Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

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 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 (except any part reported by the estate on its income tax return) 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 it until the year the bonds are cashed or disposed of or the year they mature, whichever is earlier. In the year that person reports the interest, he or she can claim a deduction for any federal estate tax that was paid on the part of the interest included in the decedent's estate.

For more information on income in respect of a 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%-of-adjusted- gross-income 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. $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 income 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 up to the amount of the interest earned on the bonds traded. When your series HH or series H bonds mature, or if you dispose of them before maturity, you report as interest the difference between their redemption value and your cost. Your cost is the sum of the amount you paid for the traded series EE or series E bonds plus any amount you had to pay at the time of the trade.

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

1. You chose to report the increase in the redemption value of the bond each year. The interest shown on your Form 1099-INT will not be reduced by amounts previously included in income.
2. You received the bond from a decedent. The interest shown on your Form 1099-INT will not be reduced by any interest reported by the decedent before death, or on the decedent's final return, or by the estate on the estate's income tax return.
3. Ownership of the bond was transferred. The interest shown on your Form 1099-INT will not be reduced by interest that accrued before the transfer.
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 1099-INT 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 profit-sharing plan. The interest shown on your Form 1099-INT will not be reduced by the interest portion of the amount taxable as a distribution from the plan and not taxable as interest. (This amount is generally shown on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year of distribution.)

For more information on including the correct amount of interest on your return, see U.S. savings bond interest previously reported or Nominee distributions under How To Report Interest Income, later.

Interest on U.S. savings bonds is exempt from state and local taxes. The Form 1099-INT you receive will indicate the amount that is for U.S. savings 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, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989, to figure your exclusion. Attach the form to your Form 1040 or Form 1040A.

Qualified U.S. savings bonds.   A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must be issued either in your name (sole owner) or in your and your spouse's names (co-owners). You must be at least 24 years old before the bond's issue date.

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

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

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

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 tuition program or to a Coverdell education savings account. For information about these programs, see Publication 970, Tax Benefits for 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 or certificate granting program.

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

Reduction for certain benefits.   You must reduce your qualified higher educational expenses by 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:
   1. Veterans' educational assistance benefits,
   2. Benefits under a qualified tuition program, or
   3. Certain employer-provided educational assistance benefits.

Effect of other education benefits.   Do not include in your qualified expenses any expense used to:

1. Figure an education credit on Form 8863,
2. Figure how much of a distribution from a Coverdell ESA you can exclude from your income, or
3. Figure how much of a distribution from a qualified tuition program you can exclude from your income.

For information about these benefits, see Publication 970.

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

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

Example.   In February 2002, Mark and Joan, a married couple, cashed a qualified series EE U.S. savings bond they bought in April 1994. They received proceeds of $7,280, representing principal of $5,000 and interest of $2,280. In 2002, 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 a Coverdell ESA. They can exclude $1,253 ($2,280 × ($4,000 ÷ $7,280)) of interest in 2002. They must pay tax on the remaining $1,027 ($2,280 - $1,253) 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 2002, use the Alternate Line 6 Worksheet below instead.

Modified adjusted gross income limit.   The interest exclusion is limited if your modified adjusted gross income (modified AGI) is:

• $57,600 to $72,600 for taxpayers filing single or head of household, and
• $86,400 to $116,400 for married taxpayers filing jointly, or for a qualifying widow(er) with dependent child.

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

Modified AGI.   Modified AGI, for purposes of this exclusion, is adjusted gross income (line 22 of Form 1040A or line 36 of Form 1040) figured before the interest exclusion, and modified by adding back any:

1. Foreign earned income exclusion,
2. Foreign housing exclusion or deduction,
3. Exclusion of income for bona fide residents of American Samoa,
4. Exclusion for income from Puerto Rico,
5. Exclusion for adoption benefits received under an employer's adoption assistance program,
6. Deduction for tuition and fees, and
7. Deduction for student loan interest.

Use the worksheet in the instructions for line 9, Form 8815, to figure your modified AGI. If you claim any of the exclusion or deduction items listed above (except items 6 and 7), add the amount of the exclusion or deduction (except any deduction for tuition and fees or student loan interest) to the amount on line 5 of the 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 your net investment income (see Investment Interest in chapter 3), you cannot figure the deduction until you have figured this interest exclusion. Therefore, if you had interest expenses attributable to royalties and deductible on Schedule E (Form 1040), you must make a special computation of your deductible interest without regard to this exclusion to figure the net royalty income included in your modified AGI.

You can use a dummy Form 4952, Investment Interest Expense Deduction, to make the special computation. On this form, include in your net investment income your total interest income for the year from series EE and I U.S. savings bonds. Use the deductible interest amount from this form only to figure your modified AGI. Do not attach this form to your tax return.

After you figure this interest exclusion, use a separate Form 4952 to figure your actual deduction for investment interest expenses, and attach that form to your return.

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

U.S. Treasury Bills,
Notes, and Bonds

Treasury bills, notes, and bonds are direct debts (obligations) of the U.S. Government.

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

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

Treasury bills.   These bills generally have a 4-week, 13-week, 26-week, or 52-week maturity period. They are issued at a discount in the amount of $1,000 and multiples of $1,000. The difference between the discounted price you pay for the bills and the face value you receive at maturity is interest income. Generally, you report this interest income when the bill is paid at maturity. See Discount on Short-Term Obligations under Discount on Debt Instruments, later.

If you reinvest your Treasury bill at its maturity in a new Treasury bill, note, or bond, you will receive payment for the difference between the proceeds of the maturing bill (par amount less any tax withheld) and the purchase price of the new Treasury security. However, you must report the full amount of the interest income on each of your Treasury bills at the time it reaches maturity.

Treasury notes and bonds.   Treasury notes have maturity periods of more than 1 year, ranging up to 10 years. Maturity periods for Treasury bonds are longer than 10 years. Both of these Treasury issues generally are issued in denominations of $1,000 to $1 million. Both notes and bonds generally pay interest every 6 months. Generally, you report this interest for the year paid. When the notes or bonds mature, you can redeem these securities for face value.

Treasury notes and bonds are usually sold by auction with competitive bidding. If, after compiling the competitive bids, a determination is made that the purchase price is less than the face value, you will receive a refund for the difference between the purchase price and the face value. This amount is considered original issue discount. However, the original issue discount rules (discussed later) do not apply if the discount is less than one-fourth of 1% (.0025) of the face amount multiplied by the number of full years from the date of original issue to maturity. See De minimis OID under Original Issue Discount (OID), later. If the purchase price is determined to be more than the face amount, the difference is a premium. (See Bond Premium Amortization in chapter 3.)

For other information on these notes or bonds, write to:

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

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

Treasury inflation-indexed securities.   These securities pay interest twice a year at a fixed rate, based on a principal amount that is adjusted to take into account inflation and deflation. For the tax treatment of these securities, see Inflation-Indexed Debt Instruments under Original Issue Discount (OID), later.

Retirement, sale, or redemption.   For information on the retirement, sale, or redemption of U.S. government obligations, see Capital or Ordinary Gain or Loss in chapter 4. Also see Nontaxable Trades in chapter 4 for information about trading U.S. Treasury obligations for certain other designated issues.

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