in the preceding example, and a recomputation of your alternative minimum tax. If inclusion of the recovery does not change your total tax, you do not include the recovery in your income. However, if your total tax increases by any amount, you received a tax benefit from the deduction and you must include the recovery in your income up to the amount by which the deduction reduced your tax in the earlier year.

Non-Itemized Deduction Recoveries

This section discusses recovery of deductions other than those deducted on Schedule A (Form 1040).

Total recovery included in income. If you recover an amount that you deducted in an earlier year in figuring your adjusted gross income, you must generally include the full amount of the recovery in your income in the year received.

Total recovery not included in income. If any part of the deduction you took for the recovered amount did not reduce your tax, you may be able to exclude at least part of the recovery from your income. You must include the recovery in your income only up to the amount by which the deduction reduced your tax in the year of the deduction. (See Tax benefit rule, earlier.)

Negative taxable income. If your taxable income was a negative amount, reduce the recovery by that negative amount. Include this reduced recovery in your income.

Unused tax credits. If you recover an item deducted in an earlier year in which you had unused tax credits, you must refigure the earlier year's tax to determine if you must include the recovery in your income. To do this, add the amount of the recovery to your earlier year's taxable income and refigure the tax and the credits on the recomputed amount. If the recomputed tax, after application of the credits, is more than the actual tax in the earlier year, include the recovery in your income up to the amount by which it reduced the tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year.

If your tax, after application of the credits, does not change, you did not have a tax benefit from the deduction. Do not include the recovery in your income.

Amounts Recovered for Credits

If you received a recovery in 2001 for an item for which you claimed a tax credit in an earlier year, you must increase your 2001 tax by the amount of the recovery, up to the amount by which the credit reduced your tax in the earlier year. You had a recovery if there was a downward price adjustment or similar adjustment on the item for which you claimed a credit.

This rule does not apply to the investment credit or the foreign tax credit. Recoveries of these credits are covered by other provisions of the law. See Publication 514, Foreign Tax Credit for Individuals, or Form 4255, Recapture of Investment Credit, for details.

Survivor Benefits

Generally, payments made by or for an employer because of an employee's death must be included in income. The following discussions explain the tax treatment of certain payments made to survivors. For additional information, see Publication 559.

Lump-sum payments. Lump-sum payments you receive from a decedent's employer as the surviving spouse or beneficiary may be accrued salary payments; distributions from employee profit-sharing, pension, annuity, or stock bonus plans; or other items that should be treated separately for tax purposes. The tax treatment of these lump-sum payments depends on the type of payment.

Salary or wages. Salary or wages received after the death of the employee are usually ordinary income to you.

Qualified employee retirement plans. Lump-sum distributions from qualified employee retirement plans are subject to special tax treatment. For information on these distributions, get Publication 575 (or Publication 721 if you are the survivor of a federal employee or retiree).

Deceased public safety officers. If you are a survivor of a public safety officer who died in the line of duty, you may be able to exclude from income certain amounts you receive.

For this purpose, the term public safety officer includes police and law enforcement officers, firefighters, and rescue squad and ambulance crew members.

Unemployment Benefits

The tax treatment of unemployment benefits you receive depends on the type of program paying the benefits.

Unemployment compensation. You must include in your income all unemployment compensation you receive. You should receive a Form 1099-G showing the amount paid to you. Generally, you enter unemployment compensation on line 19 of Form 1040, line 13 of Form 1040A, or line 3 of Form 1040EZ.

Types of unemployment compensation. Unemployment compensation generally includes any amount received under an unemployment compensation law of the United States or of a state. It includes the following benefits.

  • Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund.
  • State unemployment insurance benefits.
  • Railroad unemployment compensation benefits.
  • Disability payments from a government program paid as a substitute for unemployment compensation. (Amounts received as workers' compensation for injuries or illness are not unemployment compensation. See Workers' Compensation under Sickness and Injury Benefits, earlier.)
  • Trade readjustment allowances under the Trade Act of 1974.
  • Benefits under the Airline Deregulation Act of 1978.
  • Unemployment assistance under the Disaster Relief Act Amendments of 1974.

Governmental program. If you contribute to a governmental unemployment compensation program and your contributions are not deductible, amounts you receive under the program are not included as unemployment compensation until you recover your contributions.

Repayment of unemployment compensation. If you repaid in 2001 unemployment compensation you received in 2001, subtract the amount you repaid from the total amount you received and enter the difference on line 19 of Form 1040, line 13 of Form 1040A, or line 3 of Form 1040EZ. On the dotted line next to your entry, write "Repaid" and the amount you repaid. If you repaid unemployment compensation in 2001 that you included in your income in an earlier year, you can deduct the amount repaid on Schedule A (Form 1040) if you itemize deductions. See Repayments, later.

Tax withholding. You can choose to have federal income tax withheld from your unemployment compensation. To make this choice, complete Form W-4V, Voluntary Withholding Request, and give it to the paying office. Tax will be withheld at 15% of your payment.

Caution: If you do not choose to have tax withheld from your unemployment compensation, you may be liable for estimated tax. For more information on estimated tax, get Publication 505, Tax Withholding and Estimated Tax.

Supplemental unemployment benefits. Benefits received from an employer-financed fund (to which the employees did not contribute) are not unemployment compensation. They are taxable as wages and are subject to withholding for income tax and social security and Medicare taxes. Report these payments on line 7 of Form 1040 or Form 1040A or on line 1 of Form 1040EZ.

Repayment of benefits. You may have to repay some of your supplemental unemployment benefits to qualify for trade readjustment allowances under the Trade Act of 1974. If you repay supplemental unemployment benefits in the same year you receive them, reduce the total benefits by the amount you repay. If you repay the benefits in a later year, you must include the full amount of the benefits in your income for the year you received them.

Deduct the repayment in the later year as an adjustment to gross income on Form 1040. (You cannot use Form 1040A or Form 1040EZ.) Include the repayment on line 32 of Form 1040, and write "Sub-Pay TRA" and the amount on the dotted line next to line 32. If the amount you repay in a later year is more than $3,000, you may be able to take a credit against your tax for the later year instead of deducting the amount repaid. For information on this, see Repayments, later.

Private unemployment fund. Unemployment benefit payments from a private fund to which you voluntarily contribute are taxable only if the amounts you receive are more than your total payments into the fund. Report the taxable amount on line 21 of Form 1040.

Payments by a union. Benefits paid to you as an unemployed member of a union from regular union dues are included in your income on line 21 of Form 1040.

Guaranteed annual wage. Payments you receive from your employer during periods of unemployment, under a union agreement that guarantees you full pay during the year, are taxable as wages. Include them on line 7 of Form 1040 or Form 1040A or on line 1 of Form 1040EZ.

State employees. Payments similar to a state's unemployment compensation may be made by the state to its employees who are not covered by the state's unemployment compensation law. Although the payments are fully taxable, do not report them as unemployment compensation. Report these payments on line 21 of Form 1040.

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