Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

Market Discount Bonds

A market discount bond is any bond having market discount except:

1. Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),
2. Tax-exempt obligations that you bought before May 1, 1993,
3. U.S. savings bonds, and
4. Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date, generally because of an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

1. You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments under Capital Gains and Losses in chapter 4.
2. You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount. See Partial principal payments, later in this discussion.
3. If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Deferral of interest deduction for market discount bonds under When To Deduct Investment Interest in chapter 3.

Market discount.   Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than one-fourth of 1% (.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond).

If a market discount bond also has OID, the market discount is the sum of the bond's issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.

Bonds acquired at original issue.   Generally, a bond that you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you are also considered to have acquired it at original issue.

Exceptions.   A bond you acquired at original issue can be a market discount bond if either of the following is true.

1. Your cost basis in the bond is less than the bond's issue price.
2. The bond is issued in exchange for a market discount bond under a plan of reorganization. (This does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same.)

Accrued market discount.   The accrued market discount is figured in one of two ways.

Ratable accrual method.   Treat the market discount as accruing in equal daily installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.

Constant yield method.   Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond.

For information about using the constant yield method, see Figuring OID using the constant yield method under Debt Instruments Issued After 1984 in Publication 1212. To use this method to figure market discount (instead of OID), treat the bond as having been issued on the date you acquired it. Treat the amount of your basis (immediately after you acquired the bond) as the issue price. Then apply the formula shown in Publication 1212.

Choosing to include market discount in income currently.   You can make this choice if you have not revoked a prior choice to include market discount in income currently within the last 5 calendar years. Make the choice by attaching to your timely filed return a statement in which you:

1. State that you have included market discount in your gross income for the year under section 1278(b) of the Internal Revenue Code, and
2. Describe the method you used to figure the accrued market discount for the year.

Once you make this choice, it will apply to all market discount bonds that you acquire during the tax year and in later tax years. You cannot revoke your choice without the consent of the IRS.

Also see Election To Report All Interest as OID, later. If you make that election, you must use the constant yield method.

Effect on basis.   You increase the basis of your bonds by the amount of market discount you include in your income.

Partial principal payments.   If you receive a partial payment of principal on a market discount bond that you acquired after October 22, 1986, and you did not choose to include the discount in income currently, you must treat the payment as ordinary interest income up to the amount of the bond's accrued market discount. Reduce the amount of accrued market discount reportable as interest at disposition by that amount.

You can choose to figure accrued market discount for this purpose:

1. On the basis of the constant yield method, described earlier,
2. In proportion to the accrual of OID for any accrual period, if the debt instrument has OID, or
3. In proportion to the amount of stated interest paid in the accrual period, if the debt instrument has no OID.

Under method (2) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator (top part) of the fraction is the OID for the period, and the denominator (bottom part) is the total remaining OID at the beginning of the period.

Under method (3) above, figure accrued market discount for a period by multiplying the total remaining market discount by a fraction. The numerator is the stated interest paid in the accrual period, and the denominator is the total stated interest remaining to be paid at the beginning of the accrual period.

Discount on
Short-Term Obligations

When you buy a short-term obligation (one with a fixed maturity date of 1 year or less from the date of issue), other than a tax-exempt obligation, you can generally choose to include any discount and interest payable on the obligation in income currently. If you do not make this choice, the following rules generally apply.

1. You must treat any gain when you sell, exchange, or redeem the obligation as ordinary income, up to the amount of the ratable share of the discount. See Discounted Debt Instruments under Capital Gains and Losses in chapter 4.
2. If you borrow money to buy or carry the obligation, your deduction for interest paid on the debt is limited. See Deferral of interest deduction for short-term obligations under When To Deduct Investment Interest in chapter 3.

Short-term obligations for which no choice is available.   You must include any discount or interest in current income as it accrues for any short-term obligation (other than a tax-exempt obligation) that is:

1. Held by an accrual-basis taxpayer,
2. Held primarily for sale to customers in the ordinary course of your trade or business,
3. Held by a bank, regulated investment company, or common trust fund,
4. Held by certain pass-through entities,
5. Identified as part of a hedging transaction, or
6. A stripped bond or stripped coupon held by the person who stripped the bond or coupon (or by any other person whose basis in the obligation is determined by reference to the basis in the hands of that person).

Effect on basis.   Increase the basis of your obligation by the amount of discount you include in income currently.

Figuring the accrued discount.   Figure the accrued discount by using either the ratable accrual method or the constant yield method discussed previously in Accrued market discount under Market Discount Bonds, earlier.

Government obligations.   For an obligation described above that is a short-term government obligation, the amount you include in your income for the current year is the accrued acquisition discount, if any, plus any other accrued interest payable on the obligation. The acquisition discount is the stated redemption price at maturity minus your basis.

If you choose to use the constant yield method to figure accrued acquisition discount, treat the cost of acquiring the obligation as the issue price. If you choose to use this method, you cannot change your choice.

Nongovernment obligations.   For an obligation listed above that is not a government obligation, the amount you include in your income for the current year is the accrued OID, if any, plus any other accrued interest payable. If you choose the constant yield method to figure accrued OID, apply it by using the obligation's issue price.

Choosing to include accrued acquisition discount instead of OID.   You can choose to report accrued acquisition discount (defined earlier under Government obligations) rather than accrued OID on these short-term obligations. Your choice will apply to the year for which it is made and to all later years and cannot be changed without the consent of the IRS.

You must make your choice by the due date of your return, including extensions, for the first year for which you are making the choice. Attach a statement to your return or amended return indicating:

1. Your name, address, and social security number,
2. The choice you are making and that it is being made under section 1283(c)(2) of the Internal Revenue Code,
3. The period for which the choice is being made and the obligation to which it applies, and
4. Any other information necessary to show you are entitled to make this choice.

Choosing to include accrued discount and other interest in current income.   If you acquire short-term discount obligations that are not subject to the rules for current inclusion in income of the accrued discount or other interest, you can choose to have those rules apply. This choice applies to all short-term obligations you acquire during the year and in all later years. You cannot change this choice without the consent of the IRS.

The procedures to use in making this choice are the same as those described for choosing to include acquisition discount instead of OID on nongovernment obligations in current income. However, you should indicate that you are making the choice under section 1282(b)(2) of the Internal Revenue Code.

Also see the following discussion. If you make the election to report all interest currently as OID, you must use the constant yield method.

Election To Report
All Interest as OID

Generally, you can elect to treat all interest on a debt instrument acquired during the tax year as OID and include it in income currently. For purposes of this election, interest includes stated interest, acquisition discount, OID, de minimis OID, market discount, de minimis market discount, and unstated interest as adjusted by any amortizable bond premium or acquisition premium. See Treasury Regulation 1.1272-3.

When To Report
Interest Income

• Accrual method
• Cash method

When to report your interest income depends on whether you use the cash method or an accrual method to report income.

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

Example.   On September 1, 2000, you loaned another individual $2,000 at 12% compounded annually. You are not in the business of lending money. The note stated that principal and interest would be due on August 31, 2002. In 2002, you received $2,508.80 ($2,000 principal and $508.80 interest). If you use the cash method, you must include in income on your 2002 return the $508.80 interest you received in that year.

Constructive receipt.   You constructively receive income when it is credited to your account or made available to you. You do not need to have physical possession of it. For example, you are considered to receive interest, dividends, or other earnings on any deposit or account in a bank, savings and loan, or similar financial institution, or interest on life insurance policy dividends left to accumulate, when they are credited to your account and subject to your withdrawal. This is true even if they are not yet entered in your passbook.

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

1. Make withdrawals in multiples of even amounts,
2. Give a notice to withdraw before making the withdrawal,
3. Withdraw all or part of the account to withdraw the earnings, or
4. Pay a penalty on early withdrawals, unless the interest you are to receive on an early withdrawal or redemption is substantially less than the interest payable at maturity.

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

Example.   If, in the previous example, you use an accrual method, you must include the interest in your income as you earn it. You would report the interest as follows: 2000, $80; 2001, $249.60; and 2002, $179.20.

Coupon bonds.   Interest on coupon bonds is taxable in the year the coupon becomes due and payable. It does not matter when you mail the coupon for payment.

How To Report
Interest Income

• Nominee
• Original issue discount (OID)

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

You cannot use Form 1040EZ if your interest income is more than $1,500. Instead, you must use Form 1040A or Form 1040.

In addition, you cannot use Form 1040EZ if you must use Form 1040, as described later, or if any of the statements listed under Schedule B, later, are true.

Form 1040A.   You must complete Part I of Schedule 1 (Form 1040A) if you file Form 1040A and any of the following are true.

1. Your taxable interest income is more than $1,500.
2. You are claiming the interest exclusion under the Education Savings Bond Program (discussed earlier).
3. You received interest from a seller-financed mortgage, and the buyer used the property as a home.
4. You received a Form 1099-INT for tax-exempt interest.
5. You received a Form 1099-INT for U.S. savings bond interest that includes amounts you reported before 2002.
6. You received, as a nominee, interest that actually belongs to someone else.
7. You received a Form 1099-INT for interest on frozen deposits.

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

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

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

1. You forfeited interest income because of the early withdrawal of a time deposit,
2. You received or paid accrued interest on securities transferred between interest payment dates,
3. You had a financial account in a foreign country, unless the combined value of all foreign accounts was $10,000 or less during all of 2002 or the accounts were with certain U.S. military banking facilities,
4. You acquired taxable bonds after 1987 and choose to reduce interest income from the bonds by any amortizable bond premium (discussed in chapter 3 under Bond Premium Amortization), or
5. You are reporting OID in an amount more or less than the amount shown on Form 1099-OID.

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

1. Your taxable interest income is more than $1,500.
2. You are claiming the interest exclusion under the Education Savings Bond Program (discussed earlier).
3. You had a foreign account.
4. You received interest from a seller-financed mortgage, and the buyer used the property as a home.
5. You received a Form 1099-INT for tax-exempt interest.
6. You received a Form 1099-INT for U.S. savings bond interest that includes amounts you reported before 2002.
7. You received, as a nominee, interest that actually belongs to someone else.
8. You received a Form 1099-INT for interest on frozen deposits.
9. You received a Form 1099-INT for interest on a bond that you bought between interest payment dates.
10. Statement (4) or (5) in the preceding list is true.

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

Reporting tax-exempt interest.   Report the total of your tax-exempt interest (such as interest or accrued OID on certain state and municipal bonds) and exempt-interest dividends from a mutual fund on line 8b of Form 1040A or Form 1040. If you file Form 1040EZ, print TEI in the space to the right of the words Form 1040EZ on line 2. After TEI, show the amount of your tax-exempt interest, but do not add tax-exempt interest in the total on Form 1040EZ, line 2.

You should not have received a Form 1099-INT for tax-exempt interest. But if you did, you must fill in Schedule 1 (Form 1040A) or Schedule B (Form 1040). See the Schedule 1 or Schedule B instructions for how to report this. Be sure to also show this tax-exempt interest on line 8b.

Do not report interest from an individual retirement arrangement (IRA) as tax-exempt interest.

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

1099 INT

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

Box 3 of Form 1099-INT shows the amount of interest income you received from U.S. savings bonds, Treasury bills, Treasury notes, and Treasury bonds. Add the amount shown in box 3 to any other taxable interest income you received, unless part of the amount in box 3 was previously included in your interest income. If part of the amount shown in box 3 was previously included in your interest income, see U.S. savings bond interest previously reported, later. If you redeemed U.S. savings bonds you bought after 1989 and you paid qualified educational expenses, see Interest excluded under the Education Savings Bond Program, later.

Box 4 (federal income tax withheld) of Form 1099-INT will contain an amount if you were subject to backup withholding. Report the amount from box 4 on Form 1040EZ, line 7, on Form 1040A, line 39, or on Form 1040, line 62.

Box 5 of Form 1099-INT shows investment expenses you may be able to deduct as an itemized deduction. Chapter 3 discusses investment expenses.

If there are entries in boxes 6 and 7 of Form 1099-INT, you must file Form 1040. You may be able to take a credit for the amount shown in box 6 (foreign tax paid) unless you deduct this amount on Schedule A of Form 1040 as Other taxes. To take the credit, you may have to file Form 1116, Foreign Tax Credit. For more information, see Publication 514, Foreign Tax Credit for Individuals.

Form 1099-OID.   The taxable OID on a discounted obligation for the part of the year you owned it is shown in box 1 of Form 1099-OID. Include this amount in your total taxable interest income. But see Refiguring OID shown on Form 1099-OID under Original Issue Discount (OID), earlier.

You must report all taxable OID even if you do not receive a Form 1099-OID.

Box 2 of Form 1099-OID shows any taxable interest on the obligation other than OID. Add this amount to the OID shown in box 1 and include the result in your total taxable income.

If you forfeited interest or principal on the obligation because of an early withdrawal, the deductible amount will be shown in box 3. See Penalty on early withdrawal of savings, later.

Box 4 of Form 1099-OID will contain an amount if you were subject to backup withholding. Report the amount from box 4 on Form 1040EZ, line 7, on Form 1040A, line 39, or on Form 1040, line 62.

Box 7 of Form 1099-OID shows investment expenses you may be able to deduct as an itemized deduction. Chapter 3 discusses investment expenses.

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

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

1. Several lines above line 2, enter a subtotal of all interest listed on line 1.
2. Below the subtotal write U.S. Savings Bond Interest Previously Reported and enter amounts previously reported or interest accrued before you received the bond.
3. Subtract these amounts from the subtotal and enter the result on line 2.

Example 1.   Your parents bought U.S. savings bonds for you when you were a child. The bonds were issued in your name, and the interest on the bonds was reported each year as it accrued. (See Choice to report interest each year under U.S. Savings Bonds, earlier.)

On line 1, Part I of Schedule 1 (Form 1040A), enter your interest income as shown on Form 1099-INT - $1,022.00. (If you had other taxable interest income, you would enter it next and then enter a subtotal, as described earlier, before going to the next step.) Several lines above line 2, write U.S. Savings Bond Interest Previously Reported and enter $990.80 ($1,022.00 - $31.20). Subtract $990.80 from $1,022.00 and write $31.20 on line 2. Enter $31.20 on line 4 of Schedule 1 and on line 8a of Form 1040A.

Example 2.   Your uncle died and left you a $1,000 series EE bond. You redeem the bond when it reaches maturity.

You file Form 1040 and you complete Schedule B. On line 1 of Schedule B, you list the $500 and $300 interest amounts shown on your Forms 1099. Several lines above line 2, you put a subtotal of $800. Below this subtotal, write U.S. Savings Bond Interest Previously Reported and enter the $200 interest included in your uncle's final return. Subtract the $200 from the subtotal and write $600 on line 2. You then complete the rest of the form.

Worksheet for savings bonds distributed from a retirement or profit-sharing plan.   If you cashed a savings bond acquired in a taxable distribution from a retirement or profit-sharing plan (as discussed under U.S. Savings Bonds, earlier), your interest income does not include the interest accrued before the distribution and taxed as a distribution from the plan.

Use the worksheet below to figure the amount you subtract from the interest shown on Form 1099-INT.

Your employer should tell you the value of each bond on the date it was distributed.

Example.   You received a distribution of series EE U.S. savings bonds in December 2000 from your company's profit-sharing plan.