2000 Publication 550

ContentsImportant Changes ............................ 1

Important Reminders ......................... 2

Introduction ........................................ 2

Chapter 1. Investment Income .......... 3General Information ........................ 3Interest Income ............................... 4Discount on Debt Instruments ........ 12When To Report Interest Income ... 15How To Report Interest Income ..... 16Dividends and Other Corporate

Distributions ............................. 18Stripped Preferred Stock ................ 22REMICs, FASITs, and Other CDOs 22S Corporations ................................ 23Investment Clubs ............................ 24

Chapter 2. Tax Shelters ..................... 26

Chapter 3. Investment Expenses ..... 29Limits on Deductions ...................... 29Interest Expenses ........................... 29Bond Premium Amortization ........... 31Expenses of Producing Income ...... 32Nondeductible Expenses ................ 33How To Report Investment

Expenses ................................. 34When To Report Investment

Expenses ................................. 34

Chapter 4. Sales and Trades ofInvestment Property ................... 36

What is a Sale or Trade? ............... 36Basis of Investment Property ......... 39How To Figure Gain or Loss .......... 42Nontaxable Trades ......................... 43Transfers Between Spouses .......... 44Related Party Transactions ............ 44Capital Gains and Losses .............. 45

Holding Period ............................. 49Nonbusiness Bad Debts .............. 50Short Sales .................................. 51Wash Sales .................................. 52Options ......................................... 53Straddles ...................................... 54Rollover of Gain From Publicly

Traded Securities ..................... 57Gains on Qualified Small Business

Stock ........................................ 58Reporting Capital Gains and

Losses ...................................... 59Special Rules for Traders in

Securities ................................. 64

Chapter 5. How To Get Tax Help ...... 65

Glossary .............................................. 66

Index .................................................... 68

Important ChangesReporting capital gain distributions onForm 1040A. For 2000, you may be able toreport your capital gain distributions frommutual funds on Form 1040A, instead of onForm 1040. A worksheet in the Form 1040Ainstructions is used to figure the tax. For de-tails, see Reporting Capital Gains and Lossesin chapter 4.

Departmentof theTreasury

InternalRevenueService

Publication 550Cat. No. 15093R

InvestmentIncome andExpenses(Including CapitalGains and Losses)

For use in preparing

2000 Returns

Definition of noncapital assets expanded.The definition of noncapital assets (assetsthat generally produce ordinary rather thancapital gain or loss when sold) has been ex-panded to include three additional categoriesof assets. These are listed in chapter 4 underCapital Assets and Noncapital Assets.

Constructive ownership transactions. Ifyou have a gain from a constructive owner-ship transaction entered into after July 11,1999, involving certain financial assets andthe gain normally would be treated as along-term capital gain, all or part of the gainmay be treated as ordinary income. For moreinformation, see Gains From Certain Con-structive Ownership Transactions in chapter4.

Photographs of missing children. TheInternal Revenue Service is a proud partnerwith the National Center for Missing and Ex-ploited Children. Photographs of missingchildren selected by the Center may appearin this publication on pages that would other-wise be blank. You can help bring thesechildren home by looking at the photographsand calling 1–800–THE-LOST (1–800–843–5678) if you recognize a child.

Important RemindersInvesting in DC Zone assets. Beginning in2003, investments in District of ColumbiaEnterprise Zone (DC Zone) assets held morethan 5 years will qualify for a special taxbenefit. If you sell or trade a DC Zone assetat a gain, you will not have to include anyqualified capital gain in your gross income.This exclusion applies to an interest in, orproperty of, certain businesses operating inthe District of Columbia. For more informa-

tion, see Publication 954, Tax Incentives forEmpowerment Zones and Other DistressedCommunities.

U.S. property acquired from a foreign per-son. If you acquire a U.S. real property in-terest from a foreign person or firm, you mayhave to withhold income tax on the amountyou pay for the property (including cash, thefair market value of other property, and anyassumed liability). Domestic or foreign cor-porations, partnerships, trusts, and estatesmay also have to withhold on certain distri-butions and other transactions involving U.S.real property interests. If you fail to withhold,you may be held liable for the tax, penaltiesthat apply, and interest. For more information,see Publication 515, Withholding of Tax onNonresident Aliens and Foreign Corporations.

Foreign source income. If you are a U.S.citizen with investment income from sourcesoutside the United States (foreign income),you must report that income on your tax re-turn unless it is exempt by U.S. law. This istrue whether you reside inside or outside theUnited States and whether or not you receivea Form 1099 from the foreign payer.

Alien's individual taxpayer identificationnumber (ITIN). The IRS will issue an ITIN toa nonresident or resident alien who does nothave and is not eligible to get a social securitynumber (SSN). To apply for an ITIN, file FormW–7, Application for IRS Individual TaxpayerIdentification Number with the IRS. Enteryour ITIN wherever an SSN is requested ona tax return. If you must include anotherperson's SSN on your return and that persondoes not have and cannot get an SSN, enterthat person's ITIN.

An ITIN is for tax use only. It does notentitle you to social security benefits orchange your employment or immigration sta-tus under U.S. law.

IntroductionThis publication provides information on thetax treatment of investment income and ex-penses. It explains what investment incomeis taxable and what investment expenses aredeductible. It explains when and how to showthese items on your tax return. It also explainshow to determine and report gains and losseson the disposition of investment property andprovides information on property trades andtax shelters.

There is a glossary at the end of thispublication that defines many of the termsused.

Investment income. This generally includesinterest, dividends, capital gains, and othertypes of distributions.

Investment expenses. These include inter-est paid or incurred to acquire investmentproperty and expenses to manage or collectincome from investment property.

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our website at www.irs.gov/help/email2.html .

You can write to us at the following ad-dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

We respond to many letters by telephone.Therefore, it would be helpful if you wouldinclude your daytime phone number, includ-ing the area code, in your correspondence.

1.InvestmentIncome

TopicsThis chapter discusses:

• Interest income,

• Dividends and other corporate distribu-tions,

• Real estate mortgage investmentconduits (REMICs), financial assetsecuritization investment trusts (FASITs),and other collateralized debt obligations(CDOs),

• S corporations, and

• Investment clubs.

Useful ItemsYou may want to see:

Publication

� 525 Taxable and Nontaxable Income

� 537 Installment Sales

� 564 Mutual Fund Distributions

� 590 Individual Retirement Arrange-ments (IRAs)

� 925 Passive Activity and At-Risk Rules

� 1212 List of Original Issue Discount In-struments

Form (and Instructions)

� Schedule B (Form 1040) Interest andOrdinary Dividends

� Schedule 1 (Form 1040A) Interest andOrdinary Dividends for Form1040A Filers

� 1099 General Instructions for Forms1099, 1098, 5498, and W–2G

� 3115 Application for Change in Ac-counting Method

� 6251 Alternative Minimum Tax — Indi-viduals

� 8582 Passive Activity Loss Limitations

� 8615 Tax for Children Under Age 14Who Have Investment Income ofMore Than $1,400

� 8814 Parents' Election To ReportChild's Interest and Dividends

� 8815 Exclusion of Interest From SeriesEE and I U.S. Savings Bonds Is-sued After 1989

� 8818 Optional Form To Record Re-demption of Series EE and I U.S.Savings Bonds Issued After 1989

See chapter 5 for information about get-ting these publications and forms.

General InformationA few items of general interest are coveredhere.

RECORDS

Recordkeeping. You should keep alist showing sources and amounts ofinvestment income that you receive

during the year. Also, keep the forms you re-ceive that show your investment income(Forms 1099–INT, Interest Income, and1099–DIV, Dividends and Distributions, forexample) as an important part of your rec-ords.

Tax on investment income of a child underage 14. Part of a child's 2000 investmentincome may be taxed at the parent's tax rate.This may happen if all of the following aretrue.

1) The child was under age 14 on January1, 2001.

2) The child had more than $1,400 of in-vestment income (such as taxable inter-est and dividends) and has to file a taxreturn.

3) Either parent was alive at the end of2000.

If all of these statements are true, Form 8615must be completed and attached to the child'stax return. If any of these statements is nottrue, Form 8615 is not required and the child'sincome is taxed at his or her own tax rate.

However, the parent can choose to in-clude the child's interest and dividends on theparent's return if certain requirements aremet. Use Form 8814 for this purpose.

For more information about the tax on in-vestment income of children and the parents'election, see Publication 929, Tax Rules forChildren and Dependents.

Beneficiary of an estate or trust. Interest,dividends, and other investment income youreceive as a beneficiary of an estate or trustis generally taxable income. You should re-ceive a Schedule K–1 (Form 1041), Benefi-ciary's Share of Income, Deductions, Credits,etc., from the fiduciary. Your copy of Sched-ule K–1 and its instructions will tell you whereto report the income on your Form 1040.

Social security number (SSN). You mustgive your name and SSN to any person re-quired by federal tax law to make a return,statement, or other document that relates toyou. This includes payers of interest and div-idends.

SSN for joint account. If the funds in ajoint account belong to one person, list thatperson's name first on the account and givethat person's SSN to the payer. (For infor-mation on who owns the funds in a joint ac-count, see Joint accounts, later.) If the jointaccount contains combined funds, give theSSN of the person whose name is listed firston the account.

These rules apply both to joint ownershipby a married couple and to joint ownershipby other individuals. For example, if you opena joint savings account with your child usingfunds belonging to the child, list the child'sname first on the account and give the child'sSSN.

Custodian account for your child. Ifyour child is the actual owner of an accountthat is recorded in your name as custodian forthe child, give the child's SSN to the payer.For example, you must give your child's SSNto the payer of dividends on stock owned byyour child, even though the dividends are paidto you as custodian.

Penalty for failure to supply SSN. Youwill be subject to a penalty if, when required,you fail to:

1) Include your SSN on any return, state-ment, or other document,

2) Give your SSN to another person whohas to include it on any return, state-ment, or other document, or

3) Include the SSN of another person onany return, statement, or other docu-ment.

The penalty is $50 for each failure up to amaximum penalty of $100,000 for any calen-dar year.

You will not be subject to this penalty ifyou can show that your failure to provide theSSN was due to a reasonable cause and notto willful neglect.

If you fail to supply an SSN, you may alsobe subject to backup withholding.

Backup withholding. Your investment in-come is generally not subject to regular with-holding. However, it may be subject to backupwithholding to ensure that income tax is col-lected on the income. Under backup with-holding, the bank, broker, or other payer ofinterest, original issue discount (OID), divi-dends, cash patronage dividends, or royaltiesmust withhold, as income tax, 31% of theamount you are paid.

Backup withholding applies if:

1) You do not give the payer your identifi-cation number (either a social securitynumber or an employer identificationnumber) in the required manner,

2) The Internal Revenue Service (IRS) no-tifies the payer that you gave an incor-rect identification number,

3) The IRS notifies the payer that you aresubject to backup withholding on interestor dividends because you haveunderreported interest or dividends onyour income tax return, or

4) You are required, but fail, to certify thatyou are not subject to backup withhold-ing for the reason described in (3).

Certification. For new accounts payinginterest or dividends, you must certify underpenalties of perjury that your social securitynumber (SSN) is correct and that you are notsubject to backup withholding. Your payer willgive you a Form W–9 , Request for TaxpayerIdentification Number and Certification, orsimilar form, to make this certification. If youfail to make this certification, backup with-holding may begin immediately on your newaccount or investment.

Underreported interest and dividends.You will be considered to have underreportedyour interest and dividends if the IRS hasdetermined for a tax year that—

1) You failed to include any part of a re-portable interest or dividend paymentrequired to be shown on your return, or

Chapter 1 Investment Income

2) You were required to file a return and toinclude a reportable interest or dividendpayment on that return, but you failed tofile the return.

How to stop backup withholding due tounderreporting. If you have been notifiedthat you underreported interest or dividends,you can request a determination from the IRSto prevent backup withholding from startingor to stop backup withholding once it has be-gun. You must show that at least one of thefollowing situations applies.

1) No underreporting occurred.

2) You have a bona fide dispute with theIRS about whether underreporting oc-curred.

3) Backup withholding will cause or iscausing an undue hardship, and it isunlikely that you will underreport interestand dividends in the future.

4) You have corrected the underreportingby filing a return if you did not previouslyfile one and by paying all taxes, penal-ties, and interest due for anyunderreported interest or dividend pay-ments.

If the IRS determines that backup with-holding should stop, it will provide you with acertification and will notify the payers whowere sent notices earlier.

How to stop backup withholding due toan incorrect identification number. If youhave been notified by a payer that you aresubject to backup withholding because youhave provided an incorrect SSN or employeridentification number, you can stop it by fol-lowing the instructions the payer gives you.

Reporting backup withholding. Ifbackup withholding is deducted from your in-terest or dividend income or other reportablepayment, the bank or other business mustgive you an information return for the year (forexample, a Form 1099–INT) that indicates theamount withheld. The information return willshow any backup withholding as “Federal in-come tax withheld.”

Nonresident aliens. Generally, pay-ments made to nonresident aliens are notsubject to backup withholding. You can useForm W–8BEN , Certificate of Foreign Statusof Beneficial Owner for United States TaxWithholding, to certify exempt status. How-ever, this does not exempt you from the 30%(or lower treaty) withholding rate that mayapply to your investment income. For infor-mation on the 30% rate, see Publication 519,U.S. Tax Guide for Aliens.

Penalties. There are civil and criminalpenalties for giving false information to avoidbackup withholding. The civil penalty is $500.The criminal penalty, upon conviction, is afine of up to $1,000, or imprisonment of up to1 year, or both.

Where to report investment income. Table1–1 gives an overview of the forms andschedules to use to report some commontypes of investment income. But, see the restof this publication for detailed informationabout reporting investment income.

Joint accounts. In a joint account, two ormore 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 theproperty as determined by local law.

Example. You and your husband have ajoint money market account. Under state law,half the income from the account belongs toyou, and half belongs to your husband. If youfile separate returns, you each report half ofthe income.

Income from property given to a child.Property you give as a parent to your childunder the Model Gifts of Securities to MinorsAct, the Uniform Gifts to Minors Act, or anysimilar law, becomes the child's property.

Income from the property is taxable to thechild, except that any part used to satisfy alegal obligation to support the child is taxableto the parent or guardian having that legalobligation.

Savings account with parent as trustee.Interest income from a savings accountopened for a child who is a minor, but placedin the name and subject to the order of theparents as trustees, is taxable to the child if,under the law of the state in which the childresides, both of the following are true.

1) The savings account legally belongs tothe child.

2) The parents are not legally permitted touse any of the funds to support the child.

Accuracy-related penalty. An accuracy-related penalty of 20% can be charged forunderpayments of tax due to negligence ordisregard of rules or regulations or substantialunderstatement of tax. For information on thepenalty and any interest that applies, seePenalties in chapter 2.

Interest Income Terms you may need to know (seeGlossary):

Accrual method Below-market loanCash method Demand loanForgone interest Gift loanInterestNominee Original issue discount Private activity bondTerm loan

This section discusses the tax treatment ofdifferent types of interest income.

In general, any interest that you receiveor that is credited to your account and canbe withdrawn is taxable income. (It does nothave to be entered in your passbook.) Ex-ceptions to this rule are discussed later.

Form 1099–INT. Interest income is gener-ally reported to you on Form 1099–INT, or asimilar statement, by banks, savings andloans, and other payers of interest. This formshows you the interest you received duringthe 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 amountof interest income that you receive for the taxyear. This includes amounts reported to youon Form 1099–INT and amounts for whichyou did not receive a Form 1099–INT.

Nominees. Generally, if someone re-ceives interest as a nominee for you, thatperson will give you a Form 1099–INT show-ing the interest received on your behalf.

If you receive a Form 1099–INT that in-cludes amounts belonging to another person,see the discussion on nominee distributions,later, under How To Report Interest Income.

Incorrect amount. If you receive a Form1099–INT that shows an incorrect amount (orother incorrect information), you should askthe issuer for a corrected form. The new Form1099–INT you receive will be marked “COR-RECTED.”

Form 1099–OID. Reportable interest incomemay also be shown on Form 1099–OID, Ori-ginal Issue Discount. For more informationabout amounts shown on this form, see Ori-ginal Issue Discount (OID), later in this chap-ter.

Exempt-interest dividends. Exempt-interest dividends you receive from a regu-lated investment company (mutual fund) arenot included in your taxable income. (How-ever, see Information-reporting requirement,next.) You will receive a notice from the mu-tual fund telling you the amount of theexempt-interest dividends that you received.Exempt-interest dividends are not shown onForm 1099–DIV or Form 1099–INT.

Information-reporting requirement. Al-though exempt-interest dividends are nottaxable, you must show them on your tax re-turn if you have to file. This is aninformation-reporting requirement and doesnot change the exempt-interest dividends totaxable income. See How To Report InterestIncome, later.

Note. Exempt-interest dividends paidfrom specified private activity bonds may besubject to the alternative minimum tax. SeeForm 6251 and its instructions for more in-formation about this tax. (Private activitybonds are discussed later under State or Lo-cal Government Obligations.)

Interest on VA dividends. Interest on in-surance dividends that you leave on depositwith the Department of Veterans Affairs (VA)is not taxable. This includes interest paid ondividends on converted United States Gov-ernment Life Insurance policies and on Na-tional Service Life Insurance policies.

Individual retirement arrangements (IRAs).Interest on a Roth IRA or education IRAgenerally is not taxable. Interest on a tradi-tional IRA is tax deferred. You generally donot include it in your income until you makewithdrawals from the IRA. See Publication590 for more information.

Taxable Interest — General Taxable interest includes interest you receivefrom bank accounts, loans you make to oth-ers, and other sources. The following aresome sources of taxable interest.

Dividends that are actually interest. Cer-tain distributions commonly called dividendsare actually interest. You must report as in-terest so-called “dividends” on deposits or onshare accounts in:

• Cooperative banks,

• Credit unions,


Table 1–1. Where To Report Common Types of Investment Income

IncomeIf you fileForm 1040

If you can fileForm 1040A

If you can fileForm 1040EZ

Taxable interest that totals$400 or less

Ordinary dividends that total$400 or less

Taxable interest that totalsmore than $400

Ordinary dividends that totalmore than $400

Savings bond interest you willexclude because of highereducation expenses

Gain or loss from sale ofstocks and bonds

Gain or loss from exchangesof like investment property

Line 2Line 8a (You may need to fileSchedule B as well.)

Line 9 (You may need to fileSchedule B as well.)

Line 8a; also use Schedule B

Line 9; also use Schedule B

Schedule B; also use Form8815

Line 13; also use Schedule D

Line 13; also use Schedule Dand Form 8824

Line 8a (You may need to fileSchedule 1 as well.)

Line 9 (You may need to fileSchedule 1 as well.)

Line 8a; also use Schedule 1

Line 9; also use Schedule 1

Schedule 1; also use Form8815

You cannot use Form 1040A.

You cannot use Form 1040EZ.

(For detailed information about reporting investment income, see the rest of this publication, especiallyHow To Report Interest Income and How To Report Dividend Income in chapter 1.)

Capital gain distributions(if you have to file Schedule D)

Schedule D, line 13

Capital gain distributions (if youdo not have to file Schedule D)

Line 13 Line 10

• Domestic building and loan associations,

• Domestic savings and loan associations,

• Federal savings and loan associations,and

• Mutual savings banks.

Money market funds. Generally, amountsyou receive from money market funds shouldbe reported as dividends, not as interest.

Money market certificates, savings certif-icates, and other deferred interest ac-counts. If you open any of these accounts,interest may be paid at fixed intervals of 1year or less during the term of the account.You generally must include this interest inyour income when you actually receive it orare entitled to receive it without paying asubstantial penalty. The same is true for ac-counts that mature in 1 year or less and payinterest in a single payment at maturity. If in-terest is deferred for more than 1 year, seeOriginal Issue Discount (OID), later.

Interest subject to penalty for earlywithdrawal. If you withdraw funds from adeferred interest account before maturity, youmay have to pay a penalty. You must reportthe total amount of interest paid or creditedto your account during the year, without sub-tracting the penalty. See Penalty on earlywithdrawal of savings under How To ReportInterest Income, later, for more informationon how to report the interest and deduct thepenalty.

Money borrowed to invest in moneymarket certificate. The interest you pay onmoney borrowed from a bank or savings in-stitution to meet the minimum deposit re-quired for a money market certificate from theinstitution and the interest you earn on thecertificate are two separate items. You mustreport the total interest you earn on the cer-tificate in your income. If you itemize de-ductions, you can deduct the interest you payas investment interest, up to the amount of

your net investment income. See InterestExpenses in chapter 3.

Example. You deposited $5,000 with abank and borrowed $5,000 from the bank tomake up the $10,000 minimum deposit re-quired to buy a 6–month money market cer-tificate. The certificate earned $575 at matu-rity in 2000, but you received only $265,which represented the $575 you earned mi-nus $310 interest charged on your $5,000loan. The bank gives you a Form 1099–INTfor 2000 showing the $575 interest youearned. The bank also gives you a statementshowing that you paid $310 interest for 2000.You must include the $575 in your income. Ifyou itemize your deductions on Schedule A(Form 1040), you can deduct $310, subjectto the net investment income limit.

Gift for opening account. If you receivenoncash gifts or services for making depositsor for opening an account in a savings insti-tution, you may have to report the value asinterest.

For deposits of less than $5,000, gifts orservices valued at more than $10 must bereported as interest. For deposits of $5,000or more, gifts or services valued at more than$20 must be reported as interest. The valueis determined by the cost to the financial in-stitution.

Example. You open a savings accountat your local bank and deposit $800. The ac-count earns $20 interest. You also receive a$15 calculator. If no other interest is creditedto your account during the year, the Form1099–INT you receive will show $35 interestfor the year. You must report $35 interest in-come on your tax return.

Interest on insurance dividends. Intereston insurance dividends left on deposit withan insurance company that can be withdrawnannually is taxable to you in the year it iscredited to your account. However, if you can

withdraw it only on the anniversary date of thepolicy (or other specified date), the interest istaxable in the year that date occurs.

Prepaid insurance premiums. Any increasein the value of prepaid insurance premiums,advance premiums, or premium deposit fundsis interest if it is applied to the payment ofpremiums due on insurance policies or madeavailable for you to withdraw.

U.S. obligations. Interest on U.S. obli-gations, such as U.S. Treasury bills, notesand bonds, issued by any agency or instru-mentality of the United States is taxable forfederal income tax purposes.

Interest on tax refunds. Interest you receiveon tax refunds is taxable income.

Interest on condemnation award. If thecondemning authority pays you interest tocompensate you for a delay in payment of anaward, the interest is taxable.

Installment sale payments. If a contract forthe sale or exchange of property provides fordeferred payments, it also usually provides forinterest payable with the deferred payments.That interest is taxable when you receive it.If little or no interest is provided for in a de-ferred payment contract, part of each pay-ment may be treated as interest. See Un-stated Interest in Publication 537.

Interest on annuity contract. Accumulatedinterest on an annuity contract you sell beforeits maturity date is taxable.

Usurious interest. Usurious interest is in-terest charged at an illegal rate. This interestis taxable unless state law automaticallychanges it to a payment on the principal.

Interest income on frozen deposits. Ex-clude from your gross income interest on fro-zen deposits. A deposit is frozen if, at the end


of the year, you cannot withdraw any part ofthe deposit because:

1) The financial institution is bankrupt orinsolvent, or

2) The state in which the institution is lo-cated has placed limits on withdrawalsbecause other financial institutions in thestate are bankrupt or insolvent.

The amount of interest you must excludeis the interest that was credited on the frozendeposits minus the sum of:

1) The net amount you withdrew from thesedeposits during the year, and

2) The amount you could have withdrawnas of the end of the year (not reducedby any penalty for premature with-drawals of a time deposit).

If you receive a Form 1099–INT for interestincome on deposits that were frozen at theend of 2000, see Frozen deposits under HowTo Report Interest Income for informationabout reporting this interest income exclusionon your 2000 tax return.

The interest you exclude must be reportedin the later tax year when you can withdrawit from your account.

Example. $100 of interest was creditedon your frozen deposit during the year. Youwithdrew $80 but could not withdraw anymore as of the end of the year. You mustinclude $80 in your income for the year. Youmust exclude $20.

Bonds traded flat. If you buy a bond wheninterest has been defaulted or when the in-terest has accrued but has not been paid, thatinterest is not income and is not taxable asinterest if paid later. When you receive apayment of that interest, it is a return of cap-ital that reduces the remaining cost basis. In-terest that accrues after the date of purchase,however, is taxable interest income for theyear received or accrued. See Bonds SoldBetween Interest Dates, later in this chapter.

Below-Market Loans If you make a below-market gift or demandloan, you must report as interest income anyforgone interest (defined later) from that loan.The below-market loan rules and exceptionsare described in this section. For more infor-mation, see section 7872 of the InternalRevenue Code and its regulations.

If you receive a below-market loan, youmay be able to deduct the forgone interest,as well as any interest that you actually paid,but not if it is personal interest.

Loans subject to the rules. The rules forbelow-market loans apply to:

• Gift loans,

• Pay-related loans,

• Corporation-shareholder loans,

• Tax avoidance loans, and

• Loans to qualified continuing care facili-ties (made after October 11, 1985) undera continuing care contract.

A pay-related loan is any below-marketloan between an employer and an employeeor between an independent contractor and a

person for whom the contractor provides ser-vices.

A tax avoidance loan is any below-marketloan where the avoidance of federal tax is oneof the main purposes of the interest arrange-ment.

Forgone interest. For any period, forgoneinterest is:

1) The amount of interest that would bepayable for that period if interest accruedon the loan at the applicable federal rateand was payable annually on December31, minus

2) Any interest actually payable on the loanfor the period.

Applicable federal rate. Applicable fed-eral rates are published by the IRS eachmonth in the Internal Revenue Bulletin. Youcan also contact the IRS to get these rates.See chapter 5 for the telephone number tocall.

Rules for below-market loans. The rulesthat apply to a below-market loan depend onwhether the loan is a gift loan, demand loan,or term loan.

Gift and demand loans. A gift loan is anybelow-market loan where the forgone interestis in the nature of a gift.

A demand loan is a loan payable in full atany time upon demand by the lender. A de-mand loan is a below-market loan if no inter-est is charged or if interest is charged at arate below the applicable federal rate.

A demand loan or gift loan that is abelow-market loan is generally treated as anarm's-length transaction in which the lenderis treated as having made:

1) A loan to the borrower in exchange fora note that requires the payment of in-terest at the applicable federal rate, and

2) An additional payment to the borrower inan amount equal to the forgone interest.

The borrower is generally treated as trans-ferring the additional payment back to thelender as interest. The lender must report thatamount as interest income.

The lender's additional payment to theborrower is treated as a gift, dividend, contri-bution to capital, pay for services, or otherpayment, depending on the substance of thetransaction. The borrower may have to reportthis payment as taxable income, dependingon its classification.

These transfers are considered to occurannually, generally on December 31.

Term loans. A term loan is any loan thatis not a demand loan. A term loan is abelow-market loan if the amount of the loanis more than the present value of all paymentsdue under the loan.

A lender who makes a below-market termloan other than a gift loan is treated astransferring an additional lump-sum cashpayment to the borrower (as a dividend, con-tribution to capital, etc.) on the date the loanis made. The amount of this payment is theamount of the loan minus the present value,at the applicable federal rate, of all paymentsdue under the loan. An equal amount istreated as original issue discount (OID). Thelender must report the annual part of the OIDas interest income. The borrower may be ableto deduct the OID as interest expense. SeeOriginal Issue Discount (OID), later.

Exceptions to the below-market loan rules.Exceptions to the below-market loan rules arediscussed here.

Exception for loans of $10,000 or less.The rules for below-market loans do not applyto any day on which the total outstandingamount of loans between the borrower andlender is $10,000 or less. This exception ap-plies only to:

1) Gift loans between individuals if the giftloan is not directly used to buy or carryincome-producing assets, and

2) Pay-related loans or corporation-shareholder loans if the avoidance offederal tax is not a principal purpose ofthe interest arrangement.

This exception does not apply to a termloan described in (2) above that previouslyhas been subject to the below-market loanrules. Those rules will continue to apply evenif the outstanding balance is reduced to$10,000 or less.

Age exception for loans to continuingcare facilities. Loans to qualified continuingcare facilities under continuing care contractsare not subject to the rules for below-marketloans for the calendar year if the lender or thelender's spouse is 65 or older at the end ofthe year. For 2000, this exception applies onlyto the part of the total outstanding loan bal-ance that is $139,700 or less.

Exception for loans without significanttax effect. Loans are excluded from thebelow-market loan rules if their interest ar-rangements do not have a significant effecton the federal tax liability of the borrower orthe lender. These loans include:

1) Loans made available by the lender tothe general public on the same termsand conditions that are consistent withthe lender's customary business prac-tice,

2) Loans subsidized by a federal, state, ormunicipal government that are madeavailable under a program of generalapplication to the public,

3) Certain employee-relocation loans,

4) Certain loans from a foreign person, un-less the interest income would be effec-tively connected with the conduct of aU.S. trade or business and would not beexempt from U.S. tax under an incometax treaty,

5) Gift loans to a charitable organization,contributions to which are deductible, ifthe total outstanding amount of loansbetween the organization and lender is$250,000 or less at all times during thetax year, and

6) Other loans on which the interest ar-rangement can be shown to have nosignificant effect on the federal tax li-ability of the lender or the borrower.

For a loan described in (6) above, all thefacts and circumstances are used to deter-mine if the interest arrangement has a signif-icant effect on the federal tax liability of thelender or borrower. Some factors to be con-sidered are:

• Whether items of income and deductiongenerated by the loan offset each other,

• The amount of these items,


• The cost to you of complying with thebelow-market loan rules, if they were toapply, and

• Any reasons other than taxes for struc-turing the transaction as a below-marketloan.

If you structure a transaction to meet thisexception, and one of the principal purposesof structuring the transaction in that way is theavoidance of federal tax, the loan will beconsidered a tax-avoidance loan and this ex-ception will not apply.

Limit on forgone interest for gift loansof $100,000 or less. For gift loans betweenindividuals, if the outstanding loans betweenthe lender and borrower total $100,000 orless, the forgone interest to be included inincome by the lender and deducted by theborrower is limited to the amount of the bor-rower'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 limitdoes not apply to a loan if the avoidance offederal tax is one of the main purposes of theinterest arrangement.

Effective dates. These rules apply to termloans made after June 6, 1984, and to de-mand loans outstanding after that date.

U.S. Savings Bonds This section provides tax information on U.S.savings bonds. It explains how to report theinterest income on these bonds and how totreat transfers of these bonds.

For other information on U.S. savingsbonds, write to:

Bureau of the Public DebtAttn: Customer InformationP.O. Box 1328Parkersburg, WV 26106–1328.

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

Accrual method taxpayers. If you use anaccrual method of accounting, you must re-port interest on U.S. savings bonds each yearas it accrues. You cannot postpone reportinginterest until you receive it or until the bondsmature.

Cash method taxpayers. If you use thecash method of accounting, as most individ-ual taxpayers do, you generally report the in-terest on U.S. savings bonds when you re-ceive it. But see the discussion of Series EEand series I bonds, below.

Series HH bonds. These bonds are issuedat face value. Interest is paid twice a year bydirect deposit to your bank account. If you area cash method taxpayer, you must report in-terest on these bonds as income in the yearyou receive it.

Series HH bonds were first offered in1980. Before 1980, series H bonds were is-sued. Series H bonds are treated the sameas series HH bonds. If you are a cash methodtaxpayer, you must report the interest whenyou receive it.

Series H bonds have a maturity period of30 years. Series HH bonds mature in 20years.

Series EE and series I bonds. Interest onthese bonds is payable when you redeem thebonds. The difference between the purchaseprice and the redemption value is taxable in-terest.

Series EE bonds were first offered in July1980. They have a maturity period of 30years. Before July 1980, series E bondswere issued. The original 10-year maturityperiod of series E bonds has been extendedto 40 years for bonds issued before Decem-ber 1965 and 30 years for bonds issued afterNovember 1965. Series EE and series Ebonds are issued at a discount. The facevalue is payable to you at maturity.

Series I bonds were first offered in 1998.These are inflation-indexed bonds issued attheir face amount with a maturity period of 30years. The face value plus accrued interestis payable to you at maturity.

If you use the cash method of reportingincome, you can report the interest on seriesEE, series E, and series I bonds in either ofthe following ways.

1) Method 1. Postpone reporting the inter-est until the earlier of the year you cashor dispose of the bonds or the year inwhich they mature. (However, seeSavings bonds traded, later.) Note. Se-ries E bonds issued in 1960 and 1970matured in 2000. If you have usedmethod 1, you generally must report theinterest on these bonds on your 2000return.

2) Method 2. Choose to report the increasein redemption value as interest eachyear.

You must use the same method for all seriesEE, series E, and series I bonds you own. Ifyou do not choose method 2 by reporting theincrease in redemption value as interest eachyear, you must use method 1.

TIPIf you plan to cash your bonds in thesame year that you will pay for highereducational expenses, you may want

to use method 1 because you may be able toexclude the interest from your income. Tolearn how, see Education Savings Bond Pro-gram, later.

Change from method 1. If you want tochange your method of reporting the interestfrom method 1 to method 2, you can do sowithout permission from the IRS. In the yearof change you must report all interest accruedto date and not previously reported for all yourbonds.

Once you choose to report the interesteach year, you must continue to do so for allseries EE, series E, and series I bonds youown and for any you get later, unless you re-quest permission to change, as explainednext.

Change from method 2. To change frommethod 2 to method 1, you must requestpermission from the IRS. Permission for thechange is automatically granted if you sendthe IRS a statement that meets all the fol-lowing requirements.

1) You have typed or printed at the top,“Change in Method of Accounting UnderSection 6.01 of the Appendix of Rev.Proc. 99–49” (or later update).

2) It includes your name and social securitynumber under the label in (1).

3) It identifies the savings bonds for whichyou are requesting this change.

4) It includes your agreement to:

a) Report all interest on any bondsacquired during or after the year ofchange when the interest is realizedupon disposition, redemption, orfinal maturity, whichever is earliest,and

b) Report all interest on the bondsacquired before the year of changewhen the interest is realized upondisposition, redemption, or finalmaturity, whichever is earliest, withthe exception of the interest re-ported in prior tax years.

5) It includes your signature.

You must attach this statement to your taxreturn for the year of change, which you mustfile by the due date (including extensions).

You can have an automatic extension of6 months from the due date of your return(including extensions) to file the statementwith an amended return. To get this exten-sion, you must have filed your original returnby the due date (including extensions). At thetop of the statement, write “Filed Pursuant toReg. 301.9100–2.”

By the date you file the originalstatement, you must also send a copyto the address below.

Commissioner of Internal RevenueAttention: CC:DOM:IT&A (AutomaticRulings Branch)P.O. Box 7604Benjamin Franklin StationWashington, DC 20044.

If you use a private delivery service, sendthe copy to the Commissioner of InternalRevenue, Attention: CC:DOM:IT&A (Auto-matic Rulings Branch), 1111 Constitution Av-enue, NW, Washington, DC 20224.

Instead of filing this statement, you canrequest permission to change from method 2to method 1 by filing Form 3115. In that case,follow the form instructions for an automaticchange. No user fee is required.

Co-owners. If a U.S. savings bond is issuedin the names of co-owners, such as you andyour child or you and your spouse, intereston the bond is generally taxable to the co-owner who bought the bond.

One co-owner's funds used. If you usedyour funds to buy the bond, you must pay thetax on the interest. This is true even if you letthe other co-owner redeem the bond andkeep all the proceeds. Under these circum-stances, since the other co-owner will receivea Form 1099–INT at the time of redemption,the other co-owner must provide you withanother Form 1099–INT showing the amountof interest from the bond that is taxable toyou. The co-owner who redeemed the bondis a “nominee.” See Nominee distributionsunder How To Report Interest Income, later,for more information about how a person whois a nominee reports interest income belong-ing to another person.

Both co-owners' funds used. If you andthe other co-owner each contribute part of thebond's purchase price, the interest is gener-ally taxable to each of you, in proportion to theamount each of you paid.


Table 1–2. Who Pays the Tax on U.S. Savings Bond Interest

IF . . . THEN the tax on the bond interest mustbe paid by . . .

You buy a bond in your name and the nameof another person as co-owners, using onlyyour own funds

You buy a bond in the name of anotherperson, who is the sole owner of the bond

You and another person buy a bond asco-owners, each contributing part of thepurchase price

You and your spouse, who live in acommunity property state, buy a bond thatis community property

You.

The person for whom you bought the bond.

Both you and the other co-owner, inproportion to the amount each paid for thebond.

You and your spouse. If you file separatereturns, both you and your spouse generallypay tax on one-half of the interest.

Transfer to a trust. If you own series E,series EE, or series I bonds and transfer themto a trust, giving up all rights of ownership,you must include in your income for that yearthe interest earned to the date of transfer ifyou have not already reported it. However, ifyou are considered the owner of the trust andif the increase in value both before and afterthe transfer continues to be taxable to you,you can continue to defer reporting the inter-est earned each year. You must include thetotal interest in your income in the year youcash or dispose of the bonds or the year thebonds finally mature, whichever is earlier.

The same rules apply to previouslyunreported interest on series EE or series Ebonds if the transfer to a trust consisted ofseries HH or series H bonds you acquired ina trade for the series EE or series E bonds.See Savings bonds traded, later.

Decedents. The manner of reporting interestincome on series E, series EE, or series Ibonds, after the death of the owner, dependson the accounting and income-reportingmethod previously used by the decedent.

Decedent who reported interest eachyear. If the bonds transferred because ofdeath were owned by a person who used anaccrual method, or who used the cashmethod and had chosen to report the interesteach year, the interest earned in the year ofdeath up to the date of death must be re-ported on that person's final return. Theperson who acquires the bonds includes inincome only interest earned after the date ofdeath.

Decedent who postponed reporting in-terest. If the transferred bonds were ownedby a decedent who had used the cash methodand had not chosen to report the interest eachyear, and who had bought the bonds entirelywith his or her own funds, all interest earnedbefore death must be reported in one of thefollowing ways.

1) The surviving spouse or personal repre-sentative (executor, administrator, etc.)who files the final income tax return ofthe decedent can choose to include onthat return all of the interest earned onthe bonds before the decedent's death.The person who acquires the bonds thenincludes in income only interest earnedafter the date of death.

2) If the choice in (1) is not made, the in-terest earned up to the date of death isincome in respect of the decedent. Itshould not be included in the decedent'sfinal return. All of the interest earnedboth before and after the decedent'sdeath is income to the person who ac-quires the bonds. If that person uses thecash method and does not choose toreport the interest each year, he or shecan postpone reporting it until the yearthe bonds are cashed or disposed of orthe year they mature, whichever is ear-lier. In the year that person reports theinterest, he or she can claim a deductionfor any federal estate tax that was paidon the part of the interest included in thedecedent's estate.

For more information on income in respectof a decedent, see Publication 559, Survivors,Executors, and Administrators.

Example 1. Your uncle, a cash methodtaxpayer, died and left you a $1,000 seriesEE bond. He had bought the bond for $500

Community property. If you and yourspouse live in a community property state andhold bonds as community property, one-halfof the interest is considered received by eachof you. If you file separate returns, each ofyou generally must report one-half of thebond interest. For more information aboutcommunity property, see Publication 555,Community Property.

Table 1–2. These rules are also shownin Table 1–2.

Child as only owner. Interest on U.S.savings bonds bought for and registered onlyin the name of your child is income to yourchild, even if you paid for the bonds and arenamed as beneficiary. If the bonds are seriesEE, series E, or series I bonds, the intereston the bonds is income to your child in theearlier of the year the bonds are cashed ordisposed of or the year the bonds mature,unless your child chooses to report the inter-est income each year.

Choice to report interest each year.The choice to report the accrued interest eachyear can be made either by your child or byyou for your child. This choice is made byfiling an income tax return that shows all theinterest earned to date, and by stating on thereturn that your child chooses to report theinterest each year. Either you or your childshould keep a copy of this return.

Unless your child is otherwise required tofile a tax return for any year after making thischoice, your child does not have to file a re-turn only to report the annual accrual of U.S.savings bond interest under this choice.However, see Tax on investment income ofa child under age 14, earlier, under GeneralInformation. Neither you nor your child canchange the way you report the interest unlessyou request permission from the IRS, as dis-cussed earlier under Change from method 2.

Ownership transferred. If you bought seriesE, series EE, or series I bonds entirely withyour own funds and had them reissued inyour co-owner's name or beneficiary's namealone, you must include in your gross incomefor the year of reissue all interest that youearned on these bonds and have not previ-ously reported. But, if the bonds were reis-sued in your name alone, you do not have toreport the interest accrued at that time.

This same rule applies when bonds (otherthan bonds held as community property) aretransferred between spouses or incident todivorce.

Example. You bought series EE bondsentirely with your own funds. You did notchoose to report the accrued interest eachyear. Later, you transfer the bonds to yourformer spouse under a divorce agreement.You must include the deferred accrued inter-est, from the date of the original issue of thebonds to the date of transfer, in your incomein the year of transfer. Your former spouseincludes in income the interest on the bondsfrom the date of transfer to the date of re-demption.

Purchased jointly. If you and a co-ownereach contributed funds to buy series E, seriesEE, or series I bonds jointly and later havethe bonds reissued in the co-owner's namealone, you must include in your gross incomefor the year of reissue your share of all theinterest earned on the bonds that you havenot previously reported. At the time of reissue,the former co-owner does not have to includein gross income his or her share of the inter-est earned that was not reported before thetransfer. This interest, however, as well as allinterest earned after the reissue, is income tothe former co-owner.

This income-reporting rule also applieswhen the bonds are reissued in the name ofyour former co-owner and a new co-owner.But the new co-owner will report only his orher share of the interest earned after thetransfer.

If bonds that you and a co-owner boughtjointly are reissued to each of you separatelyin the same proportion as your contribution tothe purchase price, neither you nor your co-owner has to report at that time the interestearned before the bonds were reissued.

Example 1. You and your spouse eachspent an equal amount to buy a $1,000 seriesEE savings bond. The bond was issued toyou and your spouse as co-owners. You bothpostpone reporting interest on the bond. Youlater have the bond reissued as two $500bonds, one in your name and one in yourspouse's name. At that time neither you noryour spouse has to report the interest earnedto the date of reissue.

Example 2. You bought a $1,000 seriesEE savings bond entirely with your own funds.The bond was issued to you and your spouseas co-owners. You both postponed reportinginterest on the bond. You later have the bondreissued as two $500 bonds, one in yourname and one in your spouse's name. Youmust report half the interest earned to thedate of reissue.


and had not chosen to report the interest eachyear. At the date of death, interest of $200had 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 in-come tax return. The $200 is income in re-spect of the decedent.

You are a cash method taxpayer and donot choose to report the interest each yearas it is earned. If you cash the bond when itreaches maturity value of $1,000, you report$500 interest income—the difference be-tween maturity value of $1,000 and the ori-ginal cost of $500. For that year, you candeduct (as a miscellaneous itemized de-duction not subject to the 2%-of-adjusted-gross-income limit) any federal estate tax paidbecause the $200 interest was included inyour uncle's estate.

Example 2. If, in Example 1, the executorhad chosen to include the $200 accrued in-terest in your uncle's final return, you wouldreport only $300 as interest when you cashedthe bond at maturity. $300 is the interestearned after your uncle's death.

Example 3. If, in Example 1, you makeor have made the choice to report the in-crease in redemption value as interest eachyear, you include in gross income for the yearyou acquire the bond all of the unreportedincrease in value of all series E, series EE,and series I bonds you hold, including the$200 on the bond you inherited from youruncle.

Example 4. When your aunt died, sheowned series H bonds that she had acquiredin a trade for series E bonds. You were thebeneficiary of these bonds. Your aunt usedthe cash method and did not choose to reportthe interest on the series E bonds each yearas it accrued. Your aunt's executor chose notto include any interest earned before youraunt's death on her final return.

The income in respect of the decedent isthe sum of the unreported interest on the se-ries E bonds and the interest, if any, payableon the series H bonds but not received as ofthe date of your aunt's death. You must reportany interest received during the year as in-come on your return. The part of the interestthat was payable but not received before youraunt's death is income in respect of the de-cedent and may qualify for the estate tax de-duction. For information on when to report theinterest on the series E bonds traded, seeSavings bonds traded, later.

Savings bonds distributed from a retire-ment or profit-sharing plan. If you acquirea U.S. savings bond in a taxable distributionfrom a retirement or profit-sharing plan, yourincome for the year of distribution includes thebond's redemption value (its cost plus the in-terest accrued before the distribution). Whenyou redeem the bond (whether in the year ofdistribution or later), your interest income in-cludes only the interest accrued after thebond was distributed. To figure the interestreported as a taxable distribution and yourinterest income when you redeem the bond,see Worksheet for savings bonds distributedfrom a retirement or profit-sharing plan underHow To Report Interest Income, later.

Savings bonds traded. If you postponedreporting the interest on your series EE orseries E bonds, you did not recognize taxableincome when you traded the bonds for series

HH or series H bonds, unless you receivedcash in the trade. (You cannot trade series Ibonds for series HH bonds.) Any cash youreceived is income up to the amount of theinterest earned on the bonds traded. Whenyour series HH or series H bonds mature, orif you dispose of them before maturity, youreport as interest the difference between theirredemption value and your cost. Your cost isthe sum of the amount you paid for the tradedseries EE or series E bonds plus any amountyou had to pay at the time of the trade.

Example 1. You own series E bonds withaccrued interest of $523 and a redemptionvalue of $2,723 and have postponed reportingthe interest. You trade the bonds for $2,500in series HH bonds and $223 in cash. Youmust report the $223 as taxable income in theyear of the trade.

Example 2. The facts are the same as inExample 1. You hold the series HH bondsuntil maturity, when you receive $2,500. Youmust report $300 as interest income in theyear of maturity. This is the difference be-tween their redemption value, $2,500, andyour cost, $2,200 (the amount you paid for theseries E bonds). (It is also the difference be-tween the accrued interest of $523 on theseries E bonds and the $223 cash receivedon the trade.)

Choice to report interest in year oftrade. You can choose to treat all of thepreviously unreported accrued interest onseries EE or series E bonds traded for seriesHH bonds as income in the year of the trade.If you make this choice, it is treated as achange from method 1. See Change frommethod 1 under Series EE and series I bonds,earlier.

Form 1099–INT for U.S. savings bond in-terest. When you cash a bond, the bank orother payer that redeems it must give you aForm 1099–INT if the interest part of thepayment you receive is $10 or more. Box 3of your Form 1099–INT should show the in-terest as the difference between the amountyou received and the amount paid for thebond. However, your Form 1099–INT mayshow more interest than you have to includeon your income tax return. For example, thismay happen if any of the following are true.

1) You chose to report the increase in theredemption value of the bond each year.The interest shown on your Form1099–INT will not be reduced byamounts previously included in income.

2) You received the bond from a decedent.The interest shown on your Form1099–INT will not be reduced by any in-terest reported by the decedent beforedeath, or on the decedent's final return,or by the estate on the estate's incometax return.

3) Ownership of the bond was transferred.The interest shown on your Form1099–INT will not be reduced by interestthat accrued before the transfer.

4) You were named as a co-owner and theother co-owner contributed funds to buythe bond. The interest shown on yourForm 1099–INT will not be reduced bythe amount you received as nominee forthe other co-owner. (See Co-owners,earlier in this section, for more informa-tion about the reporting requirements.)

5) You received the bond in a taxable dis-tribution from a retirement or profit-sharing plan. The interest shown on yourForm 1099–INT will not be reduced bythe interest portion of the amount taxableas a distribution from the plan and nottaxable as interest. (This amount isgenerally shown on Form 1099–R, Dis-tributions From Pensions, Annuities,Retirement or Profit-Sharing Plans,IRAs, Insurance Contracts, etc., for theyear of distribution.)

For more information on including thecorrect amount of interest on your return, seeU.S. savings bond interest previously re-ported or Nominee distributions under HowTo Report Interest Income, later.

TIPInterest on U.S. savings bonds is ex-empt from state and local taxes. TheForm 1099–INT you receive will indi-

cate the amount that is for U.S. savings bondsinterest in box 3. Do not include this incomeon your state or local income tax return.

Education Savings Bond ProgramYou may be able to exclude from income allor part of the interest you receive on the re-demption of qualified U.S. savings bondsduring the year if you pay qualified highereducational expenses during the same year.This exclusion is known as the EducationSavings Bond Program.

If you are married, you can qualify for thisexclusion only if you file a joint return withyour spouse.

Form 8815. Use Form 8815, Exclusion ofInterest From Series EE and I U.S. SavingsBonds Issued After 1989, to figure your ex-clusion. Attach the form to your Form 1040or Form 1040A.

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

CAUTION!

The date a bond is issued may beearlier than the date the bond is pur-chased because bonds are issued as

of the first day of the month in which they arepurchased.

Beneficiary. You can designate any in-dividual (including a child) as a beneficiary ofthe bond.

Verification by IRS. If you claim the ex-clusion, the IRS will check it by using bondredemption information from the Departmentof Treasury.

Qualified expenses. Qualified higher edu-cational expenses are tuition and fees re-quired for you, your spouse, or your depend-ent (for whom you claim an exemption) toattend an eligible educational institution.

Qualified expenses include any contribu-tion you make to a qualified state tuition pro-gram or to an education IRA. For informationabout state tuition programs and educationIRAs, see Publication 970, Tax Benefits forHigher Education.

Qualified expenses do not include ex-penses for room and board or for courses in-volving sports, games, or hobbies that are notpart of a degree program.


Eligible educational institutions. Theseinstitutions include most public, private, andnonprofit universities, colleges, and voca-tional schools that are accredited and are el-igible to participate in student aid programsrun by the Department of Education.

Reduction for certain benefits. Youmust reduce your qualified higher educationalexpenses by certain benefits the student mayhave received. These benefits include:

1) Qualified scholarships that are exemptfrom tax (see Publication 520, Scholar-ships and Fellowships, for informationon qualified scholarships), and

2) Any other nontaxable payments (otherthan gifts, bequests, or inheritances) re-ceived for educational expenses, suchas:

a) Veterans' educational assistancebenefits,

b) Benefits under a qualified state tui-tion program, or

c) Certain employer-provided educa-tional assistance benefits.

Effect of other tax benefits. Do not in-clude in your qualified expenses any expenseused to:

1) Figure an education credit on Form8863, or

2) Figure how much of a distribution froman education IRA you can exclude fromyour income.

For information about education credits oreducation IRAs, see Publication 970.

Amount excludable. If the total proceeds(interest and principal) from the qualified U.S.savings bonds you redeem during the yearare not more than your qualified higher edu-cational expenses for the year, you can ex-clude all of the interest. If the proceeds aremore than the expenses, you can excludeonly part of the interest.

To determine the excludable amount,multiply the interest part of the proceeds bya fraction. The numerator (top part) of thefraction is the qualified higher educationalexpenses you paid during the year. The de-nominator (bottom part) of the fraction is thetotal proceeds you received during the year.

Example. In February 2000, Mark andJoan, a married couple, cashed a qualifiedseries EE U.S. savings bond they bought inNovember 1992. They received proceeds of$7,564, representing principal of $5,000 andinterest of $2,564. In 2000, they paid $4,000of their daughter's college tuition. They arenot claiming an education credit for thatamount, and they do not have an educationIRA. They can exclude $1,356 ($2,564 ×($4,000 ÷ $7,564)) of interest in 2000. Theymust pay tax on the remaining $1,208 ($2,564− $1,356) interest.

Figuring the interest part of the pro-ceeds (Form 8815, line 6). To figure theamount of interest to report on Form 8815,line 6, use the Line 6 Worksheet in the Form8815 instructions.

If you previously reported any interestfrom savings bonds cashed during2000, use the Alternate Line 6 Work-

sheet below instead.

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

• $54,100 to $69,100 for taxpayers filingsingle or head of household, and

• $81,100 to $111,100 for married taxpay-ers filing jointly, or for a qualifyingwidow(er) with dependent child.

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

Modified AGI. Modified AGI, for purposesof this exclusion, is adjusted gross income(line 20 of Form 1040A or line 34 of Form1040) 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 resi-dents of American Samoa,

4) Exclusion for income from Puerto Rico,

5) Exclusion for adoption benefits receivedunder an employer's adoption assistanceprogram, and

6) Deduction for student loan interest.

Use the worksheet in the instructions forline 9, Form 8815, to figure your modifiedAGI. If you claim any of the items (1) – (6)listed above, add the amount of the exclusionor deduction to the amount on line 5 of theworksheet, and enter the total on Form 8815,line 9, as your modified AGI.

Royalties included in modified AGI.Because the deduction for interest expensesattributable to royalties and other investmentsis limited to your net investment income (seeInvestment Interest in chapter 3), you cannotfigure the deduction until you have figured thisinterest exclusion. Therefore, if you had in-terest expenses attributable to royalties anddeductible on Schedule E (Form 1040), youmust make a special computation of yourdeductible interest without regard to this ex-clusion to figure the net royalty income in-cluded in your modified AGI.

You can use a “dummy” Form 4952, In-vestment Interest Expense Deduction, tomake the special computation. On this form,include in your net investment income yourtotal interest income for the year from seriesEE and I U.S. savings bonds. Use thedeductible interest amount from this form onlyto figure your modified AGI. Do not attach thisform to your tax return.

After you figure this interest exclusion, usea separate Form 4952 to figure your actualdeduction for investment interest expenses,and attach that form to your return.

Alternate Line 6 Worksheet

RECORDS

Recordkeeping. If you claim the in-terest exclusion, you must keep awritten record of the qualified U.S.

savings bonds you redeem. Your record mustinclude the serial number, issue date, facevalue, and total redemption proceeds (princi-pal and interest) of each bond. You can useForm 8818 , Optional Form To Record Re-demption of Series EE and I U.S. SavingsBonds Issued After 1989, to record this infor-mation. You should also keep bills, receipts,canceled checks, or other documentation thatshows you paid qualified higher educationalexpenses during the year.

U.S. Treasury Bills,Notes, and Bonds Treasury bills, notes, and bonds are directdebts (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 incometaxes. You should receive Form 1099–INTshowing the amount of interest (in box 3) thatwas paid to you for the year.

Payments of principal and interest gener-ally will be credited to your designatedchecking or savings account by direct depositthrough the TREASURY DIRECT system.

Treasury bills. These bills generally have a13-week, 26-week, or 52-week maturity pe-riod. They are issued at a discount in theamount of $1,000 and multiples of $1,000.The difference between the discounted priceyou pay for the bills and the face value youreceive at maturity is interest income. Gener-ally, you report this interest income when thebill is paid at maturity. See Discount onShort-Term Obligations under Discount onDebt Instruments, later.

If you reinvest your Treasury bill at itsmaturity in a new Treasury bill, note, or bond,you will receive payment for the differencebetween the proceeds of the maturing bill (paramount less any tax withheld) and the pur-chase price of the new Treasury security.However, you must report the full amount ofthe interest income on each of your Treasurybills at the time it reaches maturity.

Treasury notes and bonds. Treasury noteshave maturity periods of more than 1 year,ranging up to 10 years. Maturity periods forTreasury bonds are longer than 10 years.Both of these Treasury issues generally areissued in denominations of $1,000 to $1million. Both notes and bonds generally payinterest every 6 months. Generally, you re-port this interest for the year paid. When thenotes or bonds mature, you can redeemthese securities for face value.

Treasury notes and bonds are usually soldby auction with competitive bidding. If, aftercompiling the competitive bids, a determi-nation is made that the purchase price is lessthan the face value, you will receive a refundfor the difference between the purchase priceand the face value. This amount is consid-ered original issue discount. However, theoriginal issue discount rules (discussed later)do not apply if the discount is less than one-fourth of 1% (.0025) of the face amountmultiplied by the number of full years from thedate of original issue to maturity. See Deminimis OID under Original Issue Discount(OID), later. If the purchase price is deter-

1. Enter the amount from Form 8815, line5 ...........................................................

2. Enter the face value of all post-1989series EE bonds cashed in 2000 ........

3. Multiply line 2 above by 50% (.50) ......4. Enter the face value of all series I

bonds cashed in 2000. ........................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 .


mined to be more than the face amount, thedifference is a premium. (See Bond PremiumAmortization in chapter 3.)

For other information on these notesor bonds, write to:

Bureau of the Public DebtAttn: Customer InformationP.O. Box 1328Parkersburg, WV 26106-1328.

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

Treasury Inflation-Indexed Securities.These securities pay interest twice a year ata fixed rate, based on a principal amount thatis adjusted to take into account inflation anddeflation. For the tax treatment of these se-curities, see Inflation-Indexed Debt Instru-ments under Original Issue Discount (OID),later.

Retirement, sale, or redemption. For infor-mation on the retirement, sale, or redemptionof U.S. government obligations, see Capitalor Ordinary Gain or Loss in chapter 4. Alsosee Nontaxable Trades in chapter 4 for infor-mation about trading U.S. Treasury obli-gations for certain other designated issues.

Bonds Sold BetweenInterest Dates If you sell a bond between interest paymentdates, part of the sales price represents in-terest accrued to the date of sale. You mustreport that part of the sales price as interestincome for the year of sale.

If you buy a bond between interest pay-ment dates, part of the purchase price repre-sents interest accrued before the date ofpurchase. When that interest is paid to you,treat it as a return of your capital investment,rather than interest income, by reducing yourbasis in the bond. See Accrued interest onbonds under How To Report Interest Income,later in this chapter, for information on re-porting the payment.

Insurance Life insurance proceeds paid to you as ben-eficiary of the insured person are usually nottaxable. But if you receive the proceeds ininstallments, you must usually report part ofeach installment payment as interest income.

For more information about insuranceproceeds received in installments, see Publi-cation 525.

Interest option on insurance. If you leavelife insurance proceeds on deposit with aninsurance company under an agreement topay interest only, the interest paid to you istaxable.

Annuity. If you buy an annuity with life in-surance proceeds, the annuity payments youreceive are taxed as pension and annuity in-come, not as interest income. See Publication939, General Rule for Pensions and Annui-ties, for information on taxation of pensionand annuity income.

State or LocalGovernment ObligationsInterest you receive on an obligation issuedby a state or local government is generallynot taxable. The issuer should be able to tellyou whether the interest is taxable. Theissuer should also give you a periodic (oryear-end) statement showing the tax treat-ment of the obligation. If you invested in theobligation through a trust, a fund, or otherorganization, that organization should giveyou this information.

CAUTION!

Even if interest on the obligation is notsubject to income tax, you may haveto report capital gain or loss when you

sell it. Estate, gift, or generation-skipping taxmay also apply to other dispositions of theobligation.

Tax-Exempt InterestInterest on a bond used to finance govern-ment operations generally is not taxable if thebond is issued by a state, the District ofColumbia, a U.S. possession, or any of theirpolitical subdivisions. Political subdivisionsinclude:

• Port authorities,

• Toll road commissions,

• Utility services authorities,

• Community redevelopment agencies, and

• Qualified volunteer fire departments (forcertain obligations issued after 1980).

There are other requirements for tax-exemptbonds. Contact the issuing state or localgovernment agency or see sections 103 and141 through 150 of the Internal RevenueCode and the related regulations.

TIPObligations that are not bonds. In-terest on a state or local governmentobligation may be tax exempt even if

the obligation is not a bond. For example, in-terest on a debt evidenced only by an ordi-nary written agreement of purchase and salemay be tax exempt. Also, interest paid by aninsurer on default by the state or politicalsubdivision may be tax exempt.

Registration requirement. A bond issuedafter June 30, 1983, generally must be inregistered form for the interest to be tax ex-empt.

Indian tribal government. Bonds issued af-ter 1982 by an Indian tribal government aretreated as issued by a state. Interest on thesebonds is generally tax exempt if the bondsare part of an issue of which substantially allof the proceeds are to be used in the exerciseof any essential government function. How-ever, interest on private activity bonds (otherthan certain bonds for tribal manufacturingfacilities) is taxable.

Original issue discount. Original issue dis-count (OID) on tax-exempt state or localgovernment bonds is treated as tax-exemptinterest.

For information on the treatment of OIDwhen you dispose of a tax-exempt bond, seeTax-exempt state and local governmentbonds under Discounted Debt Instruments inchapter 4.

Stripped bonds or coupons. For specialrules that apply to stripped tax-exempt obli-gations, see Stripped Bonds and Couponsunder Original Issue Discount (OID), later.

Information reporting requirement. If youmust file a tax return, you are required toshow any tax-exempt interest you receivedon your return. This is an information-reporting requirement only. It does notchange tax-exempt interest to taxable inter-est. See Reporting tax-exempt interest underHow To Report Interest Income, later in thischapter. That discussion also explains whatto do if you receive a Form 1099–INT fortax-exempt interest.

Taxable InterestInterest on some state or local obligations istaxable.

Federally guaranteed bonds. Interest onfederally guaranteed state or local obligationsissued after 1983 is generally taxable. Thisrule does not apply to interest on obligationsguaranteed by the following U.S. Govern-ment agencies.

• Bonneville Power Authority (if the guar-antee was under the Northwest PowerAct as in effect on July 18, 1984).

• Department of Veterans Affairs.

• Federal Home Loan Mortgage Corpo-ration.

• Federal Housing Administration.

• Federal National Mortgage Association.

• Government National Mortgage Corpo-ration.

• Resolution Funding Corporation.

• Student Loan Marketing Association.

Mortgage revenue bonds. The proceedsof these bonds are used to finance mortgageloans for homebuyers. Generally, interest onstate or local government home mortgagebonds issued after April 24, 1979, is taxableunless the bonds are qualified mortgagebonds or qualified veterans' mortgage bonds.

Arbitrage bonds. Interest on arbitragebonds issued by state or local governmentsafter October 9, 1969, is taxable. An arbitragebond is a bond, any portion of the proceedsof which is expected to be used to buy (or toreplace funds used to buy) higher yieldinginvestments. A bond is treated as an arbitragebond if the issuer intentionally uses any partof the proceeds of the issue in this manner.

Private activity bonds. Interest on a privateactivity bond that is not a qualified bond (de-fined below) is taxable. Generally, a privateactivity bond is part of a state or local gov-ernment bond issue that meets both of thefollowing requirements.

1) More than 10% of the proceeds of theissue is to be used for a private businessuse.

2) More than 10% of the payment of theprincipal or interest is:

a) Secured by an interest in propertyto be used for a private businessuse (or payments for this property),or


b) Derived from payments for property(or borrowed money) used for aprivate business use.

Also, a bond is generally considered a privateactivity bond if the amount of the proceeds tobe used to make or finance loans to personsother than government units is more than 5%of the proceeds or $5 million (whichever isless).

Qualified bond. Interest on a private ac-tivity bond that is a qualified bond is tax ex-empt. A qualified bond is an exempt-facilitybond (including an enterprise zone facilitybond), qualified student loan bond, qualifiedsmall issue bond (including a tribal manufac-turing facility bond), qualified redevelopmentbond, qualified mortgage bond, qualified vet-erans' mortgage bond, or qualified 501(c)(3)bond (a bond issued for the benefit of certaintax-exempt organizations).

Interest that you receive on these tax-exempt bonds (except qualified 501(c)(3)bonds), if issued after August 7, 1986, gen-erally is a “tax preference item” and may besubject to the alternative minimum tax. SeeForm 6251 and its instructions for more in-formation.

Enterprise zone facility bonds. Intereston certain private activity bonds issued by astate or local government to finance a facilityused in an empowerment zone or enterprisecommunity is tax exempt. For information onthese bonds, see Publication 954.

Market discount. Market discount on a tax-exempt bond is not tax-exempt. If you boughtthe bond after April 30, 1993, you can chooseto accrue the market discount over the periodyou own the bond and include it in your in-come currently, as taxable interest. See Mar-ket Discount Bonds under Discount on DebtInstruments, later. If you do not make thatchoice, or if you bought the bond before May1, 1993, any gain from market discount istaxable when you dispose of the bond.

For more information on the treatment ofmarket discount when you dispose of a tax-exempt bond, see Discounted Debt Instru-ments under Capital or Ordinary Gain or Lossin chapter 4.

Discount onDebt Instruments Terms you may need to know (seeGlossary):

Market discountMarket discount bond Original issue discount (OID) Premium

In general, a debt instrument, such as a bond,note, debenture, or other evidence of indebt-edness, that bears no interest or bears inter-est at a lower than current market rate willusually be issued at less than its face amount.This discount is, in effect, additional interestincome. The following are some of the typesof discounted debt instruments.

• Corporate bonds.

• Municipal bonds.

• Certificates of deposit.

• Notes between individuals.

• Stripped bonds and coupons.

• Collateralized debt obligations (CDOs).

The discount on these instruments (exceptmunicipal bonds) is taxable in most instances.The discount on municipal bonds generally isnot taxable (but see State or Local Govern-ment Obligations, earlier, for exceptions). Seealso REMICs, FASITs, and Other CDOs,later, for information about applying the rulesdiscussed in this section to the regular inter-est holder of a real estate mortgage invest-ment conduit, a financial asset securitizationinvestment trust, or other CDO.

Original IssueDiscount (OID)OID is a form of interest. You generally in-clude OID in your income as it accrues overthe term of the debt instrument, whether ornot you receive any payments from theissuer.

A debt instrument generally has OID whenthe instrument is issued for a price that is lessthan its stated redemption price at maturity.OID is the difference between the stated re-demption price at maturity and the issueprice.

All instruments that pay no interest beforematurity are presumed to be issued at a dis-count. Zero coupon bonds are one exampleof these instruments.

The OID accrual rules generally do notapply to short-term obligations (those with afixed maturity date of 1 year or less from dateof issue). See Discount on Short-Term Obli-gations, later.

For information about the sale of a debtinstrument with OID, see chapter 4.

De minimis OID. You can treat the discountas zero if it is less than one-fourth of 1%(.0025) of the stated redemption price at ma-turity multiplied by the number of full yearsfrom the date of original issue to maturity.This small discount is known as “de minimis”OID.

Example 1. You bought a 10-year bondwith a stated redemption price at maturity of$1,000, issued at $980 with OID of $20.One-fourth of 1% of $1,000 (stated redemp-tion price) times 10 (the number of full yearsfrom the date of original issue to maturity)equals $25. Because the $20 discount is lessthan $25, the OID is treated as zero. (If youhold the bond at maturity, you will recognize$20 ($1,000 − $980) of capital gain.)

Example 2. The facts are the same as inExample 1, except that the bond was issuedat $950. The OID is $50. Because the $50discount is more than the $25 figured in Ex-ample 1, you must include the OID in incomeas it accrues over the term of the bond.

Debt instrument bought after originalissue. If you buy a debt instrument with deminimis OID at a premium, the discount is notincludible in income. If you buy a debt instru-ment with de minimis OID at a discount, thediscount is reported under the market dis-count rules. See Market Discount Bonds, laterin this chapter.

Exceptions to reporting OID. The OID rulesdiscussed here do not apply to the followingdebt instruments.

1) Tax-exempt obligations. (However, seeStripped tax-exempt obligations, later.)

2) U.S. savings bonds.

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

4) Obligations issued by an individual be-fore March 2, 1984.

5) Loans between individuals, if all the fol-lowing are true.

a) The lender is not in the businessof lending money.

b) The amount of the loan, plus theamount of any outstanding priorloans between the same individ-uals, is $10,000 or less.

c) Avoiding any federal tax is not oneof the principal purposes of theloan.

Form 1099–OIDThe issuer of the debt instrument (or yourbroker, if you held the instrument through abroker) should give you Form 1099–OID, Or-iginal Issue Discount, or a similar statement,if the total OID for the calendar year is $10or more. Form 1099–OID will show, in box 1,the amount of OID for the part of the year thatyou held the bond. It also will show, in box2, the stated interest that you must include inyour income. A copy of Form 1099–OID willbe sent to the IRS. Do not file your copy withyour return. Keep it for your records.

In most cases, you must report the entireamount in boxes 1 and 2 of Form 1099–OIDas interest income. But see Refiguring OIDshown on Form 1099–OID, later in this dis-cussion, and also Original issue discount(OID) adjustment under How To Report In-terest Income, later in this chapter, for moreinformation.

Form 1099–OID not received. If you hadOID for the year but did not receive a Form1099–OID, see Publication 1212, which liststotal OID on certain debt instruments and hasinformation that will help you figure OID. Ifyour debt instrument is not listed in Publica-tion 1212, consult the issuer for further infor-mation about the accrued OID for the year.

Nominee. If someone else is the holder ofrecord (the registered owner) of an OID in-strument that belongs to you and receives aForm 1099–OID on your behalf, that personmust give you a Form 1099–OID.

If you receive a Form 1099–OID that in-cludes amounts belonging to another person,see Nominee distributions under How ToReport Interest Income, later.

Refiguring OID shown on Form 1099–OID.You must refigure the OID shown in box 1 ofForm 1099–OID if either of the following ap-ply.

1) You bought the debt instrument after itsoriginal issue and paid a premium or anacquisition premium.

2) The debt instrument is a stripped bondor a stripped coupon (including certainzero coupon instruments). See FiguringOID under Stripped Bonds and Cou-pons, later in this chapter.

See Original issue discount (OID) adjustmentunder How To Report Interest Income, later


in this chapter, for information about reportingthe correct amount of OID.

Premium. You bought a debt instrumentat a premium if its adjusted basis immediatelyafter purchase was greater than the total ofall amounts payable on the instrument afterthe purchase date, other than qualified statedinterest.

If you bought an OID debt instrument ata premium, you generally do not have to re-port any OID as ordinary income.

Qualified stated interest. In general, thisis stated interest that is unconditionally pay-able in cash or property (other than debt in-struments of the issuer) at least annually ata fixed rate.

Acquisition premium. You bought adebt instrument at an acquisition premium ifboth of the following are true.

1) You did not pay a premium.

2) The instrument's adjusted basis imme-diately after purchase (including pur-chase at original issue) was greater thanits adjusted issue price. This is the issueprice plus the OID previously accrued,minus any payment previously made onthe instrument other than qualified statedinterest.

Acquisition premium reduces the amount ofOID includible in your income. For informa-tion about figuring the correct amount of OIDto include in your income, see Figuring OIDon Long-Term Debt Instruments in Publica-tion 1212.

Refiguring periodic interest shown onForm 1099–OID. If you disposed of a debtinstrument or acquired it from another holderduring the year, see Bonds Sold Between In-terest Dates, earlier, for information about thetreatment of periodic interest that may beshown in box 2 of Form 1099–OID for thatinstrument.

Applying the OID RulesThe rules for reporting OID depend on thedate the long-term debt instrument was is-sued.

Debt instruments issued after 1954 andbefore May 28, 1969 (before July 2, 1982,if a government instrument). For these in-struments, you do not report the OID until theyear you sell, exchange, or redeem the in-strument. If a gain results and the instrumentis a capital asset, the amount of the gainequal to the OID is ordinary interest income.The rest of the gain is capital gain. If there isa loss on the sale of the instrument, the entireloss is a capital loss and no reporting of OIDis required.

In general, the amount of gain that is or-dinary interest income equals the followingamount:

Debt instruments issued after May 27,1969 (after July 1, 1982, if a governmentinstrument), and before 1985. If you holdthese debt instruments as capital assets, you

must include a part of the discount in yourgross income each year that you own the in-struments.

Effect on basis. Your basis in the instru-ment is increased by the amount of OID thatyou include in your gross income.

Debt instruments issued after 1984. Forthese debt instruments, you report the totalOID that applies each year regardless ofwhether you hold that debt instrument as acapital asset.

Effect on basis. Your basis in the instru-ment is increased by the amount of OID thatyou include in your gross income.

Certificates of Deposit (CDs) If you buy a CD with a maturity of more than1 year, you must include in income each yeara part of the total interest due and report it inthe same manner as other OID.

This also applies to similar deposit ar-rangements with banks, building and loanassociations, etc., including:

• Time deposits,

• Bonus plans,

• Savings certificates,

• Deferred income certificates,

• Bonus savings certificates, and

• Growth savings certificates.

Bearer CDs. These are not issued in thedepositor's name and are transferable fromone individual to another.

Banks must provide the IRS and the per-son redeeming the bearer certificate with aForm 1099–INT.

CDs issued after 1982 generally must bein registered form. For more information, seeBearer Obligations under Capital Gains andLosses in chapter 4.

Time deposit open account arrangement.This is an arrangement with a fixed maturitydate in which you make deposits on aschedule arranged between you and yourbank. But there is no actual or constructivereceipt of interest until the fixed maturity dateis reached. For instance, you and your bankenter into an arrangement under which youagree to deposit $100 each month for a pe-riod of 5 years. Interest will be compoundedtwice a year at 71/2%, but payable only at theend of the 5-year period. You must include apart of the interest in your income as OIDeach year. Each year the bank must give youa Form 1099–OID to show you the amountyou must include in your income for the year.

Redemption before maturity. If, before thematurity date, you redeem a deferred interestaccount for less than its stated redemptionprice at maturity, you can deduct the amountof OID that you previously included in incomebut did not receive.

Renewable certificates. If you renew a CDat maturity, it is treated as a redemption anda purchase of a new certificate. This is trueregardless of the terms of renewal.

Face-Amount Certificates These certificates are subject to the OIDrules. They are a form of endowment con-tracts issued by insurance or investmentcompanies for either a lump-sum payment orperiodic payments, with the face amount be-

coming payable on the maturity date of thecertificate.

In general, the difference between theface amount and the amount you paid for thecontract is OID. You must include a part of theOID in your income over the term of the cer-tificate.

The issuer must give you a statement onForm 1099–OID indicating the amount youmust include in your income each year.

Inflation-IndexedDebt InstrumentsIf you hold an inflation-indexed debt instru-ment (other than a series I U.S. savingsbond), you must report as OID any increasein the inflation-adjusted principal amount ofthe instrument that occurs while you held theinstrument during the year. In general, aninflation-indexed debt instrument is a debt in-strument on which the payments are adjustedfor inflation and deflation (such as TreasuryInflation-Indexed Securities). You should re-ceive Form 1099–OID from the payer show-ing the amount you must report as OID andany qualified stated interest paid to you duringthe year. For more information, see Publica-tion 1212.

Stripped Bonds and Coupons If you strip one or more coupons from a bondand sell the bond or the coupons, the bondand coupons are treated as separate debtinstruments issued with OID.

The holder of a stripped bond has the rightto receive the principal (redemption price)payment. The holder of a stripped coupon hasthe right to receive interest on the bond.

Stripped bonds and stripped coupons in-clude:

1) Zero coupon instruments availablethrough the Department of the Treas-ury's Separate Trading of Registered In-terest and Principal of Securities(STRIPS) program and government-sponsored enterprises such as the Res-olution Funding Corporation and the Fi-nancing Corporation, and

2) Instruments backed by U.S. Treasurysecurities that represent ownership in-terests in those securities, such as obli-gations backed by U.S. Treasury bondsthat are offered primarily by brokeragefirms.

Seller. If you strip coupons from a bond andsell the bond or coupons, include in incomethe interest that accrued while you held thebond before the date of sale to the extent youdid not previously include this interest in yourincome. For an obligation acquired after Oc-tober 22, 1986, you must also include themarket discount that accrued before the dateof sale of the stripped bond (or coupon) to theextent you did not previously include this dis-count in your income.

Add the interest and market discount thatyou include in income to the basis of the bondand coupons. Allocate this adjusted basisbetween the items you keep and the itemsyou sell, based on the fair market value of theitems. The difference between the sale priceof the bond (or coupon) and the allocatedbasis of the bond (or coupon) is your gain orloss from the sale.

Treat any item you keep as an OID bondoriginally issued and bought by you on thesale date of the other items. If you keep the

Number of fullmonths you heldthe instrument × OriginalNumber of full Issuemonths from date Discountof original issueto date of maturity


bond, treat the amount of the redemptionprice of the bond that is more than the basisof the bond as the OID. If you keep the cou-pons, treat the amount payable on the cou-pons that is more than the basis of the cou-pons as the OID.

Buyer. If you buy a stripped bond or strippedcoupon, treat it as if it were originally issuedon the date you buy it. If you buy a strippedbond, treat as OID any excess of the statedredemption price at maturity over your pur-chase price. If you buy a stripped coupon,treat as OID any excess of the amount pay-able on the due date of the coupon over yourpurchase price.

Figuring OID. The rules for figuring OID onstripped bonds and stripped coupons dependon the date the debt instruments were pur-chased, not the date issued.

You must refigure the OID shown on theForm 1099–OID you receive for a strippedbond or coupon. For information about figur-ing the correct amount of OID on these in-struments to include in your income, seeFiguring OID on Stripped Bonds and Couponsin Publication 1212. However, owners ofstripped bonds and coupons should not relyon the OID shown in Section II of Publication1212, because the amounts listed in SectionII for stripped bonds or coupons are figuredwithout reference to the date or price at whichyou acquired them.

Stripped tax-exempt obligations. You donot have to pay tax on OID on any strippedtax-exempt bond or coupon that you boughtbefore June 11, 1987. However, if you ac-quired it after October 22, 1986, you mustaccrue OID on it to determine its basis whenyou dispose of it. See Original issue discount(OID) on debt instruments under Stocks andBonds in chapter 4.

You may have to pay tax on part of theOID on stripped tax-exempt bonds or cou-pons that you bought after June 10, 1987. Forinformation on figuring the taxable part, seeTax-Exempt Bonds and Coupons under Fig-uring OID on Stripped Bonds and Coupons inPublication 1212.

Market Discount Bonds A market discount bond is any bond havingmarket discount except:

1) Short-term obligations (those with fixedmaturity dates of up to 1 year from thedate of issue),

2) Tax-exempt obligations that you boughtbefore May 1, 1993,

3) U.S. savings bonds, and

4) Certain installment obligations.

Market discount arises when the value ofa debt obligation decreases after its issuedate, generally because of an increase in in-terest rates. If you buy a bond on the sec-ondary market, it may have market discount.

When you buy a market discount bond,you can choose to accrue the market discountover the period you own the bond and includeit in your income currently as interest income.If you do not make this choice, the followingrules generally apply.

1) You must treat any gain when you dis-pose of the bond as ordinary interest in-come, up to the amount of the accruedmarket discount. See Discounted DebtInstruments under Capital Gains andLosses in chapter 4.

2) You must treat any partial payment ofprincipal on the bond as ordinary interestincome, up to the amount of the accruedmarket discount. See Partial principalpayments, later in this discussion.

3) If you borrow money to buy or carry thebond, your deduction for interest paid onthe debt is limited. See Deferral of inter-est deduction for market discount bondsunder When To Deduct Investment In-terest in chapter 3.

Market discount. Market discount is theamount of the stated redemption price of abond at maturity that is more than your basisin the bond immediately after you acquire it.You treat market discount as zero if it is lessthan one-fourth of 1% (.0025) of the statedredemption price of the bond multiplied by thenumber of full years to maturity (after youacquire the bond).

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

Bonds acquired at original issue. Gener-ally, a bond that you acquired at original issueis not a market discount bond. If your adjustedbasis in a bond is determined by reference tothe adjusted basis of another person whoacquired the bond at original issue, you arealso considered to have acquired it at originalissue.

Exceptions. A bond you acquired at ori-ginal issue can be a market discount bond ifeither of the following is true.

1) Your cost basis in the bond is less thanthe bond's issue price.

2) The bond is issued in exchange for amarket discount bond under a plan ofreorganization. (This does not apply ifthe bond is issued in exchange for amarket discount bond issued before July19, 1984, and the terms and interestrates of both bonds are the same.)

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

Ratable accrual method. Treat themarket discount as accruing in equal dailyinstallments during the period you hold thebond. Figure the daily installments by dividingthe market discount by the number of daysafter the date you acquired the bond, up toand including its maturity date. Multiply thedaily installments by the number of days youheld the bond to figure your accrued marketdiscount.

Constant yield method. Instead of usingthe ratable accrual method, you can chooseto figure the accrued discount using a con-stant interest rate (the constant yield method).Make this choice by attaching to your timelyfiled return a statement identifying the bondand stating that you are making a constantinterest rate election. The choice takes effect

on the date you acquired the bond. If youchoose to use this method for any bond, youcannot change your choice for that bond.

For information about using the constantyield method, see Figuring OID using theconstant yield method under Debt Instru-ments Issued After 1984 in Publication 1212.To use this method to figure market discount(instead of OID), treat the bond as havingbeen issued on the date you acquired it. Treatthe amount of your basis (immediately afteryou acquired the bond) as the issue price.Then apply the formula shown in Publication1212.

Choosing to include market discount inincome currently. You can make this choiceif you have not revoked a prior choice to in-clude market discount in income currentlywithin the last 5 calendar years. Make thechoice by attaching to your timely filed returna statement in which you:

1) State that you have included marketdiscount in your gross income for theyear under section 1278(b) of the Inter-nal Revenue Code, and

2) Describe the method you used to figurethe accrued market discount for the year.

Once you make this choice, it will apply toall market discount bonds that you acquireduring the tax year and in later tax years. Youcannot revoke your choice without the con-sent of the IRS.

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

Effect on basis. You increase the basisof your bonds by the amount of market dis-count you include in your income.

Partial principal payments. If you receivea partial payment of principal on a marketdiscount bond that you acquired after October22, 1986, and you did not choose to includethe discount in income currently, you musttreat the payment as ordinary interest incomeup to the amount of the bond's accrued mar-ket discount. Reduce the amount of accruedmarket discount reportable as interest at dis-position by that amount.

You can choose to figure accrued marketdiscount for this purpose:

1) On the basis of the constant yieldmethod, described earlier,

2) In proportion to the accrual of OID forany accrual period, if the debt instrumenthas OID, or

3) In proportion to the amount of stated in-terest paid in the accrual period, if thedebt instrument has no OID.

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

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


Discount onShort-Term Obligations When you buy a short-term obligation (onewith a fixed maturity date of 1 year or lessfrom the date of issue), other than a tax-exempt obligation, you can generally chooseto accrue any discount and interest payableon the obligation and include it in incomecurrently. If you do not make this choice, thefollowing rules generally apply.

1) You must treat any gain when you sell,exchange, or redeem the obligation asordinary income, up to the amount of theratable share of the discount. See Dis-counted Debt Instruments under CapitalGains and Losses in chapter 4.

2) If you borrow money to buy or carry theobligation, your deduction for interestpaid on the debt is limited. See Deferralof interest deduction for short-term obli-gations under When To Deduct Invest-ment Interest in chapter 3.

Short-term obligations for which nochoice is available. You must include anydiscount or interest in current income as itaccrues for any short-term obligation (otherthan a tax-exempt obligation) that is:

1) Held by an accrual-basis taxpayer,

2) Held primarily for sale to customers inthe ordinary course of your trade orbusiness,

3) Held by a bank, regulated investmentcompany, or common trust fund,

4) Held by certain pass-through entities,

5) Identified as part of a hedging trans-action, or

6) A stripped bond or stripped coupon heldby the person who stripped the bond orcoupon (or by any other person whosebasis in the obligation is determined byreference to the basis in the hands ofthat person).

Effect on basis. Increase the basis of yourobligation by the amount of discount you in-clude in income currently.

Accrual methods. Figure the accrued dis-count by using either the ratable accrualmethod or the constant yield method dis-cussed previously in Accrued market discountunder Market Discount Bonds, earlier.

Government obligations. For an obligationdescribed above that is a short-term govern-ment obligation, the amount you include inyour income for the current year is the ac-crued acquisition discount, if any, plus anyother accrued interest payable on the obli-gation. The acquisition discount is thestated redemption price at maturity minusyour basis.

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

Nongovernment obligations. For an obli-gation listed above that is not a governmentobligation, the amount you include in your in-come for the current year is the accrued OID,if any, plus any other accrued interest pay-able. If you choose the constant yield methodto figure accrued OID, apply it by using theobligation's issue price.

Choosing to include accrued acquisi-tion discount instead of OID. You canchoose to report accrued acquisition discount(defined earlier under Governmentobligations) rather than accrued OID on theseshort-term obligations. Your choice will applyto the year for which it is made and to all lateryears and cannot be changed without theconsent of the IRS.

You must make your choice by the duedate of your return, including extensions, forthe first year for which you are making thechoice. Attach a statement to your return oramended return indicating:

1) Your name, address, and social securitynumber,

2) The choice you are making and that it isbeing made under section 1283(c)(2) ofthe Internal Revenue Code,

3) The period for which the choice is beingmade and the obligation to which it ap-plies, and

4) Any other information necessary to showyou are entitled to make this choice.

Choosing to include accrued discount andother interest in current income. If you ac-quire short-term discount obligations that arenot subject to the rules for current inclusionin income of the accrued discount or otherinterest, you can choose to have those rulesapply. This choice applies to all short-termobligations you acquire during the year andin all later years. You cannot change thischoice without the consent of the IRS.

The procedures to use in making thischoice are the same as those described forchoosing to include acquisition discount in-stead of OID on nongovernment obligationsin current income. However, you should in-dicate that you are making the choice undersection 1282(b)(2) of the Internal RevenueCode.

Also see the following discussion. If youmake the election to report all interest cur-rently as OID, you must use the constant yieldmethod.

Election To ReportAll Interest as OIDGenerally, you can elect to treat all intereston a debt instrument acquired during the taxyear as OID and include it in income currently.For purposes of this election, interest includesstated interest, acquisition discount, OID, deminimis OID, market discount, de minimismarket discount, and unstated interest asadjusted by any amortizable bond premiumor acquisition premium. See Treasury Regu-lation 1.1272–3.

When To ReportInterest Income Terms you may need to know (seeGlossary):

Accrual method Cash method

When to report your interest income dependson whether you use the cash method or anaccrual method to report income.

Cash method. Most individual taxpayers usethe cash method. If you use this method, yougenerally report your interest income in theyear in which you actually or constructivelyreceive it. However, there are special rules forreporting the discount on certain debt instru-ments. See U.S. Savings Bonds and Discounton Debt Instruments, earlier.

Example. On September 1, 1998, youloaned another individual $2,000 at 12%,compounded annually. You are not in thebusiness of lending money. The note statedthat principal and interest would be due onAugust 31, 2000. In 2000, you received$2,508.80 ($2,000 principal and $508.80 in-terest). If you use the cash method, you mustinclude in income on your 2000 return the$508.80 interest you received in that year.

Constructive receipt. You constructivelyreceive income when it is credited to youraccount or made available to you. You do notneed to have physical possession of it. Forexample, you are considered to receive in-terest, dividends, or other earnings on anydeposit or account in a bank, savings andloan, or similar financial institution, or intereston life insurance policy dividends left to ac-cumulate, when they are credited to your ac-count and subject to your withdrawal. This istrue even if they are not yet entered in yourpassbook.

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

1) Make withdrawals in multiples of evenamounts,

2) Give a notice to withdraw before makingthe withdrawal,

3) Withdraw all or part of the account towithdraw the earnings, or

4) Pay a penalty on early withdrawals, un-less the interest you are to receive onan early withdrawal or redemption issubstantially less than the interest pay-able at maturity.

Accrual method. If you use an accrualmethod, you report your interest income whenyou earn it, whether or not you have receivedit. Interest is earned over the term of the debtinstrument.

Example. If, in the previous example, youuse an accrual method, you must include theinterest in your income as you earn it. Youwould report the interest as follows: 1998,$80; 1999, $249.60; and 2000, $179.20.

Coupon bonds. Interest on coupon bondsis taxable in the year the coupon becomesdue and payable. It does not matter when youmail the coupon for payment.


How To ReportInterest Income Terms you may need to know (seeGlossary):

Nominee Original issue discount (OID)

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

You cannot use Form 1040EZ if your in-terest income is more than $400. Instead, youmust use Form 1040A or Form 1040.

In addition, you cannot use Form 1040EZif you must use Form 1040, as describedlater, or if any of the statements listed underSchedule B, later, are true.

Form 1040A. You must complete Part I ofSchedule 1 (Form 1040A) if you file Form1040A and any of the following are true.

1) Your taxable interest income is morethan $400.

2) You are claiming the interest exclusionunder the Education Savings Bond Pro-gram (discussed earlier).

3) You received interest from a seller-financed mortgage, and the buyer usedthe 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 includesamounts you reported before 2000.

6) You received, as a nominee, interest thatactually belongs to someone else.

7) You received a Form 1099–INT for in-terest on frozen deposits.

List each payer's name and the amount ofinterest income received from each payer online 1. If you received a Form 1099–INT orForm 1099–OID from a brokerage firm, listthe brokerage firm as the payer.

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

Form 1040. You must use Form 1040 in-stead of Form 1040A or Form 1040EZ if:

1) You forfeited interest income becauseof the early withdrawal of a time deposit,

2) You received or paid accrued interest onsecurities transferred between interestpayment dates,

3) You had a financial account in a foreigncountry, unless the combined value ofall foreign accounts was $10,000 or lessduring all of 2000 or the accounts werewith certain U.S. military banking facili-ties,

4) You acquired taxable bonds after 1987and choose to reduce interest incomefrom the bonds by any amortizable bondpremium (discussed in chapter 3 underBond Premium Amortization), or

5) You are reporting OID in an amountmore or less than the amount shown onForm 1099–OID.

Schedule B. You must complete Part Iof Schedule B (Form 1040) if you file Form1040 and any of the following apply.

1) Your taxable interest income is morethan $400.

2) You are claiming the interest exclusionunder the Education Savings Bond Pro-gram (discussed earlier).

3) You had a foreign account.

4) You received interest from a seller-financed mortgage, and the buyer usedthe 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 includesamounts you reported before 2000.

7) You received, as a nominee, interest thatactually belongs to someone else.

8) You received a Form 1099–INT for in-terest on frozen deposits.

9) You received a Form 1099–INT for in-terest on a bond that you bought be-tween interest payment dates.

10) Statement (4) or (5) in the preceding listis true.

On line 1, Part I, list each payer's name andthe amount received from each. If you re-ceived a Form 1099–INT or Form 1099–OIDfrom a brokerage firm, list the brokerage firmas the payer.

Reporting tax-exempt interest. Report thetotal of your tax-exempt interest (such as in-terest or accrued OID on certain state andmunicipal bonds) and exempt-interest divi-dends from a mutual fund on line 8b of Form1040A or Form 1040. If you file Form 1040EZ,print “TEI” in the space to the right of thewords “Form 1040EZ” on line 2. After “TEI,”show the amount of your tax-exempt interest,but do not add tax-exempt interest in the totalon Form 1040EZ, line 2.

You should not have received a Form1099–INT for tax-exempt interest. But if youdid, you must fill in Schedule 1 (Form 1040A)or Schedule B (Form 1040). See the Sched-ule 1 or Schedule B instructions for how toreport this. Be sure to also show this tax-exempt interest on line 8b.

CAUTION!

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

Form 1099–INT. Your taxable interest in-come, except for interest from U.S. savingsbonds and Treasury obligations, is shown inbox 1 of Form 1099–INT. Add this amount toany other taxable interest income you re-ceived. You must report all of your taxableinterest income even if you do not receive aForm 1099–INT.

If you forfeited interest income becauseof the early withdrawal of a time deposit, thedeductible amount will be shown on Form1099–INT, in box 2. See Penalty on earlywithdrawal of savings, later.

Box 3 of Form 1099–INT shows theamount of interest income you received fromU.S. savings bonds, Treasury bills, Treasurynotes, and Treasury bonds. Add the amountshown in box 3 to any other taxable interestincome you received, unless part of the

amount in box 3 was previously included inyour interest income. If part of the amountshown in box 3 was previously included inyour interest income, see U.S. savings bondinterest previously reported, later. If you re-deemed U.S. savings bonds you bought after1989 and you paid qualified educational ex-penses, see Interest excluded under the Ed-ucation Savings Bond Program, later.

Box 4 (federal income tax withheld) ofForm 1099–INT will contain an amount if youwere subject to backup withholding. Reportthe amount from box 4 on Form 1040EZ, line7, on Form 1040A, line 36, or on Form 1040,line 58.

Box 5 of Form 1099–INT shows invest-ment expenses you may be able to deductas an itemized deduction. Chapter 3 dis-cusses investment expenses.

If there are entries in boxes 6 and 7 ofForm 1099–INT, you must file Form 1040.You may be able to take a credit for theamount shown in box 6 (foreign tax paid) un-less you deduct this amount on Schedule Aof Form 1040 as “Other taxes.” To take thecredit, you may have to file Form 1116 , For-eign Tax Credit. For more information, seePublication 514, Foreign Tax Credit for Indi-viduals.

Form 1099–OID. The taxable OID on a dis-counted obligation for the part of the year youowned it is shown in box 1 of Form1099–OID. Include this amount in your totaltaxable interest income. But see RefiguringOID shown on Form 1099–OID under OriginalIssue Discount (OID), earlier.

You must report all taxable OID even ifyou do not receive a Form 1099–OID.

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

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

Box 4 of Form 1099–OID will contain anamount if you were subject to backup with-holding. Report the amount from box 4 onForm 1040EZ, line 7, on Form 1040A, line 36,or on Form 1040, line 58.

Box 7 of Form 1099–OID shows invest-ment expenses you may be able to deductas an itemized deduction. Chapter 3 dis-cusses investment expenses.

U.S. savings bond interest previously re-ported. If you received a Form 1099–INT forU.S. savings bond interest, the form mayshow interest you do not have to report. SeeForm 1099–INT for U.S. savings bond interestunder U.S. Savings Bonds, earlier.

On line 1, Part I of Schedule B (Form1040), or on line 1, Part I of Schedule 1 (Form1040A), report all the interest shown on yourForm 1099–INT. Then follow these steps.

1) Several lines above line 2, enter a sub-total of all interest listed on line 1.

2) Below the subtotal write “U.S. SavingsBond Interest Previously Reported” andenter amounts previously reported or in-terest accrued before you received thebond.

3) Subtract these amounts from the sub-total and enter the result on line 2.


CORRECTED (if checked)Payer’s RTN (optional)PAYER’S name, street address, city, state, ZIP code, and telephone no. OMB No. 1545-0112

Interest Income

Interest income not included in box 31PAYER’S Federal identification number RECIPIENT’S identification number

$Early withdrawal penalty Interest on U.S. Savings

Bonds and Treas. obligations32RECIPIENT’S name

$$Federal income tax withheld4Street address (including apt. no.)

$Foreign country or U.S.possession

7Foreign tax paid6City, state, and ZIP code

Account number (optional)

$Department of the Treasury - Internal Revenue ServiceForm 1099-INT

Copy BFor Recipient

This is important taxinformation and is

being furnished to theInternal Revenue

Service. If you arerequired to file a return,a negligence penalty orother sanction may beimposed on you if thisincome is taxable and

the IRS determines thatit has not been

reported.

(Keep for your records.)

Form 1099-INT

Investment expenses5

$

2000

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

In April 2000, you redeemed one of thebonds — a $1,000 series EE bond. The bondwas originally issued in March 1982. Whenyou redeemed the bond, you received$1,826.40 for it.

The Form 1099–INT you received showsinterest income of $1,326.40. However, sincethe interest on your savings bonds was re-ported yearly, you need only include the$53.20 interest that accrued from January2000 to April 2000.

You received no other taxable interest for2000. You file Form 1040A.

On line 1, Part I of Schedule 1 (Form1040A), enter your interest income as shownon Form 1099–INT — $1,326.40. (If you hadother taxable interest income, you would en-ter it next and then enter a subtotal, as de-scribed earlier, before going to the next step.)Several lines above line 2, write “U.S.Savings Bond Interest Previously Reported”and enter $1,273.20 ($1,326.40 − $53.20).Subtract $1,273.20 from $1,326.40 and write$53.20 on line 2. Enter $53.20 on line 4 ofSchedule 1 and on line 8a of Form 1040A.

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

Your uncle paid $500 for the bond, so$500 of the amount you receive upon re-demption is interest income. Your uncle's ex-ecutor included in your uncle's final return$200 of the interest that had accrued at thetime of your uncle's death. You have to in-clude only $300 in your income.

The bank where you redeem the bondgives you a Form 1099–INT showing interestincome of $500. You also receive a Form1099–INT showing taxable interest incomeof $300 from your savings account.

You file Form 1040 and you completeSchedule B. On line 1 of Schedule B, you list

the $500 and $300 interest amounts shownon your Forms 1099. Several lines above line2, you put a subtotal of $800. Below thissubtotal, write “U.S. Savings Bond InterestPreviously Reported” and enter the $200 in-terest included in your uncle's final return.Subtract the $200 from the subtotal and write$600 on line 2. You then complete the restof the form.

Worksheet for savings bonds distrib-uted from a retirement or profit-sharingplan. If you cashed a savings bond acquiredin a taxable distribution from a retirement orprofit-sharing plan (as discussed under U.S.Savings Bonds, earlier), your interest incomedoes not include the interest accrued beforethe distribution and taxed as a distributionfrom the plan.

Use the worksheet below to figure theamount you subtract from the interestshown on Form 1099–INT.

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

Example. You received a distribution ofseries EE U.S. savings bonds in January1999 from your company's profit-sharing plan.

In April 2000, you redeemed a $100 seriesEE bond that was part of the distribution youreceived in 1999. You received $93.04 for thebond. The company told you that the bondwas bought in May 1989 for $50 and that thevalue of the bond at the time of distribution in1999 was $87.68. (This is the amount you

included on your 1999 return.) The bank gaveyou a Form 1099–INT that shows $43.04 in-terest (the total interest from the date thebond was purchased to the date of redemp-tion). Since a part of the interest was includedin your income in 1999, you need to includein your 2000 income only the interest thataccrued after the bond was distributed to you.

On line 1 of Schedule B (Form 1040), in-clude all the interest shown on your Form1099–INT as well as any other taxable inter-est income you received. Several lines aboveline 2, put a subtotal of all interest listed online 1. Below this subtotal write “U.S. SavingsBond Interest Previously Reported” and enterthe amount figured on the worksheet below.

Subtract $37.68 from the subtotal and enterthe result on line 2 of Schedule B. You thencomplete the rest of the form.

Interest excluded under the EducationSavings Bond Program. Use Form 8815,to figure your interest exclusion when youredeem qualified savings bonds and payqualified higher educational expenses duringthe same year.

For more information on the exclusion andqualified higher educational expenses, seethe earlier discussion under EducationSavings Bond Program.

You must show your total interest fromqualified savings bonds that you cashed dur-ing 2000 on line 6 of Form 8815 and on line1 of either Schedule 1 (Form 1040A) orSchedule B (Form 1040). After completingForm 8815, enter the result from line 14(Form 8815) on line 3 of Schedule 1 (Form1040A) or line 3 of Schedule B (Form 1040).

A. Write the amount of cash received uponredemption of the bond ........................ $93.04

B. Write the value of the bond at the timeof distribution by the plan ..................... 87.68

C. Subtract the amount on line B from theamount on line A. This is the amountof interest accrued on the bond since itwas distributed by the plan .................. $5.36

A. Write the amount of cash received uponredemption of the bond ........................

D. Write the amount of interest shown onyour Form 1099–INT ............................ $43.04

B. Write the value of the bond at the timeof distribution by the plan .....................

E. Subtract the amount on line C from theamount on line D. This is the amountyou include in “U.S. Savings Bond In-terest Previously Reported” .................. $37.68

C. Subtract the amount on line B from theamount on line A. This is the amountof interest accrued on the bond since itwas distributed by the plan ..................

D. Write the amount of interest shown onyour Form 1099–INT ............................

E. Subtract the amount on line C from theamount on line D. This is the amountyou include in “U.S. Savings Bond In-terest Previously Reported” ..................


Interest on seller-financed mortgage. If anindividual buys his or her home from you ina sale that you finance, you must report thebuyer's name, address, and social securitynumber on line 1 of Schedule 1 (Form 1040A)or line 1 of Schedule B (Form 1040). If youdo not, you may have to pay a $50 penalty.The buyer may have to pay a $50 penalty ifhe or she does not give you this information.

You must also give your name, address,and social security number (or employeridentification number) to the buyer. If you donot, you may have to pay a $50 penalty.

Frozen deposits. Even if you receive a Form1099–INT for interest on deposits that youcould not withdraw at the end of 2000, youmust exclude these amounts from your grossincome. (See Interest income on frozen de-posits under Interest Income, earlier.) Do notinclude this income on line 8a of Form 1040Aor Form 1040. In Part I of Schedule 1 (Form1040A) or Part I of Schedule B (Form 1040),include the full amount of interest shown onyour Form 1099–INT on line 1. Several linesabove line 2, put a subtotal of all interest in-come. Below this subtotal, write “FrozenDeposits” and show the amount of interestthat you are excluding. Subtract this amountfrom the subtotal and write the result on line2.

Accrued interest on bonds. If you receiveda Form 1099–INT that reflects accrued inter-est paid on a bond you bought between in-terest payment dates, include the full amountshown as interest on the Form 1099–INT online 1, Part I of Schedule B (Form 1040).Then, below a subtotal of all interest incomelisted, write “Accrued Interest” and theamount of accrued interest. Subtract thatamount from the interest income subtotal.Enter the result on line 2 and also on Form1040, line 8a.

For more information, see Bonds SoldBetween Interest Dates, earlier.

Nominee distributions. If you received aForm 1099–INT that includes an amount youreceived as a nominee for the real owner,report the full amount shown as interest onthe Form 1099–INT on line 1, Part I ofSchedule 1 (Form 1040A) or Schedule B(Form 1040). Then, below a subtotal of allinterest income listed, write “Nominee Distri-bution” and the amount that actually belongsto someone else. Subtract that amount fromthe interest income subtotal. Enter the resulton line 2 and also on line 8a of Form 1040Aor 1040.

File Form 1099–INT with the IRS. If youreceived interest as a nominee in 2000, youmust file a Form 1099–INT for that interestwith the IRS. Send Copy A of Form 1099–INTwith a Form 1096, Annual Summary andTransmittal of U.S. Information Returns, toyour Internal Revenue Service Center byFebruary 28, 2001 (April 2, 2001 if filingelectronically). Give the actual owner of theinterest Copy B of the Form 1099–INT byJanuary 31, 2001. On Form 1099–INT, youshould be listed as the “Payer.” Prepare oneForm 1099–INT for each other owner andshow that person as the “Recipient.” How-ever, you do not have to file Form 1099–INTto show payments for your spouse. For moreinformation about the reporting requirementsand the penalties for failure to file (or furnish)

certain information returns, see the GeneralInstructions for Forms 1099, 1098, 5498, andW2–G.

Similar rules apply to OID reported to youas a nominee on Form 1099–OID. You mustfile a Form 1099–OID with Form 1096 to showthe proper distributions of the OID.

Example. You and your sister have a jointsavings account that paid $1,500 interest for2000. Your sister deposited 30% of the fundsin this account, and you and she have agreedto share the yearly interest income in propor-tion to the amount that each of you has in-vested. Because your social security numberwas given to the bank, you received a Form1099–INT for 2000 that includes the interestincome earned belonging to your sister. Thisamount is $450, or 30% of the total interestof $1,500.

You must give your sister a Form1099–INT by January 31, 2001, showing$450 of interest income that she earned for2000. You must also send a copy of thenominee Form 1099–INT, along with Form1096, to the Internal Revenue Service Centerby February 28, 2001. Show your own name,address, and social security number as thatof the “Payer” on the Form 1099–INT. Showyour sister's name, address, and social se-curity number in the blocks provided foridentification of the “Recipient.”

When you prepare your own federal in-come tax return, report the total amount ofinterest income, $1,500, on line 1, Part I ofSchedule 1 (Form 1040A) or line 1, Part I ofSchedule B (Form 1040), and identify thename of the bank that paid this interest. Showthe amount belonging to your sister, $450, asa subtraction from a subtotal of all interest onSchedule 1 (or Schedule B) and identify thissubtraction as a “Nominee Distribution.” (Yoursister will report the $450 of interest incomeon her own tax return, if she has to file a re-turn, and identify you as the payer of thatamount.)

Original issue discount (OID) adjustment. If you are reporting OID in an amount greateror less than the amount shown on Form1099–OID or other written statement (suchas for a REMIC regular interest), include thefull amount of OID shown on your Form1099–OID or other statement on line 1, PartI of Schedule B (Form 1040). If the OID to bereported is less than the amount shown onForm 1099–OID, show the OID you do nothave to report below a subtotal of the interestand OID listed. Identify the amount as “OIDAdjustment” and subtract it from the subtotal.If the OID to be reported is greater than theamount shown on Form 1099–OID, show theadditional OID below the subtotal. Identify theamount as “OID Adjustment” and add it to thesubtotal.

Penalty on early withdrawal of savings. Ifyou withdraw funds from a time-savings orother deferred interest account before matu-rity, you may be charged a penalty. The Form1099–INT or similar statement given to youby the financial institution will show the totalamount of interest in box 1 and will show thepenalty separately in box 2. You must includein income all the interest shown in box 1. Youcan deduct the penalty on line 30, Form 1040.Deduct the entire penalty even if it is morethan your interest income.

Dividends andOther CorporateDistributions Dividends are distributions of money, stock,or other property paid to you by a corporation.You also may receive dividends through apartnership, an estate, a trust, or an associ-ation that is taxed as a corporation. However,some amounts you receive that are calleddividends are actually interest income. (SeeDividends that are actually interest underTaxable Interest — General, earlier.)

You may receive any of the following kindsof distributions.

• Ordinary dividends.

• Capital gain distributions.

• Nontaxable distributions.

Most distributions that you receive are paid incash (check). However, you may receivemore stock, stock rights, other property, orservices.

Form 1099–DIV. Most corporations useForm 1099–DIV, Dividends and Distributions,to show you the distributions you receivedfrom them during the year. Keep this formwith your records. You do not have to attachit to your tax return. Even if you do not re-ceive Form 1099–DIV, you must still reportall of your taxable dividend income.

Nominees. If someone receives distribu-tions as a nominee for you, that person willgive you a Form 1099–DIV, which will showdistributions received on your behalf.

If you receive a Form 1099–DIV that in-cludes amounts belonging to another person,see Nominees under How To Report DividendIncome, later, for more information.

Form 1099–MISC. Certain substitute pay-ments in lieu of dividends or tax-exempt in-terest that are received by a broker on yourbehalf must be reported to you on Form1099–MISC, Miscellaneous Income, or asimilar statement. See also Reporting Sub-stitute Payments under Short Sales in chapter4.

Incorrect amount shown on a Form 1099. If you receive a Form 1099 that shows anincorrect amount (or other incorrect informa-tion), you should ask the issuer for a cor-rected form. The new Form 1099 you receivewill be marked “CORRECTED.”

Dividends on stock sold. If stock is sold,exchanged, or otherwise disposed of after adividend is declared, but before it is paid, theowner of record (usually the payee shown onthe dividend check) must include the dividendin income.

Dividends received in January. If a regu-lated investment company (mutual fund) orreal estate investment trust (REIT) declaresa dividend (including any exempt-interestdividend) in October, November, or Decem-ber payable to shareholders of record on adate in one of those months but actually paysthe dividend during January of the next cal-endar year, you are considered to have re-ceived the dividend on December 31. Youreport the dividend in the year it was declared.


Ordinary Dividends Ordinary (taxable) dividends are the mostcommon type of distribution from a corpo-ration. They are paid out of the earnings andprofits of a corporation and are ordinary in-come to you. This means they are not capitalgains. You can assume that any dividend youreceive on common or preferred stock is anordinary dividend unless the paying corpo-ration tells you otherwise. Ordinary dividendswill be shown in box 1 of the Form 1099–DIVyou receive.

Dividends used to buy more stock. Thecorporation in which you own stock may havea dividend reinvestment plan. This plan letsyou choose to use your dividends to buy(through an agent) more shares of stock inthe corporation instead of receiving the divi-dends in cash. If you are a member of thistype of plan and you use your dividends tobuy more stock at a price equal to its fairmarket value, you still must report the divi-dends as income.

If you are a member of a dividend rein-vestment plan that lets you buy more stockat a price less than its fair market value, youmust report as dividend income the fair mar-ket value of the additional stock on the divi-dend payment date.

You also must report as dividend incomeany service charge subtracted from your cashdividends before the dividends are used tobuy the additional stock. But you may be ableto deduct the service charge. See Expensesof Producing Income in chapter 3.

In some dividend reinvestment plans, youcan invest more cash to buy shares of stockat a price less than fair market value. If youchoose to do this, you must report as dividendincome the difference between the cash youinvest and the fair market value of the stockyou buy. When figuring this amount, use thefair market value of the stock on the dividendpayment date.

Money market funds. Report amounts youreceive from money market funds as dividendincome. Money market funds are a type ofmutual fund and should not be confused withbank money market accounts that pay inter-est.

Capital Gain Distributions Capital gain distributions (also called capitalgain dividends) are paid to you or credited toyour account by regulated investmentcompanies (commonly called mutualfunds) and real estate investment trusts(REITs). They will be shown in box 2a of theForm 1099–DIV you receive from the mutualfund or REIT.

Report capital gain distributions as long-term capital gains, regardless of how long youowned your shares in the mutual fund orREIT. See Capital gain distributions underHow To Report Dividend Income, later in thischapter.

If you receive capital gain distributions onmutual fund or REIT stock you hold 6 monthsor less and sell at a loss, see Loss on mutualfund or REIT stock held 6 months or lessunder Holding Period in chapter 4.

Undistributed capital gains of mutualfunds and REITs. Some mutual funds andREITs keep their long-term capital gains andpay tax on them. You must treat your shareof these gains as distributions, even though

you did not actually receive them. However,they are not included on Form 1099–DIV.Instead, they are reported to you on Form2439, Notice to Shareholder of UndistributedLong-Term Capital Gains.

The Form 2439 will also show how much,if any, of the undistributed capital gains isunrecaptured section 1250 gain or gain fromqualified small business stock (section 1202gain). (For information about these terms,see Capital Gain Tax Rates in chapter 4.)

Report undistributed capital gains (box 1aof Form 2439) as long-term capital gains incolumn (f) on line 11 of Schedule D (Form1040). Enter on line 11 of the UnrecapturedSection 1250 Gain Worksheet in the Sched-ule D instructions the part reported to you asunrecaptured section 1250 gain. For any gainon qualified small business stock, follow thereporting instructions under Section 1202Exclusion in chapter 4.

The tax paid on these gains by the mutualfund or REIT is shown in box 2 of Form 2439.You take credit for this tax by including it online 64, Form 1040, and checking box a onthat line. Attach Copy B of Form 2439 to yourreturn, and keep Copy C for your records.

Basis adjustment. Increase your basis inyour mutual fund, or your interest in a REIT,by the difference between the gain you reportand the credit you claim for the tax paid.

Nontaxable Distributions You may receive a return of capital or a tax-free distribution of more shares of stock orstock rights. These distributions are nottreated the same as ordinary dividends orcapital gain distributions.

Return of Capital A return of capital is a distribution that is notpaid out of the earnings and profits of a cor-poration. It is a return of your investment inthe stock of the company. You should receivea Form 1099–DIV or other statement from thecorporation showing you what part of thedistribution is a return of capital. On Form1099–DIV, a nontaxable return of capital willbe shown in box 3. If you do not receive sucha statement, you report the distribution as anordinary dividend.

Basis adjustment. A return of capital re-duces the basis of your stock. It is not taxeduntil your basis in the stock is fully recovered.If you buy stock in a corporation in differentlots at different times, and you cannot defi-nitely identify the shares subject to the returnof capital, reduce the basis of your earliestpurchases first.

When the basis of your stock has beenreduced to zero, report any additional returnof capital that you receive as a capital gain.Whether you report it as a long-term orshort-term capital gain depends on how longyou have held the stock. See Holding Periodin chapter 4.

Example. You bought stock in 1988 for$100. In 1990, you received a return of capitalof $80. You did not include this amount inyour income, but you reduced the basis ofyour stock to $20. You received a return ofcapital of $30 in 2000. The first $20 of thisamount reduced your basis to zero. You re-port the other $10 as a long-term capital gainfor 2000. You must report as a long-termcapital gain any return of capital you receiveon this stock in later years.

Liquidating distributions. Liquidating distri-butions, sometimes called liquidating divi-dends, are distributions you receive during apartial or complete liquidation of a corpo-ration. These distributions are, at least in part,one form of a return of capital. They may bepaid in one or more installments. You will re-ceive Form 1099–DIV from the corporationshowing you the amount of the liquidatingdistribution in box 8 or 9.

Any liquidating distribution you receive isnot taxable to you until you have recoveredthe basis of your stock. After the basis of yourstock has been reduced to zero, you mustreport the liquidating distribution as a capitalgain (except in certain instances involvingcollapsible corporations). Whether you reportthe gain as a long-term or short-term capitalgain depends on how long you have held thestock. See Holding Period in chapter 4.

Stock acquired at different times. If youacquired stock in the same corporation inmore than one transaction, you own morethan one block of stock in the corporation. Ifyou receive distributions from the corporationin complete liquidation, you must divide thedistribution among the blocks of stock youown in the following proportion: the numberof shares in that block over the total numberof shares you own. Divide distributions inpartial liquidation among that part of the stockthat is redeemed in the partial liquidation. Af-ter the basis of a block of stock is reduced tozero, you must report the part of any laterdistribution for that block as a capital gain.

Distributions less than basis. If the totalliquidating distributions you receive are lessthan the basis of your stock, you may havea capital loss. You can report a capital lossonly after you have received the final distri-bution in liquidation that results in the re-demption or cancellation of the stock.Whether you report the loss as a long-termor short-term capital loss depends on howlong you held the stock. See Holding Periodin chapter 4.

Distributions of Stockand Stock Rights Distributions by a corporation of its own stockare commonly known as stock dividends.Stock rights (also known as “stock options”)are distributions by a corporation of rights toacquire the corporation's stock. Generally,stock dividends and stock rights are not tax-able to you, and you do not report them onyour return.

Taxable stock dividends and stock rights.Distributions of stock dividends and stockrights are taxable to you if any of the followingapply.

1) You or any other shareholder has thechoice to receive cash or other propertyinstead of stock or stock rights.

2) The distribution gives cash or otherproperty to some shareholders and anincrease in the percentage interest in thecorporation's assets or earnings andprofits to other shareholders.

3) The distribution is in convertible pre-ferred stock and has the same result asin (2).

4) The distribution gives preferred stock tosome common stock shareholders andcommon stock to other common stockshareholders.


5) The distribution is on preferred stock.(The distribution, however, is not taxableif it is an increase in the conversion ratioof convertible preferred stock madesolely to take into account a stock divi-dend, stock split, or similar event thatwould otherwise result in reducing theconversion right.)

The term “stock” includes rights to acquirestock, and the term “shareholder” includes aholder of rights or convertible securities.

If you receive taxable stock dividends orstock rights, include their fair market value atthe time of the distribution in your income.

Constructive distributions. You must treatcertain transactions that increase yourproportionate interest in the earnings andprofits or assets of a corporation as if theywere distributions of stock or stock rights.These constructive distributions are taxableif they have the same result as a distributiondescribed in (2), (3), (4), or (5) of the abovediscussion.

This treatment applies to a change in yourstock's conversion ratio or redemption price,a difference between your stock's redemptionprice and issue price, a redemption that is nottreated as a sale or exchange of your stock,and any other transaction having a similareffect on your interest in the corporation.

Preferred stock redeemable at a pre-mium. If you hold preferred stock having aredemption price higher than its issue price,the difference (the redemption premium)generally is taxable as a constructive distri-bution of additional stock on the preferredstock.

For stock issued before October 10, 1990,you include the redemption premium in yourincome ratably over the period during whichthe stock cannot be redeemed. For stock is-sued after October 9, 1990, you include theredemption premium on the basis of its eco-nomic accrual over the period during whichthe stock cannot be redeemed, as if it wereoriginal issue discount on a debt instrument.See Original Issue Discount (OID), earlier inthis chapter.

The redemption premium is not a con-structive distribution, and therefore is nottaxable, in the following situations.

1) The stock was issued before October 10,1990 (before December 20, 1995, ifredeemable solely at the option of theissuer), and the redemption premium is“reasonable.” (For stock issued beforeOctober 10, 1990, only the part of theredemption premium that is not “reason-able” is a constructive distribution.) Theredemption premium is reasonable if itis not more than 10% of the issue priceon stock not redeemable for 5 years fromthe issue date or is in the nature of apenalty for making a premature re-demption.

2) The stock was issued after October 9,1990 (after December 19, 1995, ifredeemable solely at the option of theissuer), and the redemption premium is“de minimis.” The redemption premiumis de minimis if it is less than one-fourthof 1% (.0025) of the redemption pricemultiplied by the number of full yearsfrom the date of issue to the dateredeemable.

3) The stock was issued after October 9,1990, and must be redeemed at a

specified time or is redeemable at youroption, but the redemption is unlikelybecause it is subject to a contingencyoutside your control (not including thepossibility of default, insolvency, etc.).

4) The stock was issued after December19, 1995, and is redeemable solely atthe option of the issuer, but the re-demption premium is in the nature of apenalty for premature redemption or re-demption is not more likely than not tooccur. The redemption will be treatedunder a “safe harbor” as not more likelythan not to occur if all of the followingare true.

a) You and the issuer are not relatedunder the rules discussed in chap-ter 4 under Losses on Sales orTrades of Property, substituting“20%” for “50%.”

b) There are no plans, arrangements,or agreements that effectively re-quire or are intended to compel theissuer to redeem the stock.

c) The redemption would not reducethe stock's yield.

Basis. Your basis in stock or stock rights re-ceived in a taxable distribution is their fairmarket value when distributed. If you receivestock or stock rights that are not taxable toyou, see Stocks and Bonds in chapter 4 forinformation on how to figure their basis.

Fractional shares. You may not ownenough stock in a corporation to receive a fullshare of stock if the corporation declares astock dividend. However, with the approvalof the shareholders, the corporation may setup a plan in which fractional shares are notissued, but instead are sold, and the cashproceeds are given to the shareholders. Anycash you receive for fractional shares undersuch a plan is treated as an amount realizedon the sale of the fractional shares. You mustdetermine your gain or loss and report it asa capital gain or loss on Schedule D (Form1040). Your gain or loss is the difference be-tween the cash you receive and the basis ofthe fractional shares sold.

Example. You own one share of commonstock that you bought on January 3, 1992, for$100. The corporation declared a commonstock dividend of 5% on June 30, 2000. Thefair market value of the stock at the time thestock dividend was declared was $200. Youwere paid $10 for the fractional-share stockdividend under a plan described in the aboveparagraph. You figure your gain or loss asfollows:

Because you had held the share of stockfor more than 1 year at the time the stockdividend was declared, your gain on the stockdividend is a long-term capital gain.

Scrip dividends. A corporation that de-clares a stock dividend may issue you a scripcertificate that entitles you to a fractionalshare. The certificate is generally nontaxablewhen you receive it. If you choose to have thecorporation sell the certificate for you and giveyou the proceeds, your gain or loss is thedifference between the proceeds and the partof your basis in the corporation's stock that isallocated to the certificate.

However, if you receive a scrip certificatethat you can choose to redeem for cash in-stead of stock, the certificate is taxable whenyou receive it. You must include its fair marketvalue in income on the date you receive it.

Other DistributionsYou may receive any of the following distri-butions during the year.

Exempt-interest dividends. Exempt-interestdividends you receive from a regulated in-vestment company (mutual fund) are not in-cluded in your taxable income. You will re-ceive a notice from the mutual fund telling youthe amount of the exempt-interest dividendsyou received. Exempt-interest dividends arenot shown on Form 1099–DIV or Form1099–INT.

If you receive exempt-interest dividendson stock you hold 6 months or less and sellat a loss, see Loss on mutual fund or REITstock held 6 months or less under HoldingPeriod in chapter 4.

Information reporting requirement. Al-though exempt-interest dividends are nottaxable, you must show them on your tax re-turn if you have to file a return. This is aninformation reporting requirement and doesnot change the exempt-interest dividends totaxable income. See Reporting tax-exemptinterest under How To Report Interest In-come, earlier.

Alternative minimum tax treatment.Exempt-interest dividends paid from specifiedprivate activity bonds may be subject to thealternative minimum tax. See Form 6251 andits instructions for more information.

Dividends on insurance policies. Insur-ance policy dividends that the insurer keepsand uses to pay your premiums are not tax-able. However, you must report as taxableinterest income the interest that is paid orcredited on dividends left with the insurancecompany.

If dividends on an insurance contract(other than a modified endowment contract)are distributed to you, they are a partial returnof the premiums you paid. Do not includethem in your gross income until they are morethan the total of all net premiums you paid forthe contract. (For information on the treatmentof a distribution from a modified endowmentcontract, see Distribution Before AnnuityStarting Date From a Nonqualified Plan underTaxation of Nonperiodic Payments in Publi-cation 575, Pension and Annuity Income.)Report any taxable distributions on insurancepolicies on line 16b (Form 1040) or line 12b(Form 1040A).

Dividends on veterans' insurance. Divi-dends you receive on veterans' insurancepolicies are not taxable. In addition, intereston dividends left with the Department of Vet-erans Affairs is not taxable.

Fair market value of old stock ................... $200.00Fair market value of stock dividend (cashreceived) .................................................... + 10.00Fair market value of old stock and stockdividend ...................................................... $210.00Basis (cost) of old stock after the stockdividend(($200 ÷ $210) × $100) ............................. $95.24Basis (cost) of stock dividend(($10 ÷ $210) × $100) ............................... + 4.76Total ........................................................... $100.00

Cash received ............................................ $10.00Basis (cost) of stock dividend .................... − 4.76Gain $5.24


Patronage dividends. Generally, patronagedividends you receive in money from a coop-erative organization are included in your in-come.

Do not include in your income patronagedividends you receive on:

1) Property bought for your personal use,or

2) Capital assets or depreciable propertybought for use in your business. But youmust reduce the basis (cost) of the itemsbought. If the dividend is more than theadjusted basis of the assets, you mustreport the excess as income.

These rules are the same whether thecooperative paying the dividend is a taxableor tax-exempt cooperative.

Alaska Permanent Fund dividends. Do notreport these amounts as dividends. Instead,report these amounts on line 21 of Form1040, line 13 of Form 1040A, or line 3 of Form1040EZ.

How To ReportDividend Income Terms you may need to know (seeGlossary):

NomineeRestricted stock

Generally, you can use either Form 1040 orForm 1040A to report your dividend income.Report the total of your ordinary dividend in-come on line 9 of Form 1040 or Form 1040A.

If you receive capital gain distributions,you may be able to use Form 1040A or youmay have to use Form 1040. See Capital gaindistributions, later. If you receive nontaxabledistributions required to be reported as capitalgains, you must use Form 1040. You cannotuse Form 1040EZ if you receive any dividendincome.

Form 1099–DIV. If you owned stock onwhich you received $10 or more in dividendsand other distributions, you should receive aForm 1099–DIV. Even if you do not receivea Form 1099–DIV, you must report all of yourtaxable dividend income.

See Form 1099–DIV for more informationon how to report dividend income.

Form 1040A. You must complete Part II ofSchedule 1 (Form 1040A) and attach it toyour Form 1040A, if:

1) Your ordinary dividends (box 1 of Form1099–DIV) are more than $400, or

2) You received, as a nominee, dividendsthat actually belong to someone else.

List on line 5 each payer's name and theamount of ordinary dividends you received. Ifyou received a Form 1099–DIV from a bro-kerage firm, list the brokerage firm as thepayer.

Enter on line 6 the total of the amountslisted on line 5. Also enter this total on line9, Form 1040A.

Form 1040. You must fill in Part II ofSchedule B and attach it to your Form 1040,if:

1) Your ordinary dividends (box 1 of Form1099–DIV) are more than $400, or

2) You received, as a nominee, dividendsthat actually belong to someone else.

If your ordinary dividends are more than$400, you must also complete Part III ofSchedule B.

List on line 5, Part II of Schedule B, eachpayer's name and the amount of ordinarydividends you received. If your securities areheld by a brokerage firm (in “street name”),list the name of the brokerage firm that isshown on Form 1099–DIV as the payer. Ifyour stock is held by a nominee who is theowner of record, and the nominee creditedor paid you dividends on the stock, show thename of the nominee and the dividends youreceived or for which you were credited.

Enter on line 6 the total of the amountslisted on line 5. (However, if you hold stockas a nominee, see Nominees, later.) Alsoenter this total on line 9, Form 1040.

Dividends received on restricted stock.Restricted stock is stock that you get fromyour employer for services you perform andthat is nontransferable and subject to a sub-stantial risk of forfeiture. You do not have toinclude the value of the stock in your incomewhen you receive it. However, if you get divi-dends on restricted stock, you must includethem in your income as wages, not dividends.See Restricted Property in Publication 525 forinformation on restricted stock dividends.

Your employer should include these divi-dends in the wages shown on your FormW–2. If you also get a Form 1099–DIV forthese dividends, list them on line 5 ofSchedule B (Form 1040), with the other divi-dends you received. Enter a subtotal of allyour dividend income several lines above line6. Below the subtotal, write “Dividends on re-stricted stock reported as wages on line 7,Form 1040,” and enter the amount of thedividends included in your wages on line 7,Form 1040. Subtract this amount from thesubtotal and enter the result on line 6, Part IIof Schedule B.

Election. You can choose to include thevalue of restricted stock in gross income aspay for services. If you make this choice, re-port the dividends on the stock like any otherdividends. List them on line 5, Part II ofSchedule B, along with your other dividends(if the amount of ordinary dividends receivedfrom all sources is more than $400). If youreceive both a Form 1099–DIV and a FormW–2 showing these dividends, do not includethe dividends in your wages reported on line7, Form 1040. Attach a statement to yourForm 1040 explaining why the amount shownon line 7 of your Form 1040 is different fromthe amount shown on your Form W–2.

Independent contractor. If you receivedrestricted stock for services as an independ-ent contractor, the rules in the previous dis-cussion apply. Generally, you must treatdividends you receive on the stock as incomefrom self-employment.

Capital gain distributions. How to reportcapital gain distributions depends on whetheryou have any other capital gains or losses. Ifyou do, report capital gain distributions (box2a of Form 1099–DIV) in column (f) of line13, Part II of Schedule D (Form 1040). If youdo not have any other capital gains or losses,you may be able to report your capital gain

distributions directly on line 13 of Form 1040or line 10 of Form 1040A. In either case, seeReporting Capital Gains and Losses in chap-ter 4 for more information.

The mutual fund or real estate investmenttrust (REIT) making the distribution should tellyou how much of it is unrecaptured section1250 gain (box 2c) and how much is section1202 gain (box 2d). (For information aboutthese terms, see Capital Gain Tax Rates inchapter 4.)

Enter on line 11 of the UnrecapturedSection 1250 Gain Worksheet in the Sched-ule D instructions the part reported to you asunrecaptured section 1250 gain. If you havea gain on qualified small business stock(section 1202 gain), follow the reporting in-structions under Section 1202 Exclusion inchapter 4.

Nontaxable (return of capital) distribu-tions. Report return of capital distributions(box 3 of Form 1099–DIV) only after yourbasis in the stock has been reduced to zero.After the basis of your stock has been re-duced to zero, you must show this amounton line 1, Part I of Schedule D, if you held thestock 1 year or less. Show it on line 8, PartII of Schedule D, if you held the stock for morethan 1 year. Write “Dividend R.O.C. Exceed-ing Basis” in column (a) of Schedule D andthe name of the company. Report your gainin column (f). Your gain is the amount of thedistribution that is more than your basis in thestock.

Nominees. If you received ordinary divi-dends as a nominee (that is, the dividendsare in your name but actually belong tosomeone else), include them on line 5 ofSchedule 1 (Form 1040A) or Schedule B(Form 1040). Several lines above line 6, puta subtotal of all dividend income listed on line5. Below this subtotal, write “Nominee Distri-butions” and show the amounts received asa nominee. Subtract the total of your nomineedistributions from the subtotal. Enter the re-sult on line 6.

File Form 1099–DIV with the IRS. If youreceived dividends as a nominee in 2000, youmust file a Form 1099–DIV for those divi-dends with the IRS. Send the Form 1099–DIVwith a Form 1096, Annual Summary andTransmittal of U.S. Information Returns, toyour Internal Revenue Service Center byFebruary 28, 2001 (April 2, 2001 if filingelectronically). Give the actual owner of thedividends Copy B of the Form 1099–DIV byJanuary 31, 2001. On Form 1099–DIV, youshould be listed as the “Payer.” The otherowner should be listed as the “Recipient.” Youdo not, however, have to file a Form1099–DIV to show payments for your spouse.For more information about the reporting re-quirements and the penalties for failure to file(or furnish) certain information returns, seethe General Instructions for Forms 1099,1098, 5498, and W–2G.

Liquidating distributions. If you receive aliquidating distribution on stock, the corpo-ration will give you a Form 1099–DIV showingthe amount of the liquidating distribution inboxes 8 and 9.

For a discussion of the treatment of liqui-dating distributions, see Return of Capitalunder Nontaxable Distributions, earlier in thischapter.


CORRECTED (if checked)PAYER’S name, street address, city, state, ZIP code, and telephone no. OMB No. 1545-0110

Dividends andDistributions

RECIPIENT’S identification numberPAYER’S Federal identification number

RECIPIENT’S name

Street address (including apt. no.)

City, state, and ZIP code


Form 1099-DIV Department of the Treasury - Internal Revenue Service

Copy BFor Recipient

This is important taxinformation and is

being furnished to theInternal Revenue

Service. If you arerequired to file a return,a negligence penalty orother sanction may beimposed on you if thisincome is taxable and


reported.

(Keep for your records.)

Form 1099-DIV

Federal income tax withheld4

$Total capital gain distr.2a

$28% rate gain2b

$

Section 1202 gain2d

$

Cash liquidation distr.8

$

$

Foreign tax paid6

$

Ordinary dividends1

2c Unrecap. sec. 1250 gain

$3 Nontaxable distributions

$5 Investment expenses

Noncash liquidation distr.9

$

7 Foreign country or U.S. possession

$

2000

StrippedPreferred Stock

If the dividend rights are stripped fromcertain preferred stock, the holder of thestripped preferred stock may have to includeamounts in income equal to the amounts thatwould have been included if the stock werea bond with original issue discount (OID).

Stripped preferred stock defined. Strippedpreferred stock is any stock that meets bothof the following tests.

1) There has been a separation in owner-ship between the stock and any dividendon the stock that has not become pay-able.

2) The stock:

a) Is limited and preferred as to divi-dends,

b) Does not participate in corporategrowth to any significant extent, and

c) Has a fixed redemption price.

Treatment of buyer. If you buy strippedpreferred stock after April 30, 1993, you mustinclude certain amounts in your gross incomewhile you hold the stock. These amounts areordinary income. They are equal to theamounts you would have included in grossincome if the stock were a bond that:

1) Was issued on the purchase date of thestock, and

2) Has OID equal to:

a) The redemption price for the stock,minus

b) The price at which you bought thestock.

Report these amounts as other income online 21 of Form 1040. For information aboutOID, see Original Issue Discount (OID), ear-lier.

This treatment also applies to you if youacquire the stock in such a way (for example,by gift) that your basis in the stock is deter-mined by using a buyer's basis.

Treatment of person stripping stock. Youare treated as having purchased strippedpreferred stock if you:

1) Strip the rights to one or more dividendsfrom stock that meets test (2) underStripped preferred stock defined, earlier,and

2) Dispose of those dividend rights afterApril 30, 1993.

You are treated as making the purchase onthe date you disposed of the dividend rights.Your adjusted basis in the stripped preferredstock is treated as your purchase price. Therules described in Treatment of buyer, earlier,apply to you.

REMICs, FASITs,and Other CDOs Holders of interests in real estate mortgageinvestment conduits (REMICs), financial as-set securitization investment trusts (FASITs),and other collateralized debt obligations(CDOs) must follow special rules for reportingincome and any expenses from these invest-ment products.

REMICsA real estate mortgage investment conduit(REMIC) is an entity that is formed for thepurpose of holding a fixed pool of mortgagessecured by interests in real property. AREMIC issues regular and residual intereststo investors. For tax purposes, a REMIC isgenerally treated as a partnership with theresidual interest holders treated as the part-ners. The regular interests are treated as debtinstruments.

REMIC income or loss is not income orloss from a passive activity.

For more information about the qualifica-tions and the tax treatment that apply to aREMIC and the interests of investors in aREMIC, see sections 860A through 860G ofthe Internal Revenue Code, and the regu-lations under those sections.

Regular interest defined. A REMIC canhave several classes (also known as“tranches”) of regular interests. A regular in-terest unconditionally entitles the holder toreceive a specified principal amount (or othersimilar amount).

Residual interest defined. A residual inter-est is an interest in a REMIC that is not aregular interest. It is designated as a residualinterest by the REMIC.

Tax Treatment ofREMIC Regular InterestsA REMIC regular interest is treated as a debtinstrument for income tax purposes. Accord-ingly, the OID, market discount, and incomereporting rules that apply to bonds and otherdebt instruments as described earlier in thispublication under Discount on Debt Instru-ments apply, with certain modifications dis-cussed below.

Generally, you report your income from aregular interest on line 8a, Form 1040. Formore information on how to report interestand OID, see How To Report Interest Income,earlier.

Holders must use accrual method. Holdersof regular interests must use an accrualmethod of accounting to report OID and in-terest income. Because income under an ac-crual method is not determined by the receiptof cash, you may have to include OID or in-terest income in your taxable income even ifyou have not received any cash payments.

Forms 1099–INT and 1099–OID. Youshould receive a copy of Form 1099–INT orForm 1099–OID from the REMIC. You willalso receive a written statement by March 15,2001 (if you are a calendar year taxpayer),that provides additional information. The


statement should contain enough informationto enable you to figure your accrual of marketdiscount or amortizable bond premium.

Form 1099–INT shows the amount of in-terest income that accrued to you for the pe-riod you held the regular interest.

Form 1099–OID shows the amount of OIDand interest, if any, that accrued to you for theperiod you held the regular interest. You willnot need to make any adjustments to theamounts reported even if you held the regularinterest for only a part of the calendar year.However, if you bought the regular interestat a premium or acquisition premium, seeRefiguring OID shown on Form 1099–OIDunder Original Issue Discount (OID), earlier.

You may not get a Form 1099. Corpo-rations and other persons specified in Regu-lation 1.6049–7(c) will not receive Forms1099. These persons and fiscal year taxpay-ers may obtain tax information by contactingthe REMIC or the issuer of the CDO, if theyhold directly from the REMIC or issuer of theCDO. Publication 938, Real Estate MortgageInvestment Conduits (REMICs) Reporting In-formation, explains how to request this infor-mation.

Publication 938 is only available onthe Internet at www.irs.gov.

If you hold a regular interest or CDOthrough a nominee (rather than directly), youcan request the information from the nomineein the manner prescribed in Regulation1.6049–7(f)(7)(i).

Allocated investment expenses of aREMIC. Regular interest holders in a REMICmay be allowed to deduct the REMIC's in-vestment expenses, but only if the REMIC isa single-class REMIC. A single-class REMICis one that generally would be classified as atrust for tax purposes if it had not electedREMIC status.

The single-class REMIC will report yourshare of its investment expenses in box 5 ofForm 1099–INT or box 7 of Form 1099–OID.It will also include this amount in box 1 ofForm 1099–INT or box 2 of Form 1099–OID,and on the additional written statement.

You may be able to take a deduction forthese expenses subject to a 2% limit that alsoapplies to certain other miscellaneous item-ized deductions. See chapter 3 for more in-formation.

Redemption of REMIC regular interests atmaturity. Redemption of debt instrumentsat their maturity is treated as a sale or ex-change. You must report redemptions on yourtax return whether or not you realize gain orloss on the transaction. Your basis is youradjusted issue price, which includes any OIDyou previously reported in income.

Any amount that you receive on the re-tirement of a debt instrument is treated in thesame way as if you had sold or exchangedthat instrument. A debt instrument is retiredwhen it is reacquired or redeemed by theissuer and canceled.

Sale or exchange of a REMIC regularinterest. Some of your gain on the sale orexchange of a REMIC regular interest maybe ordinary income. The ordinary incomepart, if any, is:

• The amount that would have been in-cluded in your income if the yield to ma-

turity on the regular interest had been110% of the applicable federal rate at thebeginning of your holding period, minus

• The amount you included in your income.

Tax Treatment ofREMIC Residual Interests If you acquire a residual interest in a REMIC,you must take into account, on a quarterlybasis, your daily portion of the taxable incomeor net loss of the REMIC for each day duringthe tax year that you hold the residual inter-est. You must report these amounts as ordi-nary income or loss.

Basis in the residual interest. Your basis inthe residual interest is increased by theamount of taxable income you take into ac-count. Your basis is decreased (but not belowzero) by the amount of cash or the fair marketvalue of any property distributed to you, andby the amount of any net loss you have takeninto account. If you sell your residual interest,you must adjust your basis to reflect yourshare of the REMIC's taxable income or netloss immediately before the sale. See WashSales, in chapter 4, for more informationabout selling a residual interest.

Treatment of distributions. You must in-clude in your gross income the part of anydistribution that is more than your adjustedbasis. Treat the distribution as a gain from thesale or exchange of your residual interest.

Schedule Q. If you hold a REMIC residualinterest, you should receive Schedule Q(Form 1066), Quarterly Notice to ResidualInterest Holder of REMIC Taxable Income orNet Loss Allocation, and instructions from theREMIC each quarter. Schedule Q will indicateyour share of the REMIC's quarterly taxableincome (or loss). Do not attach the ScheduleQ to your tax return. Keep it for your records.

Use Part IV of Schedule E (Form 1040) toreport your total share of the REMIC's taxableincome (or loss) for each quarter included inyour tax year.

For more information about reporting yourincome (or loss) from a residual interest in aREMIC, follow the Schedule Q (Form 1066)and Schedule E (Form 1040) instructions.

Expenses. Subject to the 2%-of-adjusted-gross-income limit, you may be able to claima miscellaneous itemized deduction for cer-tain ordinary and necessary expenses thatyou paid or incurred in connection with yourinvestment in a REMIC. These expensesmay include certain expense items incurredby the REMIC and passed through to you.The REMIC will report these expenses to youon line 3b of Schedule Q. See chapter 3 forinformation on how to report these expenses.

Collateralized DebtObligations (CDOs) A collateralized debt obligation (CDO) is adebt instrument, other than a REMIC regularinterest, that is secured by a pool of mort-gages or other evidence of debt and that hasprincipal payments that are subject to accel-eration. (Note: While REMIC regular interestsare collateralized debt obligations, they haveunique rules that do not apply to CDOs issuedbefore 1987.) CDOs, also known as “pay-

through bonds,” are commonly divided intodifferent classes (also called “tranches”).

CDOs can be secured by a pool of mort-gages, automobile loans, equipment leases,or credit card receivables.

For more information about the qualifica-tions and the tax treatment that apply to anissuer of a CDO, see section 1272(a)(6) of theInternal Revenue Code and the regulationsunder that section.

Tax treatment of CDOs. The OID, marketdiscount, and income-reporting rules that ap-ply to bonds and other debt instruments, asdescribed earlier in this chapter under Dis-count on Debt Instruments, also apply to aCDO.

You must include interest income fromyour CDO in your gross income under yourregular method of accounting. Also includeany OID accrued on your CDO during the taxyear.

Generally, you report your income from aCDO on line 8a, Form 1040. For more infor-mation about reporting these amounts onyour return, see How To Report Interest In-come, earlier.

Forms 1099–INT and 1099–OID. Youshould receive a copy of Form 1099–INT orForm 1099–OID. You will also receive awritten statement by March 15, 2001, thatprovides additional information. The state-ment should contain enough informationabout the CDO to enable you to figure youraccrual of market discount or amortizablebond premium.

Form 1099–INT shows the amount of in-terest income paid to you for the period youheld the CDO.

Form 1099–OID shows the amount of OIDaccrued to you and the interest, if any, paidto you for the period you held the CDO. Youshould not need to make any adjustments tothe amounts reported even if you held theCDO for only a part of the calendar year.However, if you bought the CDO at a pre-mium or acquisition premium, see RefiguringOID shown on Form 1099–OID under OriginalIssue Discount (OID), earlier.

If you did not receive a Form 1099, seeYou may not get a Form 1099 under TaxTreatment of REMIC Regular Interests, ear-lier.

FASITsA financial asset securitization investmenttrust (FASIT) is an entity that securitizes debtobligations such as credit card receivables,home equity loans, and automobile loans.

A regular interest in a FASIT is treated asa debt instrument. The rules described underTax Treatment of CDOs, earlier, apply to aregular interest in a FASIT, except that aholder of a regular interest in a FASIT mustuse an accrual method of accounting to reportOID and interest income.

For more information about FASITs, seesections 860H through 860L of the InternalRevenue Code.

S Corporations In general, an S corporation does not pay atax on its income. Instead, its income andexpenses are passed through to the share-holders, who then report these items on theirown income tax returns.


If you are an S corporation shareholder,all current year income or loss and other taxitems are taxed to you at the corporation'syear end (generally, the end of the calendaryear) whether or not you actually receive anyamount. Generally, those items increase ordecrease the basis of your S corporationstock as appropriate. For more informationon basis adjustments for S corporation stock,see Stocks and Bonds under Basis of In-vestment Property in chapter 4.

Generally, S corporation distributions, ex-cept dividend distributions, are considered areturn of capital and reduce your basis in thestock of the corporation. The part of any dis-tribution that is more than your basis istreated as a gain from the sale or exchangeof property. The corporation's distributionsmay be in the form of cash or property.

Dividends of an S corporation generallyare paid only from accumulated earnings andprofits from years before 1983 or before itbecame an S corporation.

Reporting S corporation income, de-ductions, and credits. The S corporationshould send you a copy of Schedule K–1(Form 1120S) showing your share of the Scorporation's income, credits, and deductionsfor the tax year. You must report your dis-tributive share of the S corporation's income,gain, loss, deductions, or credits on the ap-propriate lines and schedules of your Form1040.

For more information about your treatmentof S corporation tax items, see Shareholder'sInstructions for Schedule K–1 (Form 1120S).

Limit on losses and deductions. Thededuction for your share of losses and de-ductions shown on Schedule K–1 (Form1120S) is limited to the adjusted basis of yourstock and any debt the corporation owes you.Any loss or deduction not allowed becauseof this limit is carried over and treated as aloss or deduction in the next tax year.

Passive activity losses. Rules apply thatlimit losses from passive activities. Your copyof Schedule K–1 and its instructions will ex-plain the limits and tell you where on yourreturn to report your share of S corporationitems from passive activities.

Form 8582. If you have a passive activityloss from an S corporation, you must com-plete Form 8582, Passive Activity Loss Lim-itations, to figure the amount of the allowableloss to enter on your return. See Publication925 for more information.

Investment Clubs An investment club is formed when a groupof friends, neighbors, business associates,or others pool their money to invest in stockor other securities. The club may or may nothave a written agreement, a charter, or by-laws.

Usually the group operates informally withmembers pledging to pay a regular amountinto the club monthly. Some clubs have acommittee that gathers information on secu-rities, selects the most promising securities,and recommends that the club invest in them.Other clubs rotate these responsibilitiesamong all their members. Most clubs requireall members to vote for or against all invest-ments, sales, trades, and other transactions.

Identifying number. Each club must havean employer identification number (EIN) touse when filing its return. The club's EIN alsomay have to be given to the payer of divi-dends or other income from investments re-corded in the club's name. To obtain an EIN,first get Form SS–4 , Application for EmployerIdentification Number, from the Internal Rev-enue Service or your nearest Social SecurityAdministration office. See chapter 5 of thispublication for more information about how toget this form.

Investments in name of member. Whenan investment is recorded in the name of oneclub member, this member must give his orher social security number (SSN) to the payerof investment income. (When an investmentis held in the names of two or more clubmembers, the SSN of only one member mustbe given to the payer.) This member is con-sidered as the record owner for the actualowner, the investment club. This member isa “nominee” and must file an information re-turn with the IRS. For example, the nomineemember must file Form 1099–DIV for divi-dend income, showing the club as the ownerof the dividend, his or her SSN, and the EINof the club.

Tax treatment of the club. Generally, aninvestment club is treated as a partnership forfederal tax purposes unless it chooses other-wise. In some situations, however, it is taxedas a corporation or a trust.

Clubs formed before 1997. Before 1997,the rules for determining how an investmentclub is treated were different from those ex-plained in the following discussions. An in-vestment club that existed before 1997 istreated for later years the same way it wastreated before 1997, unless it chooses to betreated a different way under the new rules.To make that choice, the club must file Form8832, Entity Classification Election.

Club as a PartnershipIf your club is not taxed as a corporation ora trust, it will be treated as a partnership.

Club files Form 1065. If your investmentclub is treated as a partnership, it must fileForm 1065. However, as a partner in the club,you must report on your individual return yourshare of the club's income, gains, losses,deductions, and credits for the club's tax year.(Its tax year generally must be the same taxyear as that of the partners owning a majorityinterest.) You must report these itemswhether or not you actually receive any dis-tribution from the partnership.

You should receive a copy of ScheduleK–1 (Form 1065), Partner's Share of Income,Credits, Deductions, etc., from the partner-ship. The amounts shown on Schedule K–1are your share of the partnership's income,deductions, and credits. Report each amounton the appropriate lines and schedules ofyour income tax return.

The club's expenses for producing or col-lecting income, for managing investmentproperty, or for determining any tax are listedseparately on Schedule K–1. Each individualpartner who itemizes deductions on ScheduleA (Form 1040) can deduct his or her shareof those expenses. The expenses are listedon line 22 of Schedule A along with othermiscellaneous deductions subject to the 2%limit. See chapter 3 for more information onthe 2% limit.

For more information about reporting yourincome from a partnership, see the ScheduleK–1 instructions. Also see Publication 541,Partnerships.

Passive activity losses. Rules apply thatlimit losses from passive activities. Your copyof Schedule K–1 (Form 1065) and its in-structions will tell you where on your return toreport your share of partnership items frompassive activities. If you have a passive ac-tivity loss from a partnership, you must com-plete Form 8582 to figure the amount of theallowable loss to enter on your tax return.

No social security coverage for invest-ment club earnings. If an investment clubpartnership's activities are limited to investingin savings certificates, stock, or securities,and collecting interest or dividends for itsmembers' accounts, a member's share of in-come is not earnings from self-employment.You cannot voluntarily pay the self-employ-ment tax to increase your social securitycoverage and ultimate benefits.

For more information on self-employmenttax, see Publication 533, Self-EmploymentTax.

Club as a CorporationAn investment club formed after 1996 is taxedas a corporation if:

1) It is formed under a federal or state lawthat refers to it as a corporation, bodycorporate, or body politic. It is formedunder a state law that refers to it as ajoint-stock company or joint-stock asso-ciation, or

2) It chooses to be taxed as a corporation.

Choosing to be taxed as a corporation.To choose to be taxed as a corporation, theclub cannot be a trust (see Club as a Trust,later) or otherwise subject to special treat-ment under the tax law. The club must fileForm 8832 to make the choice.

Club files Form 1120. If your club is taxedas a corporation, it must file Form 1120 (orForm 1120–A). In that case, you do not reportany of its income or expenses on your indi-vidual return. All ordinary income and ex-penses and capital gains and losses must bereported on the Form 1120 (or Form 1120–A).Any distribution the club makes that qualifiesas a dividend must be reported on Forms1096 and 1099–DIV if total distributions to theshareholder are $10 or more for the year.

You must report any distributions that youreceive from the club on your individual re-turn. You should receive a copy of Form1099–DIV from the club showing the distri-butions you received.

Some corporations can choose not to betaxed and have earnings taxed to the share-holders. See S Corporations, earlier.

For more information about corporations,see Publication 542, Corporations.

Club as a TrustIn a few cases, an investment club is taxedas a trust. In general, a trust is an arrange-ment through which trustees take title toproperty for the purpose of protecting or con-serving it for the beneficiaries under the ordi-nary rules applied in chancery or probatecourts. An arrangement is treated as a trustfor tax purposes if its purpose is to vest intrustees responsibility for protecting and con-


serving property for beneficiaries who cannotshare in that responsibility and so are notassociates in a joint enterprise for the conduct

of business for profit. If you need more infor-mation about trusts, see section 301.7701–4of the regulations.

Club files Form 1041. If your club is taxedas a trust, it must file Form 1041. You shouldreceive a copy of Schedule K–1 (Form 1041)from the trust. Report the amounts shown onSchedule K–1 on the appropriate lines andschedules of your income tax return.


2.Tax Shelters

IntroductionInvestments that yield tax benefits are some-times called “tax shelters.” In some cases,Congress has concluded that the loss of rev-enue is an acceptable side effect of specialtax provisions designed to encourage tax-payers to make certain types of investments.In many cases, however, losses from taxshelters produce little or no benefit to society,or the tax benefits are exaggerated beyondthose intended. Those cases are called“abusive tax shelters.” An investment that isconsidered a tax shelter is subject to re-strictions, including the requirement that it beregistered, as discussed later, unless it is aprojected income investment (defined later).


• How to recognize an abusive tax shelter,

• Rules enacted by Congress to curb taxshelters,

• Investors' reporting requirements, and

• Penalties that may apply.


Publication

� 538 Accounting Periods and Methods

� 556 Examination of Returns, AppealRights, and Claims for Refund

� 561 Determining the Value of DonatedProperty



� 8271 Investor Reporting of Tax ShelterRegistration Number

� 8275 Disclosure Statement

� 8275–R Regulation Disclosure State-ment


Abusive Tax SheltersAbusive tax shelters are marketing schemesthat involve artificial transactions with little orno economic reality. They often make useof unrealistic allocations, inflated appraisals,losses in connection with nonrecourse loans,mismatching of income and deductions, fi-nancing techniques that do not conform tostandard commercial business practices, orthe mischaracterization of the substance ofthe transaction. Despite appearances to thecontrary, the taxpayer generally risks little.

Abusive tax shelters commonly involvepackage deals that are designed from thestart to generate losses, deductions, or cred-its that will be far more than present or futureinvestment. Or, they may promise investorsfrom the start that future inflated appraisalswill enable them, for example, to reap chari-table contribution deductions based on thoseappraisals. (But see the appraisal require-ments discussed under Curbing Abusive TaxShelters.) They are commonly marketed interms of the ratio of tax deductions allegedlyavailable to each dollar invested. This ratio (or“write-off”) is frequently said to be severaltimes greater than one-to-one.

Since there are many abusive tax shelters,it is not possible to list all the factors youshould consider in determining whether anoffering is an abusive tax shelter. However,you should ask the following questions, whichmight provide a clue to the abusive nature ofthe plan.

• Do the tax benefits far outweigh the eco-nomic benefits?

• Is this a transaction you would seriouslyconsider, apart from the tax benefits, ifyou hoped to make a profit?

• Do shelter assets really exist and, if so,are they insured for less than their pur-chase price?

• Is there a nontax justification for the wayprofits and losses are allocated to part-ners?

• Do the facts and supporting documentsmake economic sense? In that con-nection, are there sales and resales ofthe tax shelter property at ever increasingprices?

• Does the investment plan involve a gim-mick, device, or sham to hide the eco-nomic reality of the transaction?

• Does the promoter offer to backdatedocuments after the close of the year?Are you instructed to backdate checkscovering your investment?

• Is your debt a real debt or are you as-sured by the promoter that you will neverhave to pay it?

• Does this transaction involve launderingUnited States-source income throughforeign corporations incorporated in a taxhaven and owned by United Statesshareholders?

Curbing AbusiveTax SheltersCongress has enacted a series of income taxlaws designed to halt the growth of abusivetax shelters. These provisions include thefollowing.

1) Passive activity losses and credits. The passive activity loss and credit ruleslimit the amount of losses and creditsthat can be claimed from passive activ-ities and limit the amount that can offsetnonpassive income, such as certainportfolio income from investments. Formore detailed information about deter-mining and reporting income, losses,and credits from passive activities, seePublication 925.

2) Registration of tax shelters. Generally,the organizers of certain tax sheltersmust register the shelter with the IRS.

The IRS will then assign the tax sheltera registration number. If you are an in-vestor in a tax shelter, the seller (or thetransferor) must provide you with the taxshelter registration number at the timeof sale (or transfer) or within 20 daysafter the seller or transferor receives thenumber if that date is later. See InvestorReporting, later, for more informationabout reporting this number when filingyour tax return.

3) List of tax shelter investors.Organizers and sellers of any potentiallyabusive tax shelter must maintain a listidentifying each investor. The list mustbe available for inspection by the IRS,and the information required to be in-cluded on the list generally must be keptfor 7 years. See Transfer of interests ina tax shelter, later, for more information.

4) Appraisals of donated property. Gen-erally, if you donate property valued atmore than $5,000 ($10,000 in the caseof privately traded stock), you must geta written “qualified” appraisal of theproperty's fair market value and attachan appraisal summary to your incometax return. The appraisal must be doneby a “qualified” appraiser who is not thetaxpayer, a party to a transaction inwhich the taxpayer acquired the prop-erty, the donee, or an employee or re-lated party of any of the preceding per-sons. (Related parties are defined underRelated Party Transactions in chapter4.) For more information about ap-praisals, see Publication 561.

5) Interest on penalties. If you are as-sessed an accuracy-related or civil fraudpenalty (as discussed under Penalties,later), interest will be imposed on theamount of the penalty from the due dateof the return (including any extensions)to the date you pay the penalty.

6) Accounting methods and capitaliza-tion rules. Tax shelters generally cannotuse the cash method of accounting.Also, uniform capitalization rules gener-ally apply to producing property or ac-quiring it for resale. Under those rules,the direct cost and part of the indirectcost of the property must be capitalizedor included in inventory. For more infor-mation, see Publication 538.

Projected income investment. Specialrules apply to a projected income investment.To qualify as a projected income investment,a tax shelter must not be expected to reducethe cumulative tax liability of any investorduring any year of the first 5 years endingafter the date the investment was offered forsale. In addition, the assets of a projectedincome investment must not include or relateto more than an incidental interest in:

1) Master sound recordings,

2) Motion picture or television films,

3) Videotapes,

4) Lithograph plates,

5) Copyrights,

6) Literary, musical, or artistic compos-itions, or

7) Collectibles (such as works of art, rugs,antiques, metals, gems, stamps, coins,or alcoholic beverages).

Chapter 2 Tax Shelters

Tax shelters that qualify as projected in-come investments are not subject to the reg-istration rules for tax shelters, described ear-lier. However, the requirement to maintain alist of investors that is in effect for tax sheltersalso applies to any projected income invest-ment, except for one an investor later trans-fers. See Transfer of interests in a tax shel-ter, later.

A tax shelter that previously qualified asa projected income investment may later bedisqualified if, in one of its first 5 years, it re-duces the cumulative tax liability of any in-vestor. In that case, the tax shelter becomessubject to the registration rules for tax shel-ters, described earlier.

Pre-filing notification letter. If you are aninvestor in an abusive tax shelter promotion,the IRS may send you a “pre-filing notificationletter” if it determines that it is highly likely thatthere is:

1) A gross valuation overstatement, or

2) A false or fraudulent statement regardingthe tax benefits to be derived from thetax shelter entity or arrangement.

This letter will advise you that, based upon areview of the promotion, it is believed that thepurported tax benefits are not allowable. Theletter also will advise you of the possible taxconsequences if you claim the benefits onyour income tax return.

You also may receive a notification letterafter you file your tax return. If you have al-ready claimed the benefits on your tax return,you will be advised that you can file anamended return. However, any penalties thatapply still can be asserted.

If you claim the benefits after receiving thepre-filing notification or if you fail to amendyour return, you will be notified that your taxreturn is being examined. Normal audit andappeal procedures will be followed during theexamination, and accuracy-related, civil orcriminal fraud, and other penalties will beconsidered and, when appropriate, asserted.For information on the examination of returns,see Publication 556.

Revenue rulings. The IRS has publishednumerous revenue rulings concluding that theclaimed tax benefits of various abusive taxshelters should be disallowed. A revenue rul-ing is the conclusion of the IRS on how thelaw is applied to a particular set of facts.Revenue rulings are published in the InternalRevenue Bulletin for taxpayers' guidance andinformation and also for use by IRS officials.So, if your return is examined and an abusivetax shelter is identified and challenged, apublished revenue ruling dealing with thattype of shelter, which disallows certainclaimed tax shelter benefits, could serve asthe basis for the examining official's challengeof the tax benefits that you claimed. In sucha case, the examiner will not compromiseeven if you or your representative believe thatyou have authority for the positions taken onyour tax return.

CAUTION!

The courts have generally been un-sympathetic to taxpayers involved inabusive tax shelter schemes and

have ruled in favor of the IRS in the majorityof the cases in which these shelters havebeen challenged.

Investor ReportingIf you include on your tax return any de-duction, loss, credit or other tax benefit, orany income, from an interest in a tax shelterrequired to be registered, you must report theregistration number that the tax shelter pro-vided to you. (See Registration of tax shel-ters, earlier.) Complete and attach Form 8271to your return to report the number and toprovide other information about the tax shelterand its benefits. You must also attach Form8271 to any application for tentative refund(Form 1045) and to any amended return(Form 1040X) on which these benefits areclaimed or income is reported. If you do notinclude the registration number with your re-turn, you will be subject to a penalty of $250for each such failure, unless the failure is dueto reasonable cause.

Transfer of interests in a tax shelter. If youhold an investment interest in a tax shelterand later transfer that interest to anotherperson, you must provide the tax shelter'sregistration number to each person to whomyou transferred your interest. (However, thisdoes not apply if your interest is in a projectedincome investment, described earlier.) Youmust also provide a notice substantially in thefollowing form:

The following requirements also apply.

1) Maintaining a list. You must maintaina list identifying each person to whomyou transferred your interest. Or, youmay require a designated person orseller to maintain the list. However, seeSpecial rule for projected income invest-ment, later, for an exception to this re-quirement. If you choose to delegate thisrequirement, you must give the desig-nated person or seller all of the informa-tion that you would otherwise have tomaintain on the list.

2) Providing notice. If the tax shelter is nota projected income investment, de-scribed earlier, you must provide a noticeto each person to whom you transferredyour interest. This notice must be sub-stantially in the following form:

If you do not maintain the required list ofinvestors, or do not delegate a designatedperson or seller to maintain the list, you willbe subject to a penalty of $50 for each personrequired to be on the list. But, you will nothave to pay the penalty if you can show thatthe failure to comply with this requirementwas due to reasonable cause and not willfulneglect. The maximum penalty under thisprovision is $100,000 for each tax shelter ineach calendar year.

Special rule for projected income in-vestment. If you are an investor who latertransfers an interest in a projected incomeinvestment, described earlier, you are not re-quired to maintain a list of investors unlessthe tax shelter was no longer a projected in-come investment, or otherwise became sub-ject to the registration requirements, beforethe transfer.

PenaltiesInvesting in an abusive tax shelter may be anexpensive proposition when you consider allof the consequences. First, the promotergenerally charges a substantial fee. If yourreturn is examined by the IRS and a tax de-ficiency is determined, you will be faced withpayment of more tax, interest on the under-payment, possibly a 20% accuracy-relatedpenalty, or a 75% civil fraud penalty. You mayalso be subject to the penalty for failure to paytax. These penalties are explained in the fol-lowing paragraphs.

Accuracy-related penalties. An accuracy-related penalty of 20% can be imposed forunderpayments of tax due to:

1) Negligence or disregard of rules or reg-ulations,

2) Substantial understatement of tax, or

3) Substantial valuation misstatement.

This penalty will not be imposed if you canshow that you had reasonable cause for anyunderstatement of tax and that you acted ingood faith.

If you are charged an accuracy-relatedpenalty, interest will be imposed on theamount of the penalty from the due date ofthe return (including extensions) to the dateyou pay the penalty.

Negligence or disregard of rules orregulations. The penalty for negligence ordisregard of rules or regulations is imposedonly on the part of the underpayment that isdue to negligence or disregard of rules orregulations. The penalty will not be chargedif you can show that you had reasonablecause for understating your tax and that youacted in good faith.

Negligence includes any failure to makea reasonable attempt to comply with the pro-visions of the Internal Revenue Code.

Disregard includes any careless, reckless,or intentional disregard. The penalty for dis-

You have acquired an interest in [name and ad-dress of tax shelter]. If you transfer your interestin this tax shelter to another person, you are re-quired by the Internal Revenue Service to keep alist containing that person's name, address, tax-payer identification number, the date on which youtransferred the interest, and the name, address,and tax shelter registration number of this taxshelter. If you do not want to keep such a list, youmust (1) send the information specified above to[name and address of designated person], whowill keep the list for this tax shelter, and (2) givea copy of this notice to the person to whom youtransfer your interest.

You have acquired an interest in [name and ad-dress of tax shelter] whose taxpayer identificationnumber is [if any]. The Internal Revenue Servicehas issued [name of tax shelter] the following taxshelter registration number: [number]. You mustreport this registration number to the InternalRevenue Service, if you claim any deduction, loss,credit, or other tax benefit or report any incomeby reason of your investment in [name of taxshelter]. You must report the registration number(as well as the name and taxpayer identificationnumber of [name of tax shelter]) on Form 8271.Form 8271 must be attached to the return onwhich you claim the deduction, loss, credit, orother tax benefit or report any income. Issuanceof a registration number does not indicate that thisinvestment or the claimed tax benefits have beenreviewed, examined, or approved by the InternalRevenue Service.


regard of rules and regulations can beavoided if both of the following are true.

• You have a reasonable basis for yourposition on the tax issue.

• You make an adequate disclosure of yourposition.

Use Form 8275 to make your disclosure, andattach it to your tax return. To disclose a po-sition contrary to a regulation, use Form8275–R.

Substantial understatement of tax. Anunderstatement is considered to be substan-tial if it is more than the greater of:

1) 10% of the tax required to be shown onthe return, or

2) $5,000.

An “understatement” is the amount of tax re-quired to be shown on your return for a taxyear minus the amount of tax shown on thereturn, reduced by any rebates. The term“rebate” generally means a decrease in thetax shown on your original return as the resultof your filing an amended return or claim forrefund.

Two special rules apply in the case of anunderstatement due to a tax shelter.

1) An understatement of tax does not in-clude any tax due to a tax shelter item(such as an item of income, gain, loss,deduction, or credit) if you had substan-tial authority for the tax treatment of the

item and reasonably believed that thetax treatment chosen was more likelythan not the proper one.

2) Disclosure of the tax shelter item on atax return does not reduce the amountof the understatement.

For other than tax shelters, you can file Form8275 or Form 8275–R to disclose items thatcould cause a substantial understatement ofincome tax. In that way, you can avoid thesubstantial understatement penalty if youhave a reasonable basis for your position onthe tax issue.

Also, the understatement penalty will notbe imposed if you can show that there wasreasonable cause for the underpaymentcaused by the understatement and that youacted in good faith. An important factor inestablishing reasonable cause and good faithwill be the extent of your effort to determineyour proper tax liability under the law.

Valuation misstatement. In general, youare liable for a 20% penalty for a substantialvaluation misstatement if all of the followingare true.

1) The value or adjusted basis of anyproperty claimed on the return is 200%or more of the correct amount.

2) You underpaid your tax by more than$5,000 because of the misstatement.

3) You cannot establish that you had rea-sonable cause for the underpayment andthat you acted in good faith.

You may be assessed a penalty of 40%for a gross valuation misstatement. If youmisstate the value or the adjusted basis ofproperty by 400% or more of the amount de-termined to be correct, you will be assesseda penalty of 40%, instead of 20%, of theamount you underpaid because of the grossvaluation misstatement. The penalty rate isalso 40% if the property's correct value oradjusted basis is zero.

Civil fraud penalty. If there is any under-payment of tax on your return due to fraud,a penalty of 75% of the underpayment will beadded to your tax.

Joint return. The fraud penalty on a jointreturn applies to a spouse only if some partof the underpayment is due to the fraud ofthat spouse.

Failure to pay tax. If a deficiency is as-sessed and is not paid within 10 days of thedemand for payment, an investor can be pe-nalized with up to a 25% addition to tax if thefailure to pay continues.

Whether To InvestIn light of the adverse tax consequences andthe substantial amount of penalties and in-terest that will result if the claimed tax benefitsare disallowed, you should consider tax shel-ter investments carefully and seek competentlegal and financial advice.


3.InvestmentExpensesTerms you may need to know (seeGlossary):

At-risk rules Passive activity Portfolio income


• Limits on deductions,

• Interest expenses,

• Bond premium amortization,

• Expenses of producing income,

• Nondeductible expenses, and

• How to report investment expenses.


Publication

� 535 Business Expenses


� 929 Tax Rules for Children and De-pendents

� 936 Home Mortgage Interest De-duction


� Schedule A (Form 1040) Itemized De-ductions

� 4952 Investment Interest Expense De-duction


Limits on DeductionsYour deductions for investment expensesmay be limited by:

• The at-risk rules,

• The passive activity loss limits,

• The limit on investment interest, or

• The 2% limit on certain miscellaneousitemized deductions.

The at-risk rules and passive activity rulesare explained briefly in this section. The limiton investment interest is explained later inthis chapter under Interest Expenses. The 2%limit is explained later in this chapter underExpenses of Producing Income.

At-risk rules. Special at-risk rules apply tomost income-producing activities. Theserules limit the amount of loss you can deduct

to the amount you risk losing in the activity.Generally, this is the amount of cash and theadjusted basis of property you contribute tothe activity. It also includes money you borrowfor use in the activity if you are personallyliable for repayment or if you use property notused in the activity as security for the loan.For more information, see Publication 925.

Passive activity losses and credits. Theamount of losses and tax credits you canclaim from passive activities is limited. Gen-erally, you are allowed to deduct passive ac-tivity losses only up to the amount of yourpassive activity income. Also, you can usecredits from passive activities only against taxon the income from passive activities. Thereare exceptions for certain activities, such asrental real estate activities.

Passive activity. A passive activity gen-erally is any activity involving the conduct ofany trade or business in which you do notmaterially participate and any rental activity.However, if you are involved in renting realestate, the activity is not a passive activity ifboth of the following are true.

1) More than one-half of the personal ser-vices you perform during the year in alltrades or businesses are performed inreal property trades or businesses inwhich you materially participate.

2) You perform more than 750 hours ofservices during the year in real propertytrades or businesses in which youmaterially participate.

The term trade or business generally meansany activity that involves the conduct of atrade or business, is conducted in anticipationof starting a trade or business, or involvescertain research or experimental expendi-tures. However, it does not include rental ac-tivities or certain activities treated as inci-dental to holding property for investment.

You are considered to materially partic-ipate in an activity if you are involved on aregular, continuous, and substantial basis inthe operations of the activity.

Other income (nonpassive income).Generally, you can use losses from passiveactivities only to offset income from passiveactivities. You generally cannot use passiveactivity losses to offset your other income,such as your wages or your portfolio income.Portfolio income includes gross income frominterest, dividends, annuities, or royalties thatis not derived in the ordinary course of a tradeor business. It also includes gains or losses(not derived in the ordinary course of a tradeor business) from the sale or trade of property(other than an interest in a passive activity)producing portfolio income or held for invest-ment. This includes capital gain distributionsfrom mutual funds and real estate investmenttrusts.

You cannot use passive activity losses tooffset Alaska Permanent Fund dividends.

Expenses. Do not include in the compu-tation of your passive activity income or loss:

1) Expenses (other than interest) that areclearly and directly allocable to yourportfolio income, or

2) Interest expense properly allocable toportfolio income.

However, this interest and other expensesmay be subject to other limits. These limitsare explained in the rest of this chapter.

Additional information. For more infor-mation about determining and reporting in-come and losses from passive activities, seePublication 925.

Interest Expenses This section discusses interest expenses youmay be able to deduct as an investor.

For information on business interest, seechapter 5 of Publication 535.

You cannot deduct personal interest ex-penses other than qualified home mortgageinterest, as explained in Publication 936, andinterest on certain student loans, as explainedin Publication 970, Tax Benefits for HigherEducation.

Investment Interest If you borrow money and use it to buy prop-erty you hold for investment, the interest youpay is investment interest. You can deductinvestment interest subject to the limit dis-cussed later. However, you cannot deductinterest you incurred to produce tax-exemptincome. See Tax-exempt income under Non-deductible Expenses, later. Nor can you de-duct interest expenses on straddles, alsodiscussed under Nondeductible Expenses.

Investment interest does not include anyqualified home mortgage interest or any in-terest taken into account in computing incomeor loss from a passive activity.

Investment property. Property held for in-vestment includes property that produces in-terest, dividends, annuities, or royalties notderived in the ordinary course of a trade orbusiness. It also includes property thatproduces gain or loss (not derived in the or-dinary course of a trade or business) from thesale or trade of property producing thesetypes of income or held for investment (otherthan an interest in a passive activity). In-vestment property also includes an interest ina trade or business activity in which you didnot materially participate (other than a pas-sive activity).

Partners, shareholders, and beneficia-ries. To determine your investment interest,combine your share of investment interestfrom a partnership, S corporation, estate, ortrust with your other investment interest.

Allocation of Interest Expense If you use borrowed money for business orpersonal purposes as well as for investment,you must allocate the debt among those pur-poses. Only the interest expense on the partof the debt used for investment purposes istreated as investment interest. The allocationis not affected by the use of property thatsecures the debt. However, fully deductiblehome mortgage interest is not treated as in-vestment interest and the debt does not haveto be allocated, regardless of how the pro-ceeds are used.

Example 1. You borrow $10,000 and use$8,000 to buy stock. You use the other $2,000to buy items for your home. Since 80% of thedebt is used for, and allocated to, investmentpurposes, 80% of the interest on that debt isinvestment interest. The other 20% is non-deductible personal interest.

Chapter 3 Investment Expenses

Debt proceeds received in cash. Interestyou pay on debt proceeds that you receivedin cash is generally treated as nondeductiblepersonal interest. However, you can treat anypayment you make within 30 days before orafter you receive the proceeds as made fromthose proceeds. This applies to any payment(up to the amount of the proceeds) made fromany account you own, or from cash. Also, youcan treat the payment as made on the dateyou received the cash instead of on the dateyou actually made the payment.

Debt proceeds deposited in account. If youdeposit debt proceeds in an account, thatdeposit is treated as an investment expendi-ture. Amounts held in the account are treatedas investment property, regardless of whetherthe account bears interest. Any interest youpay on the deposited proceeds is investmentinterest. But, if you withdraw the funds anduse them for another purpose, you must re-allocate the debt and any interest you pay.

Example 2. Assume in Example 1 thatyou borrowed the money on March 1 andimmediately bought the stock for $8,000. Youdid not buy the household items until June 1.You had deposited the $2,000 in the bank.You had no other transactions on the bankaccount and made no principal payments onthe debt. The $2,000 is treated as being usedfor an investment purpose for the 3-monthperiod. Your total interest expense for 3months on this debt is investment interest. InJune, you must begin to allocate 80% of thedebt and the interest expense to investmentpurposes and 20% to personal purposes.

Payments on debt require new allocation.As you repay the debt, you must reallocatethe balance. You must first reduce theamount allocated to personal purposes by therepayment. You then reallocate the rest of thedebt to find what part is for investment pur-poses.

Example 3. If, in Example 2, you repay$500 on November 1, the entire repaymentis applied against the amount allocated topersonal purposes. The debt balance is nowallocated as $8,000 for investment purposes,and $1,500 for personal purposes. Until thenext reallocation is necessary, 84% ($8,000÷ $9,500) of the debt and the interest expenseis allocated to investment.

Pass-through entities. If you use borrowedfunds to buy an interest in a partnership or Scorporation, then the interest on those fundsmust be allocated based on the assets of theentity. If you contribute to the capital of theentity, you can make the allocation using anyreasonable method.

Additional allocation rules. For more in-formation about allocating interest expense,see chapter 5 of Publication 535.

When To DeductInvestment InterestIf you use the cash method of accounting, youmust pay the interest before you can deductit.

If you use an accrual method of account-ing, you can deduct interest over the periodit accrues, regardless of when you pay it. Foran exception, see Unpaid expenses owed torelated party under When To Report Invest-ment Expenses, later in this chapter.

Example. You borrowed $1,000 on Sep-tember 6, 2000, payable in 90 days at 12%interest. On December 5, 2000, you paid thiswith a new note for $1,030, due on March 5,2001. If you use the cash method of ac-counting, you cannot deduct any part of the$30 interest on your return for 2000 becauseyou did not actually pay it. If you use an ac-crual method, you may be able to deduct aportion of the interest on the loans throughDecember 31, 2000, on your return for 2000.

Interest paid in advance. Generally, if youpay interest in advance for a period that goesbeyond the end of the tax year, you mustspread the interest over the tax years to whichit belongs under the OID rules. You can de-duct in each year only the interest for thatyear.

Interest on margin accounts. If you are acash method taxpayer, you can deduct inter-est on margin accounts to buy taxable secu-rities as investment interest in the year youpaid it. You are considered to have paid in-terest on these accounts only when you ac-tually pay the broker or when payment be-comes available to the broker through youraccount. Payment may become available tothe broker through your account when thebroker collects dividends or interest for youraccount, or sells securities held for you orreceived from you.

You cannot deduct any interest on moneyborrowed for personal reasons.

Deferral of interest deduction for marketdiscount bonds. The amount you can de-duct for interest expense you paid or accruedduring the year to buy or carry a market dis-count bond may be limited. This limit does notapply if you accrue the market discount andinclude it in your income currently.

Under this limit, the interest is deductibleonly to the extent it is more than:

1) The total interest and OID includible ingross income for the bond for the year,plus

2) The market discount for the number ofdays you held the bond during the year.

Figure the amount in (2) above using the rulesfor figuring accrued market discount in chap-ter 1 under Market Discount Bonds.

Disallowed interest expense. In theyear you dispose of the bond, you can deductthe amount of any interest expense you werenot allowed to deduct in earlier years.

Choosing to deduct disallowed interestexpense before the year of disposition.You can choose to deduct disallowed interestexpense in any year before the year you dis-pose of the bond, up to your net interest in-come from the bond during the year. The restof the disallowed interest expense remainsdeductible in the year you dispose of thebond.

Net interest income. This is the interestincome (including OID) from the bond thatyou include in income for the year, minus theinterest expense paid or accrued during theyear to purchase or carry the bond.

Deferral of interest deduction for short-term obligations. If the current incomeinclusion rules discussed in chapter 1 underDiscount on Short-Term Obligations do notapply to you, the amount you can deduct for

interest expense you paid or accrued duringthe year to buy or carry a short-term obli-gation is limited.

The interest is deductible only to the ex-tent it is more than:

1) The amount of acquisition discount orOID on the obligation for the tax year,plus

2) The amount of any interest payable onthe obligation for the year that is not in-cluded in income because of your ac-counting method (other than interesttaken into account in determining theamount of acquisition discount or OID).

The method of determining acquisition dis-count and OID for short-term obligations isdiscussed in chapter 1 under Discount onShort-Term Obligations.

Disallowed interest expense. In theyear you dispose of the obligation, or if youchoose, in another year in which you havenet interest income from the obligation, youcan deduct the amount of any interest ex-pense you were not allowed to deduct for anearlier year. Follow the same rules providedin the earlier discussion under Deferral of in-terest deduction for market discount bonds.

Limit on DeductionGenerally, your deduction for investment in-terest expense is limited to the amount of yournet investment income.

You can carry over the amount of invest-ment interest that you could not deduct be-cause of this limit to the next tax year. Theinterest carried over is treated as investmentinterest paid or accrued in that next year.

You can carry over disallowed investmentinterest to the next tax year even if it is morethan your taxable income in the year the in-terest was paid or accrued.

Net Investment IncomeDetermine the amount of your net investmentincome by subtracting your investment ex-penses (other than interest expense) fromyour investment income.

Investment income. This generally includesyour gross income from property held for in-vestment (such as interest, dividends, annui-ties, and royalties). Investment income doesnot include Alaska Permanent Fund divi-dends.

Choosing to include net capital gain.Investment income generally does not includenet capital gain from disposing of investmentproperty (including capital gain distributionsfrom mutual funds). However, you can chooseto include all or part of your net capital gainin investment income.

You make this choice by completing line4e of Form 4952 according to its instructions.

If you choose to include any amount ofyour net capital gain in investment income,you must reduce your net capital gain that iseligible for the lower capital gains tax ratesby the same amount.

For more information about the capitalgains rates, see Capital Gain Tax Rates inchapter 4.

TIPBefore making this choice, considerthe overall effect on your tax liability.Compare your tax if you make this

choice with your tax if you do not.


Investment income of child reported onparent's return. Investment income includesthe part of your child's interest and dividendincome that you choose to report on your re-turn. If the child does not have Alaska Per-manent Fund dividends or capital gain distri-butions, this is the amount on line 6 of Form8814, Parents' Election To Report Child's In-terest and Dividends.

Example. Your 8-year-old son has inter-est income of $2,000, which you choose toreport on your own return. You enter $2,000on lines 1a and 4 of Form 8814 and $600 online 6 of Form 8814 and line 21 of Form 1040.Your investment income includes this $600.

Child's Alaska Permanent Fund divi-dends. If part of the amount you report isyour child's Alaska Permanent Fund divi-dends, that part does not count as investmentincome. To figure the amount of your child'sincome that you can consider your investmentincome, start with the amount on line 6 ofForm 8814. Multiply that amount by a per-centage that is equal to the Alaska Perma-nent Fund dividends divided by the totalamount on line 4 of Form 8814. Subtract theresult from the amount on line 6 of Form8814.

Example. Your 10-year-old child has in-terest and dividend income of $4,000, includ-ing $500 in Alaska Permanent Fund divi-dends. You choose to report this on yourreturn. You enter $4,000 on line 4 of Form8814 and $2,600 on line 6 of Form 8814 andline 21 of Form 1040. You figure the amountof your child's income that you can consideryour investment income as follows:

Child's capital gain distributions. If yourchild has capital gain distributions, fill out thefollowing worksheet before completing Form4952.

Example. Your 9-year old daughter hasordinary dividends of $1,360 and a $340capital gain distribution from a mutual fund.You choose to report this income on your taxreturn. On Form 8814, you enter $1,360 online 2, $340 on line 3, $1,700 on line 4, and$300 on line 6. Then you fill out the worksheetabove. The amount on line 7 of the worksheet($240) is investment income, which you in-clude on line 4a of Form 4952. The amounton line 6 of the worksheet ($60) is includedon lines 4b and 4c of Form 4952. You mustdecide whether to make the choice to includethis $60 in investment income on line 4e.

Investment expenses. Investment ex-penses include all income-producing ex-penses (other than interest expense) relatingto the investment property that are allowable

deductions after applying the 2% limit thatapplies to miscellaneous itemized deductions.Use the smaller of:

1) The investment expenses included online 22 of Schedule A (Form 1040), or

2) The amount on line 26 of Schedule A.

See Expenses of Producing Income, later, fora discussion of the 2% limit.

Losses from passive activities. Incomeor expenses that you used in computing in-come or loss from a passive activity are notincluded in determining your investment in-come or investment expenses (including in-vestment interest expense). See Publication925 for information about passive activities.

Example. Ted is a partner in a partner-ship that operates a business. However, hedoes not materially participate in the partner-ship's business. Ted's interest in the partner-ship is considered a passive activity.

Ted's investment income from interest anddividends is $10,000. His investment ex-penses (other than interest) are $3,200 aftertaking into account the 2% limit on miscella-neous itemized deductions. His investmentinterest expense is $8,000. Ted also has in-come from the partnership of $2,000.

Ted figures his net investment income andthe limit on his investment interest expensededuction in the following way:

The $2,000 of income from the passiveactivity is not used in determining Ted's netinvestment income. His investment interestdeduction for the year is limited to $6,800, theamount of his net investment income.

Form 4952 Use Form 4952, Investment Interest ExpenseDeduction, to figure your deduction for in-vestment interest.

Example. Jane Smith is single. Her 2000income includes $3,000 in dividends and anet capital gain of $9,000 from the sale ofinvestment property. She incurred $12,500of investment interest expense. Her other in-vestment expenses directly connected withthe production of investment income total$980 after applying the 2% limit on miscella-neous itemized deductions on Schedule A(Form 1040).

For 2000, Jane chooses to include all ofher net capital gain in investment income. Hertotal investment income is $12,000 ($3,000dividends + $9,000 net capital gain). Her netinvestment income is $11,020 ($12,000 totalinvestment income − $980 other investmentexpenses).

Jane's Form 4952 is illustrated at the endof the chapter. Her investment interest ex-pense deduction is limited to $11,020, theamount of her net investment income. The$1,480 disallowed investment interest ex-pense is carried forward to 2001.

Exception to use of Form 4952. You do nothave to complete Form 4952 or attach it toyour return if you meet all of the followingtests.

• Your investment interest expense is notmore than your investment income frominterest and ordinary dividends.

• You do not have any other deductible in-vestment expenses.

• You have no carryover of investment in-terest expense from 1999.

If you meet all of these tests, you can deductall of your investment interest.

Bond PremiumAmortization If you pay a premium to buy a bond, the pre-mium is part of your basis in the bond. If thebond yields taxable interest, you can chooseto amortize the premium. This generallymeans that each year, over the life of thebond, you use a part of the premium to re-duce the amount of interest includible in yourincome. If you make this choice, you mustreduce your basis in the bond by the amorti-zation for the year.

If the bond yields tax-exempt interest, youmust amortize the premium. This amortizedamount is not deductible in determining taxa-ble income. However, each year you mustreduce your basis in the bond by the amorti-zation for the year.

Bond premium. Bond premium is theamount by which your basis in the bond rightafter you get it is more than the total of allamounts payable on the bond after you get it(other than payments of qualified stated in-terest). For example, a bond with a maturityvalue of $1,000 generally would have a $50premium if you buy it for $1,050.

Basis. In general, your basis for figuringbond premium amortization is the same asyour basis for figuring any loss on the saleof the bond. However, you may need to usea different basis for convertible bonds, bondsyou got in a trade, and bonds whose basishas to be determined using the basis of theperson who transferred the bond to you. Seesection 1.171–1(e) of the regulations.

Dealers. A dealer in taxable bonds (or any-one who holds them mainly for sale to cus-tomers in the ordinary course of a trade orbusiness or who would properly includebonds in inventory at the close of the tax year)cannot claim a deduction for amortizablebond premium.

See section 75 of the Internal RevenueCode for the treatment of bond premium bya dealer in tax-exempt bonds.

How To FigureAmortizationFor bonds issued after September 27, 1985,you must amortize bond premium using aconstant yield method on the basis of thebond's yield to maturity, determined by usingthe bond's basis and compounding at theclose of each accrual period.

Constant yield method. Figure the bondpremium amortization for each accrual periodas follows.

Step 1: determine your yield. Your yieldis the discount rate that, when used in figuringthe present value of all remaining paymentsto be made on the bond (including payments

Total investment income .......................... $10,000Minus: Investment expenses (other thaninterest) .................................................... 3,200Net investment income ............................ $6,800

Deductible investment interest expensefor the year .............................................. $6,800

$2,600 − ($2,600 × ($500 ÷ $4,000)) = $2,275

Worksheet(Keep for your records)

1. Enter amount from Form 8814, line 3 ..2. Enter amount from Form 8814, line 4 ..3. Divide line 1 by line 2 ...........................4. Base amount ......................................... $1,4005. Subtract line 4 from line 2 .....................6. Multiply line 5 by the decimal on line 3.

Enter the result here. Also include it infiguring the amounts to enter on lines4b and 4c of Form 4952. ......................

7. Subtract line 6 from line 5. Enter theresult here. Also include it on line 4a ofForm 4952. ............................................


of qualified stated interest), produces anamount equal to your basis in the bond. Fig-ure the yield as of the date you got the bond.It must be constant over the term of the bondand must be figured to at least two decimalplaces when expressed as a percentage.

If you do not know the yield, consult yourbroker or tax advisor.

Step 2: determine the accrual periods.You can choose the accrual periods to use.They may be of any length and may vary inlength over the term of the bond, but eachaccrual period can be no longer than 1 yearand each scheduled payment of principal orinterest must occur either on the first or thefinal day of an accrual period. The computa-tion is simplest if accrual periods are thesame as the intervals between interest pay-ment dates.

Step 3: determine the bond premiumfor the accrual period. To do this, multiplyyour adjusted acquisition price at the begin-ning of the accrual period by your yield. Thensubtract the result from the qualified statedinterest for the period.

Your adjusted acquisition price at the be-ginning of the first accrual period is the sameas your basis. After that, it is your basis de-creased by the amount of bond premiumamortized for earlier periods and the amountof any payment previously made on the bondother than a payment of qualified stated in-terest.

Example. On February 1, 1999, youbought a taxable bond for $110,000. Thebond has a stated principal amount of$100,000, payable at maturity on February1, 2006, making your premium $10,000($110,000 − $100,000). The bond pays qual-ified stated interest of $10,000 on February1 of each year. Your yield is 8.0745% com-pounded annually. You choose to use annualaccrual periods ending on February 1 of eachyear. To find your bond premium amortizationfor the accrual period ending on February 1,2000, you multiply the adjusted acquisitionprice at the beginning of the period($110,000) by your yield. When you subtractthe result ($8,882) from the qualified statedinterest for the period ($10,000), you find thatyour bond premium amortization for the pe-riod is $1,118.

Special rules. For special rules that ap-ply to variable rate bonds, inflation-indexedbonds, and bonds that provide for alternativepayment schedules or remote or incidentalcontingencies, see section 1.171–3 of theregulations.

Bonds Issued BeforeSeptember 28, 1985For these bonds, you can amortize bondpremium using any reasonable method.Reasonable methods include:

1) The straight-line method, and

2) The Revenue Ruling 82–10 method.

Straight-line method. Under this method,the amount of your bond premium amorti-zation is the same each month. Divide thenumber of months you held the bond duringthe year by the number of months from thebeginning of the tax year (or, if later, the dateof acquisition) to the date of maturity or earliercall date. Then multiply the result by the bondpremium (reduced by any bond premiumamortization claimed in earlier years). This

gives you your bond premium amortization forthe year.

Revenue Ruling 82–10 method. Under thismethod, the amount of your bond premiumamortization increases each month over thelife of the bond. This method is explained inRevenue Ruling 82–10.

Choosing To AmortizeYou choose to amortize the premium on tax-able bonds by reporting the amortization forthe year on your income tax return for the firsttax year for which you want the choice toapply. You should attach a statement to yourreturn that you are making this choice undersection 171. See How To Report Amorti-zation, next.

This choice is binding for the year youmake it and for later tax years. It applies toall taxable bonds you own in the year youmake the choice and also to those you ac-quire in later years.

You can change your decision to amortizebond premium only with the written approvalof the IRS. To request approval, use Form3115, Application for Change in AccountingMethod.

How To ReportAmortization Subtract the bond premium amortization fromyour interest income from these bonds.

Report the bond's interest on line 1 ofSchedule B (Form 1040). Several linesabove line 2, put a subtotal of all interestlisted on line 1. Below this subtotal, print “ABPAdjustment,” and the amortization amount.Subtract this amount from the subtotal, andenter the result on line 2.

Bond premium amortization more thaninterest. If the amount of your bond premiumamortization for an accrual period is morethan the qualified stated interest for the pe-riod, you can deduct the difference as a mis-cellaneous itemized deduction on line 27 ofSchedule A (Form 1040).

But your deduction is limited to theamount by which your total interest inclusionson the bond in prior accrual periods is morethan your total bond premium deductions onthe bond in prior periods. Any amount youcannot deduct because of this limit can becarried forward to the next accrual period.

Pre-1998 election to amortize bond pre-mium. Generally, if you first elected to amor-tize bond premium before 1998, the abovetreatment of the premium does not apply tobonds you acquired before 1988.

Bond acquired before October 23,1986. The amortization of the premium is amiscellaneous itemized deduction not subjectto the 2%-of-adjusted-gross-income limit.

Bond acquired after October 22, 1986,but before 1988. The amortization of thepremium is investment interest expense sub-ject to the investment interest limit, unless youchoose to treat it as an offset to interest in-come on the bond.

Expenses ofProducing Income You deduct investment expenses (other thaninterest expenses) as miscellaneous item-

ized deductions on Schedule A (Form 1040).To be deductible, these expenses must beordinary and necessary expenses paid or in-curred:

1) To produce or collect income, or

2) To manage property held for producingincome.

The expenses must be directly related to theincome or income-producing property, andthe income must be taxable to you.

The deduction for most income-producingexpenses is subject to a 2% limit that alsoapplies to certain other miscellaneous item-ized deductions. The amount deductible islimited to the total of these miscellaneousdeductions that is more than 2% of your ad-justed gross income.

For information on how to report expensesof producing income, see How To Report In-vestment Expenses, later.

Attorney or accounting fees. You can de-duct attorney or accounting fees that arenecessary to produce or collect taxable in-come. However, in some cases, attorney oraccounting fees are part of the basis ofproperty. See Basis of Investment Propertyin chapter 4.

Automatic investment service and divi-dend reinvestment plans. A bank may offerits checking account customers an automaticinvestment service so that, for a charge, eachcustomer can choose to invest a part of thechecking account each month in commonstock. Or, a bank that is a dividend disbursingagent for a number of publicly-owned corpo-rations may set up an automatic dividend re-investment service. Through that service,cash dividends are reinvested in more sharesof stock, after the bank deducts a servicecharge.

A corporation in which you own stock alsomay have a dividend reinvestment plan. Thisplan lets you choose to use your dividends tobuy more shares of stock in the corporationinstead of receiving the dividends in cash.

You can deduct the monthly servicecharge you pay to a bank to participate in anautomatic investment service. If you partic-ipate in a dividend reinvestment plan, you candeduct any service charge subtracted fromyour cash dividends before the dividends areused to buy more shares of stock. Deduct thecharges in the year you pay them.

Clerical help and office rent. You can de-duct office expenses, such as rent and cler-ical help, that you pay in connection with yourinvestments and collecting the taxable in-come on them.

Cost of replacing missing securities. Toreplace your taxable securities that are mis-laid, lost, stolen, or destroyed, you may haveto post an indemnity bond. You can deductthe premium you pay to buy the indemnitybond and the related incidental expenses.

You may, however, get a refund of partof the bond premium if the missing securitiesare recovered within a specified time. Undercertain types of insurance policies, you canrecover some of the expenses.

If you receive the refund in the tax yearyou pay the amounts, you can deduct only thedifference between the expenses paid andthe amount refunded. If the refund is made ina later tax year, you must include the refundin income in the year you received it, but only


to the extent that the expenses decreasedyour tax in the year you deducted them.

Fees to collect income. You can deductfees you pay to a broker, bank, trustee, orsimilar agent to collect investment income,such as your taxable bond or mortgage in-terest, or your dividends on shares of stock.

Fees to buy or sell. You cannot deducta fee you pay to a broker to acquire invest-ment property, such as stocks or bonds. Youmust add the fee to the cost of the property.See Basis of Investment Property in chapter4.

You cannot deduct any broker's fees,commissions, or option premiums you pay (orthat were netted out) in connection with thesale of investment property. They can beused only to figure gain or loss from the sale.See Reporting Capital Gains and Losses, inchapter 4, for more information about thetreatment of these sale expenses.

Investment counsel and advice. You candeduct fees you pay for counsel and adviceabout investments that produce taxable in-come. This includes amounts you pay for in-vestment advisory services.

Safe deposit box rent. You can deduct rentyou pay for a safe deposit box if you use thebox to store taxable income-producing stocks,bonds, or other investment-related papersand documents. If you also use the box tostore tax-exempt securities or personal items,you can deduct only part of the rent. SeeTax-exempt income under NondeductibleExpenses, later, to figure what part you candeduct.

State and local transfer taxes. You cannotdeduct the state and local transfer taxes youpay when you buy or sell securities. If you paythese transfer taxes when you buy securities,you must treat them as part of the cost of theproperty. If you pay these transfer taxes whenyou sell securities, you must treat them as areduction in the amount realized.

Trustee's commissions for revocabletrust. If you set up a revocable trust andhave its income distributed to you, you candeduct the commission you pay the trusteefor managing the trust to the extent it is toproduce or collect taxable income or to man-age property. However, you cannot deductany part of the commission that is forproducing or collecting tax-exempt income orfor managing property that produces tax-exempt income.

If you are a cash-basis taxpayer and paythe commissions for several years in ad-vance, you must deduct a part of the com-mission each year. You cannot deduct theentire amount in the year you pay it.

Investment expenses from pass-throughentities. If you hold an interest in a partner-ship, S corporation, real estate mortgage in-vestment conduit (REMIC), or a nonpubliclyoffered regulated investment company (mu-tual fund), you can deduct your share of thatentity's investment expenses. A partnershipor S corporation will show your share of theseexpenses on your Schedule K–1. A nonpub-licly offered mutual fund will indicate yourshare of these expenses in box 5 of Form1099–DIV, or on an equivalent statement.Publicly-offered mutual funds are discussedlater.

If you hold an interest in a REMIC, anyexpenses relating to your residual interest in-vestment will be shown on line 3b of Sched-ule Q (Form 1066) . Any expenses relating toyour regular interest investment will appear inbox 5 of Form 1099–INT or box 7 of Form1099–OID.

Report your share of these investmentexpenses on Schedule A (Form 1040), sub-ject to the 2% limit, in the same manner asyour other investment expenses.

Including mutual fund or REMIC ex-penses in income. Your share of the invest-ment expenses of a REMIC or a nonpubliclyoffered mutual fund, as described above, areconsidered to be indirect deductions throughthat pass-through entity. You must include inyour gross income an amount equal to theamount of the expenses allocated to you,whether or not you are able to claim a de-duction for those expenses. If you are ashareholder in a nonpublicly offered mutualfund, you must include on your return the fullamount of ordinary dividends or other distri-butions of stock, as shown in box 1 of Form1099–DIV or an equivalent statement. If youare a residual interest holder in a REMIC, youmust report as ordinary income on ScheduleE (Form 1040) the total amounts shown onlines 1b and 3b of Schedule Q (Form 1066).If you are a REMIC regular interest holder,you must include the amount of any expenseallocation you received on line 8a of Form1040.

Publicly-offered mutual funds. Publicly-offered mutual funds, generally, are funds thatare traded on an established securities ex-change. These funds do not pass investmentexpenses through to you. Instead, the divi-dend income they report to you in box 1 ofForm 1099–DIV is already reduced by yourshare of investment expenses. Therefore,you cannot deduct the expenses on your re-turn.

Include the amount from box 1 of Form1099–DIV in your income.

NondeductibleExpenses Some expenses that you incur as an investorare not deductible.

Stockholders' meetings. You cannot de-duct transportation and other expenses thatyou pay to attend stockholders' meetings ofcompanies in which you have no interestother than owning stock. This is true even ifyour purpose in attending is to get informationthat would be useful in making further invest-ments.

Investment-related seminar. You cannotdeduct expenses for attending a convention,seminar, or similar meeting for investmentpurposes.

Single-premium life insurance, endow-ment, and annuity contracts. You cannotdeduct interest on money you borrow to buyor carry a single-premium life insurance, en-dowment, or annuity contract.

Single premium annuity contract ascollateral. If you use a single premium an-nuity contract as collateral to obtain or con-tinue a mortgage loan, you cannot deduct any

interest on the loan that is collateralized bythe annuity contract. Figure the amount ofinterest expense disallowed by multiplying thecurrent interest rate on the mortgage loan bythe lesser of the amount of the annuity con-tract used as collateral or the amount of theloan.

Systematic borrowing on insurance. Gen-erally, you cannot deduct interest on moneyyou borrow to buy or carry a life insurance,endowment, or annuity contract if you plan tosystematically borrow part or all of the in-creases in the cash value of the contract. Thisrule applies to the interest on the total amountborrowed to buy or carry the contract, not justthe interest on the borrowed increases in thecash value.

Tax-exempt income. You cannot deductexpenses you incur to produce tax-exemptincome. Nor can you deduct interest onmoney you borrow to buy tax-exempt securi-ties or shares in a regulated investmentcompany (mutual fund) that distributes onlyexempt-interest dividends.

Short-sale expenses. The rule disallow-ing a deduction for interest expenses on tax-exempt securities applies to amounts you payin connection with personal property used ina short sale or amounts paid by others for theuse of any collateral in connection with theshort sale. However, it does not apply to theexpenses you incur if you deposit cash ascollateral for the property used in the shortsale and the cash does not earn a materialreturn during the period of the sale. Shortsales are discussed in chapter 4.

Expenses for both tax-exempt and tax-able income. You may have expenses thatare for both tax-exempt and taxable income.If you cannot specifically identify what part ofthe expenses is for each type of income, youcan divide the expenses, using reasonableproportions based on facts and circum-stances. You must attach a statement to yourreturn showing how you divided the expensesand stating that each deduction claimed is notbased on tax-exempt income.

One accepted method for dividing ex-penses is to do it in the same proportion thateach type of income is to the total income. Ifthe expenses relate in part to capital gainsand losses, include the gains, but not thelosses, in figuring this proportion. To find thepart of the expenses that is for the tax-exemptincome, divide your tax-exempt income by thetotal income and multiply your expenses bythe result.

Example. You received $6,000 interest;$4,800 was tax-exempt and $1,200 was tax-able. In earning this income, you had $500of expenses. You cannot specifically identifythe amount of each expense item that is foreach income item, so you must divide yourexpenses. 80% ($4,800 tax-exempt interestdivided by $6,000 total interest) of your ex-penses is for the tax-exempt income. Youcannot deduct $400 (80% of $500) of the ex-penses. You can deduct $100 (the rest of theexpenses) because they are for the taxableinterest.

State income taxes. If you itemize yourdeductions, you can deduct, as taxes, stateincome taxes on interest income that is ex-empt from federal income tax. But you cannotdeduct, as either taxes or investment ex-penses, state income taxes on other exemptincome.


Interest expense and carrying charges onstraddles. You cannot deduct interest andcarrying charges that are allocable to per-sonal property that is part of a straddle. Thenondeductible interest and carrying chargesare added to the basis of the straddle prop-erty. However, this treatment does not applyif:

1) All the offsetting positions making up thestraddle either consist of one or morequalified covered call options and theoptioned stock or consist of section 1256contracts (and the straddle is not part ofa larger straddle), or

2) The straddle is a hedging transaction.

For information about straddles, includingdefinitions of the terms used in this dis-cussion, see chapter 4.

Interest includes any amount you pay orincur in connection with personal propertyused in a short sale. However, you must firstapply the rules discussed in Short Sale Ex-penses under Short Sales in chapter 4.

To determine the interest on market dis-count bonds and short-term obligations thatare part of a straddle, you must first apply therules discussed under Deferral of interestdeduction for market discount bonds andDeferral of interest deduction for short-termobligations (both under Interest Expenses,earlier).

Nondeductible amount and basis adjust-ment. Figure the nondeductible amount ofinterest and carrying charges that must beadded to the basis of the straddle propertyas follows.

1) Add together:

a) Interest on indebtedness incurredor continued to buy or carry thepersonal property, and

b) All other amounts (includingcharges to insure, store, or trans-port the personal property) paid or

incurred to carry the personalproperty.

2) Subtract from the amount in (1):

a) Interest (including OID) includible ingross income for the year on thepersonal property,

b) Any income from the personalproperty treated as ordinary incomeon the disposition of of short-termgovernment obligations or as ordi-nary income under the market dis-count and short-term bond pro-visions — see Discount on DebtInstruments in chapter 1,

c) The dividends includible in grossincome for the year from the per-sonal property, and

d) Any payment on a loan of the per-sonal property for use in a shortsale that is includible in gross in-come.

How To ReportInvestment Expenses To deduct your investment expenses, youmust itemize deductions on Schedule A(Form 1040). Enter your deductible invest-ment interest expense on line 13, ScheduleA. Include any deductible short sale ex-penses. (See Short Sales in chapter 4 for in-formation on these expenses.) Also attach acompleted Form 4952 if you used that formto figure your investment interest expense.

Enter the total amount for your other in-vestment expenses (other than interest ex-penses) on line 22, Schedule A. List the typeand amount of each expense on the dottedlines next to line 22. (If necessary, you canshow the required information on an attachedstatement.) Include the total on line 23 withyour other miscellaneous deductions that aresubject to the 2% limit.

For information on how to report amortiz-able bond premium, see Bond PremiumAmortization, earlier in this chapter.

When To ReportInvestment ExpensesIf you use the cash method to report incomeand expenses, you generally deduct your ex-penses, except for certain prepaid interest, inthe year you pay them.

If you use an accrual method, you gener-ally deduct your expenses when you incur aliability for them, rather than when you paythem.

Also see When To Deduct Investment In-terest, earlier in this chapter.

Unpaid expenses owed to related party.If you use an accrual method, you cannotdeduct interest and other expenses owed toa related cash-basis person until payment ismade and the amount is includible in thegross income of that person. The relationship,for purposes of this rule, is determined as ofthe end of the tax year for which the interestor expense would otherwise be deductible.If a deduction is denied under this rule, thisrule will continue to apply even if your re-lationship with the person ceases to existbefore the amount is includible in the grossincome of that person.

This rule generally applies to those re-lationships listed in chapter 4 under RelatedParty Transactions. It also applies to accrualsby partnerships to partners, partners to part-nerships, shareholders to S corporations, andS corporations to shareholders.

The postponement of deductions for un-paid expenses and interest under the relatedparty rule does not apply to original issuediscount (OID), regardless of when paymentis made. This rule also does not apply toloans with below-market interest rates or tocertain payments for the use of property andservices when the lender or recipient has toinclude payments periodically in income, eventhough a payment has not been made.


Jane Smith 111-00-1111

12,500

0

12,500

3,000

9,000

9,000

0

9,000

12,000

980

11,020

1,480

11,020

OMB No. 1545-0191

Investment Interest Expense Deduction4952Form

� Attach to your tax return.Department of the TreasuryInternal Revenue Service

AttachmentSequence No. 72

Name(s) shown on return Identifying number

1Investment interest expense paid or accrued in 2000. See instructions1

2Disallowed investment interest expense from 1999 Form 4952, line 72

3Total investment interest expense. Add lines 1 and 23

4aGross income from property held for investment (excluding any net gain from the disposition ofproperty held for investment)

4a

Investment expenses. See instructions5 5

Net investment income. Subtract line 5 from line 4f. If zero or less, enter -0-6 6

Total Investment Interest Expense

Net Investment Income

Investment Interest Expense Deduction

b Net gain from the disposition of property held for investment

c Net capital gain from the disposition of property held for investment

d Subtract line 4c from line 4b. If zero or less, enter -0-e Enter all or part of the amount on line 4c, if any, that you elect to include in investment income.

Do not enter more than the amount on line 4b. See instructions �

f Investment income. Add lines 4a, 4d, and 4e. See instructions

Disallowed investment interest expense to be carried forward to 2001. Subtract line 6 fromline 3. If zero or less, enter -0-

7

Investment interest expense deduction. Enter the smaller of line 3 or 6. See instructions8

4f

4b

4c

4d

4e

7

8

Part III

Part I

Part II

(99)

2000


4.Sales andTrades ofInvestmentProperty

IntroductionThis chapter explains the tax treatment ofsales and trades of investment property.

Investment property. This is property thatproduces investment income. Examples in-clude stocks, bonds, and Treasury bills andnotes. Property used in a trade or businessis not investment property.

Form 1099–B. If you sold property such asstocks, bonds, or certain commoditiesthrough a broker during the year, you shouldreceive, for each sale, a Form 1099–B, Pro-ceeds From Broker and Barter ExchangeTransactions, or an equivalent statement fromthe broker. You should receive the statementby January 31 of the next year. It will showthe gross proceeds from the sale. The IRSwill also get a copy of Form 1099–B from thebroker.

Use Form 1099–B (or an equivalentstatement received from your broker) tocomplete Schedule D of Form 1040. For moreinformation, see Form 1099–B transactionsunder Reporting Capital Gains and Losses,later.

Other property transactions. Certaintransfers of property are discussed in otherIRS publications. These include:

• Sale of your main home, discussed inPublication 523, Selling Your Home,

• Installment sales, covered in Publication537, Installment Sales,

• Various types of transactions involvingbusiness property, discussed in Publica-tion 544, Sales and Other Dispositionsof Assets,

• Transfers of property at death, coveredin Publication 559, Survivors, Executors,and Administrators, and

• Disposition of an interest in a passiveactivity, discussed in Publication 925,Passive Activity and At-Risk Rules.


• What a sale or trade is,

• Basis,

• Adjusted basis,

• Figuring gain or loss,

• Nontaxable trades,

• Capital gains and losses, and

• How to report your gain or loss.


Publication

� 551 Basis of Assets

� 564 Mutual Fund Distributions


� Schedule D (Form 1040) Capital Gainsand Losses

� 6781 Gains and Losses From Section1256 Contracts and Straddles

� 8582 Passive Activity Loss Limitations

� 8824 Like-Kind Exchanges


What Is aSale or Trade?Terms you may need to know (seeGlossary):

Equity optionFutures contractMarked to marketNonequity optionOptions dealerRegulated futures contractSection 1256 contractShort sale

This section explains what is a sale or trade.It also explains certain transactions andevents that are treated as sales or trades.

A sale is generally a transfer of propertyfor money or a mortgage, note, or otherpromise to pay money. A trade is a transferof property for other property or services, andmay be taxed in the same way as a sale.

Sale and purchase. Ordinarily, a transactionis not a trade when you voluntarily sell prop-erty for cash and immediately buy similarproperty to replace it. The sale and purchaseare two separate transactions. But see Like-Kind Exchanges under Nontaxable Trades,later.

Redemption of stock. A redemption of stockis treated as a sale or trade and is subject tothe capital gain or loss provisions unless theredemption is a dividend or other distributionon stock.

Dividend versus sale or trade. Whethera redemption is treated as a sale, trade, divi-dend, or other distribution depends on thecircumstances in each case. Both direct andindirect ownership of stock will be considered.The redemption is treated as a sale or tradeof stock if:

1) The redemption is not essentially equiv-alent to a dividend — see Dividends andOther Corporate Distributions in chapter1,

2) There is a substantially disproportionateredemption of stock,

3) There is a complete redemption of all thestock of the corporation owned by theshareholder, or

4) The redemption is a distribution in partialliquidation of a corporation.

Redemption or retirement of bonds. A re-demption or retirement of bonds or notes attheir maturity generally is treated as a saleor trade. See Stocks, stock rights, and bondsand Discounted Debt Instruments underCapital or Ordinary Gain or Loss, later.

In addition, a significant modification of abond is treated as a trade of the original bondfor a new bond. For details, see section1.1001–3 of the regulations.

Surrender of stock. A surrender of stockby a dominant shareholder who retains con-trol of the corporation is treated as a contri-bution to capital rather than as an immediateloss deductible from taxable income. Thesurrendering shareholder must reallocate hisor her basis in the surrendered shares to theshares he or she retains.

Trade of investment property for an annu-ity. The transfer of investment property to acorporation, trust, fund, foundation, or otherorganization, in exchange for a fixed annuitycontract that will make guaranteed annualpayments to you for life, is a taxable trade. Ifthe present value of the annuity is more thanyour basis in the property traded, you have ataxable gain in the year of the trade. Figurethe present value of the annuity according tofactors used by commercial insurance com-panies issuing annuities.

Transfer by inheritance. The transfer ofproperty of a decedent to the executor or ad-ministrator of the estate, or to the heirs orbeneficiaries, is not a sale or other disposi-tion. No taxable gain or deductible loss resultsfrom the transfer.

Termination of certain rights and obli-gations. The cancellation, lapse, expiration,or other termination of a right or obligationwith respect to property that is a capital asset(or that would be a capital asset if you ac-quired it) is treated as a sale. Any gain or lossis treated as a capital gain or loss.

This rule does not apply to the retirementof a debt instrument. See Redemption or re-tirement of bonds, earlier.

Worthless Securities Stocks, stock rights, and bonds (other thanthose held for sale by a securities dealer) thatbecame worthless during the tax year aretreated as though they were sold on the lastday of the tax year. This affects whether yourcapital loss is long-term or short-term. SeeHolding Period, later.

If you are a cash basis taxpayer and makepayments on a negotiable promissory notethat you issued for stock that becameworthless, you can deduct these paymentsas losses in the years you actually make thepayments. Do not deduct them in the year thestock became worthless.

How to report loss. Report worthless secu-rities on line 1 or line 8 of Schedule D (Form1040), whichever applies. In columns (c) and(d), print “Worthless.” Enter the amount ofyour loss in parentheses in column (f).

Filing a claim for refund. If you do not claima loss for a worthless security on your originalreturn for the year it becomes worthless, youcan file a claim for a credit or refund due to

Chapter 4 Sales and Trades of Investment Property

the loss. You must use Form 1040X,Amended U.S. Individual Income Tax Return,to amend your return for the year the securitybecame worthless. You must file it within 7years from the date your original return forthat year had to be filed, or 2 years from thedate you paid the tax, whichever is later.(Claims not due to worthless securities or baddebts generally must be filed within 3 yearsfrom the date a return is filed, or 2 years fromthe date the tax is paid.) For more informationabout filing a claim, see Publication 556, Ex-amination of Returns, Appeal Rights, andClaims for Refund.

Constructive Salesof AppreciatedFinancial PositionsYou are treated as having made a construc-tive sale when you enter into certain trans-actions involving an appreciated financial po-sition (defined later) in stock, a partnershipinterest, or certain debt instruments. Youmust recognize gain as if the position weredisposed of at its fair market value on the dateof the constructive sale. This gives you a newholding period for the position that begins onthe date of the constructive sale. Then, whenyou close the transaction, you reduce yourgain (or increase your loss) by the gain rec-ognized on the constructive sale.

Constructive sale. You are treated as hav-ing made a constructive sale of an appreci-ated financial position if you:

1) Enter into a short sale of the same orsubstantially identical property,

2) Enter into an offsetting notional principalcontract relating to the same or sub-stantially identical property,

3) Enter into a futures or forward contractto deliver the same or substantiallyidentical property (including a forwardcontract that provides for cash settle-ment), or

4) Acquire the same or substantially identi-cal property (if the appreciated financialposition is a short sale, an offsettingnotional principal contract, or a futuresor forward contract).

You are also treated as having made aconstructive sale of an appreciated financialposition if a person related to you enters intoa transaction described above with a viewtoward avoiding the constructive sale treat-ment. For this purpose, a related person isany related party described under RelatedParty Transactions, later in this chapter.

Exception for nonmarketable securi-ties. A contract for sale of any stock, debtinstrument, or partnership interest that is nota marketable security is not a constructivesale if it settles within 1 year of the date youenter into it.

Exception for certain closed trans-actions. Do not treat a transaction as aconstructive sale if all of the following are true.

1) You closed the transaction before theend of the 30th day after the end of yourtax year.

2) You held the appreciated financial posi-tion throughout the 60-day period be-ginning on the date you closed thetransaction.

3) Your risk of loss was not reduced at anytime during that 60-day period by holdingcertain other positions.

If a closed transaction is reestablished ina substantially similar position during the60-day period beginning on the date the firsttransaction was closed, this exception stillapplies if the reestablished position is closedbefore the end of the 30th day after the endof your tax year in which the first transactionwas closed and, after that closing, (2) and (3)above are true.

Appreciated financial position. This is anyinterest in stock, a partnership interest, or adebt instrument (including a futures or forwardcontract, a short sale, or an option) if dispos-ing of the interest would result in a gain.

Exceptions. An appreciated financialposition does not include the following.

1) Any position from which all of the ap-preciation is accounted for under markedto market rules, including section 1256contracts (described later under Section1256 Contracts Marked to Market).

2) Any position in a debt instrument if:

a) The position unconditionally entitlesthe holder to receive a specifiedprincipal amount,

b) The interest payments (or othersimilar amounts) with respect to theposition are payable at a fixed rateor a variable rate described in sec-tion 1.860G–1(a)(3) of the regu-lations, and

c) The position is not convertible, ei-ther directly or indirectly, into stockof the issuer (or any related per-son).

3) Any hedge with respect to a positiondescribed in (2).

Certain trust instruments treated asstock. For the constructive sale rules, aninterest in an actively traded trust is treatedas stock unless substantially all of the valueof the property held by the trust is debt thatqualifies for the exception to the definition ofan appreciated financial position (explainedin (2) above).

Sale of appreciated financial position. Atransaction treated as a constructive sale ofan appreciated financial position is not treatedas a constructive sale of any other appreci-ated financial position, as long as you con-tinue to hold the original position. However,if you hold another appreciated financial po-sition and dispose of the original position be-fore closing the transaction that resulted inthe constructive sale, you are treated as if,at the same time, you constructively sold theother appreciated financial position.

Transitional rules. A special rule may applyif you entered into a transaction before June9, 1997, that was a constructive sale of anappreciated financial position. Under this rule,you do not take either the position or thetransaction into account to determine whetherany other constructive sale has occurred afterJune 8, 1997. This rule applies only if, beforeSeptember 4, 1997, you clearly identified thetransaction and the position in your recordsas offsetting. This rule does not apply as ofthe date you close the transaction or stopholding the position.

Transitional rule for decedents. A spe-cial rule may apply if there was a constructivesale before June 9, 1997, of an appreciatedfinancial position held by a decedent dyingafter June 8, 1997. Under this rule, treat theposition and the transaction that resulted inthe constructive sale as property constitutingrights to receive an item of income in respectof a decedent. However, gain on the positionthat accrues after the transaction is closed isnot treated as income in respect of a dece-dent.

This rule applies only if both the followingrequirements are met.

1) The transaction resulting in the con-structive sale remains open (with respectto the decedent or any related person)—

a) For at least 2 years after the dateof the transaction, and

b) At any time during the 3-year periodending on the date of the dece-dent's death.

2) The transaction was not closed beforeSeptember 5, 1997.

Section 1256 ContractsMarked to Market If you hold a section 1256 contract at the endof the tax year, you generally must treat it assold at its fair market value on the last busi-ness day of the tax year.

Section 1256 ContractA section 1256 contract is any:

1) Regulated futures contract,

2) Foreign currency contract,

3) Nonequity option, or

4) Dealer equity option.

Regulated futures contract. This is a con-tract that:

1) Provides that amounts that must be de-posited to, or can be withdrawn from,your margin account depend on dailymarket conditions (a system of markingto market), and

2) Is traded on, or subject to the rules of,a qualified board of exchange.

A qualified board of exchange is a do-mestic board of trade designated as a con-tract market by the Commodity FuturesTrading Commission, any board of trade orexchange approved by the Secretary of theTreasury, or a national securities exchangeregistered with the Securities and ExchangeCommission.

Foreign currency contract. This is a con-tract that:

1) Requires delivery of a foreign currencythat has positions traded through regu-lated futures contracts (or settlement ofwhich depends on the value of that typeof foreign currency),

2) Is traded in the interbank market, and

3) Is entered into at arm's length at a pricedetermined by reference to the price inthe interbank market.


Bank forward contracts with maturity datesthat are longer than the maturities ordinarilyavailable for regulated futures contracts areconsidered to meet the definition of a foreigncurrency contract if the above three condi-tions are satisfied.

Special rules apply to certain foreign cur-rency transactions. These transactions mayresult in ordinary gain or loss treatment. Fordetails, see Internal Revenue Code section988 and regulations sections 1.988-1(a)(7)and 1.988-3.

Nonequity option. This is any listed option(defined below) that is not an equity option.Nonequity options include debt options, com-modity futures options, currency options, andbroad-based stock index options. A broad-based stock index is based upon the valueof a group of diversified stocks or securities(such as the Standard and Poor's 500 index).

Warrants based on a stock index that areeconomically, substantially identical in allmaterial respects to options based on a stockindex are treated as options based on a stockindex.

Cash-settled options. Cash-settledoptions based on a stock index and eithertraded on or subject to the rules of a qualifiedboard of exchange are nonequity options ifthe Securities and Exchange Commission(SEC) determines that the stock index isbroad based.

This rule does not apply to options estab-lished by November 10, 1994, or before theSEC determines that the stock index is broadbased.

Listed option. This is any option that istraded on, or subject to the rules of, a qual-ified board or exchange (as discussed earlierunder Regulated futures contract). A listedoption, however, does not include an optionthat is a right to acquire stock from the issuer.

Dealer equity option. This is any listed op-tion that, for an options dealer:

1) Is an equity option,

2) Is bought or granted by that dealer in thenormal course of the dealer's businessactivity of dealing in options, and

3) Is listed on the qualified board of ex-change where that dealer is registered.

An options dealer is any person regis-tered with an appropriate national securitiesexchange as a market maker or specialist inlisted options.

Equity option. This is any option:

1) To buy or sell stock, or

2) That is valued directly or indirectly byreference to any stock, group of stocks,or stock index.

Equity options include options on certainnarrow-based stock indexes, but excludeoptions on broad-based stock indexes andoptions on stock index futures.

An equity option, however, does not in-clude an option for any group of stocks orstock index if:

1) The Commodities Futures TradingCommission has designated a contractmarket for a contract based on thatgroup or index, and that designation isin effect, or

2) The Secretary of the Treasury deter-mines that the option meets the legalrequirements for such a designation.

Marked to Market RulesA section 1256 contract that you hold at theend of the tax year will generally be treatedas sold at its fair market value on the lastbusiness day of the tax year, and you mustrecognize any gain or loss that results. Thatgain or loss is taken into account in figuringyour gain or loss when you later dispose ofthe contract, as shown in the example under60/40 rule, below.

Hedging exception. The marked to marketrules do not apply to hedging transactions.See Hedging Transactions, later.

60/40 rule. Under the marked to marketsystem, 60% of your capital gain or loss willbe treated as a long-term capital gain or loss,and 40% will be treated as a short-term cap-ital gain or loss. This is true regardless of howlong you actually held the property.

Example. On June 23, 1999, you boughta regulated futures contract for $50,000. OnDecember 31, 1999 (the last business day ofyour tax year), the fair market value of thecontract was $57,000. You have a $7,000gain recognized on your 1999 tax return,treated as 60% long-term and 40% short-termcapital gain.

On February 2, 2000, you sold the con-tract for $56,000. Because you already rec-ognized a $7,000 gain on your 1999 return,you recognize a $1,000 loss ($57,000 −$56,000) on your 2000 tax return, treated as60% long-term and 40% short-term capitalloss.

Limited partners or entrepreneurs. The60/40 rule does not apply to dealer equityoptions that result in capital gain or lossallocable to limited partners or limited entre-preneurs (defined later under HedgingTransactions). Instead, these persons shouldtreat all these gains or losses as short termunder the marked to market system.

Terminations and transfers. The markedto market rules also apply if your obligationor rights under section 1256 contracts areterminated or transferred during the tax year.In this case, use the fair market value of eachsection 1256 contract at the time of termi-nation or transfer to determine the gain orloss. Terminations or transfers may resultfrom any offsetting, delivery, exercise, as-signment, or lapse of your obligation or rightsunder section 1256 contracts.

Loss carryback election. An individual orpartnership having a net section 1256 con-tracts loss (defined later) for 2000 can electto carry this loss back 3 years, instead ofcarrying it over to the next year. See How ToReport, later, for information about reportingthis election on your return.

The loss carried back to any year underthis election cannot be more than the netsection 1256 contracts gain in that year. Inaddition, the amount of loss carried back toan earlier tax year cannot increase or producea net operating loss for that year.

The loss is carried to the earliestcarryback year first, and any unabsorbed lossamount can then be carried to each of thenext 2 tax years. In each carryback year, treat60% of the carryback amount as a long-term

capital loss and 40% as a short-term capitalloss from section 1256 contracts.

TIPDo not treat any part of a net section1256 contracts loss carried to 1997as a 28% rate gain or loss. (For 1997,

certain long-term capital gains and lossesfrom property held 18 months or less weretreated as 28% rate gains and losses (dis-cussed under Reporting Capital Gains andLosses)).

If only a portion of the net section 1256contracts loss is absorbed by carrying theloss back, the unabsorbed portion can becarried forward, under the capital loss carry-over rules, to the year following the loss. (SeeCapital Losses under Reporting Capital Gainsand Losses, later.) Figure your capital losscarryover as if, for the loss year, you had anadditional short-term capital gain of 40% ofthe amount of net section 1256 contracts lossabsorbed in the carryback years and an ad-ditional long-term capital gain of 60% of theabsorbed loss. In the carryover year, treat anycapital loss carryover from losses on section1256 contracts as if it were a loss from sec-tion 1256 contracts for that year.

Net section 1256 contracts loss. Thisloss is the lesser of:

1) The net capital loss for your tax yeardetermined by taking into account onlythe gains and losses from section 1256contracts, or

2) The capital loss carryover to the next taxyear determined without this election.

Net section 1256 contracts gain. Thisgain is the lesser of:

1) The capital gain net income for thecarryback year determined by taking intoaccount only gains and losses fromsection 1256 contracts, or

2) The capital gain net income for that year.

Figure your net section 1256 contracts gainfor any carryback year without regard to thenet section 1256 contracts loss for the lossyear or any later tax year.

Traders in section 1256 contracts. Gainor loss from the trading of section 1256 con-tracts is capital gain or loss subject to themarked to market rules. However, this doesnot apply to contracts held for purposes ofhedging property if any loss from the propertywould be an ordinary loss.

Treatment of underlying property. Thedetermination of whether an individual's gainor loss from any property is ordinary or capitalgain or loss is made without regard to the factthat the individual is actively engaged indealing in or trading section 1256 contractsrelated to that property.

How To Report If you disposed of regulated futures or foreigncurrency contracts in 2000 (or had unrealizedprofit or loss on these contracts that wereopen at the end of 1999 or 2000), you shouldreceive Form 1099–B, or an equivalentstatement, from your broker.

Form 6781. Use Part I of Form 6781, Gainsand Losses From Section 1256 Contracts andStraddles, to report your gains and lossesfrom all section 1256 contracts that are openat the end of the year or that were closed out


during the year. This includes the amountshown in box 9 of Form 1099–B. Then enterthe net amount of these gains and losses onSchedule D (Form 1040). Include a copy ofForm 6781 with your income tax return.

If the Form 1099–B you receive includesa straddle or hedging transaction, definedlater, it may be necessary to show certainadjustments on Form 6781. Follow the Form6781 instructions for completing Part I.

Loss carryback election. To carry backyour loss under the election procedures de-scribed earlier, file Form 1040X or appropriateamended return for the year to which you arecarrying the loss with an amended Form 6781attached. Follow the instructions for complet-ing Form 6781 for the loss year to make thiselection.

Hedging Transactions The marked to market rules, described ear-lier, do not apply to hedging transactions. Atransaction is a hedging transaction if both ofthe following conditions are met.

1) You entered into the transaction in thenormal course of your trade or businessprimarily to manage the risk of:

a) Price changes or currency fluctu-ations on ordinary property you hold(or will hold), or

b) Interest rate or price changes, orcurrency fluctuations, on your cur-rent or future borrowings or ordinaryobligations.

2) You clearly identified the transaction asbeing a hedging transaction before theclose of the day on which you enteredinto it.

This hedging transaction exception does notapply to transactions entered into by or forany syndicate. A syndicate is a partnership,S corporation, or other entity (other than aregular corporation) that allocates more than35% of its losses to limited partners or limitedentrepreneurs. A limited entrepreneur is aperson who has an interest in an enterprise(but not as a limited partner) and who doesnot actively participate in its management.However, an interest is not considered heldby a limited partner or entrepreneur if the in-terest holder actively participates (or did sofor at least 5 full years) in the managementof the entity, or is the spouse, child (includinga legally adopted child), grandchild, or parentof an individual who actively participates inthe management of the entity.

Hedging loss limit. If you are a limitedpartner or entrepreneur in a syndicate, theamount of a hedging loss you can claim islimited. A “hedging loss” is the amount bywhich the allowable deductions in a tax yearthat resulted from a hedging transaction (de-termined without regard to the limit) are morethan the income received or accrued duringthe tax year from this transaction.

Any hedging loss that is allocated to youfor the tax year is limited to your taxable in-come for that year from the trade or businessin which the hedging transaction occurred.Ignore any hedging transaction items in de-

termining this taxable income. If you have ahedging loss that is disallowed because ofthis limit, you can carry it over to the next taxyear as a deduction resulting from a hedgingtransaction.

If the hedging transaction relates to prop-erty other than stock or securities, the limiton hedging losses applies if the limited part-ner or entrepreneur is an individual.

The limit on hedging losses does not applyto any hedging loss to the extent that it ismore than all your unrecognized gains fromhedging transactions at the end of the taxyear that are from the trade or business inwhich the hedging transaction occurred. Theterm “unrecognized gain” has the samemeaning as defined under Straddles, later.

Sale of property used in a hedge. Onceyou identify personal property as being partof a hedging transaction, you must treat gainfrom its sale or exchange as ordinary income,not capital gain.

Self-Employment Income Gains and losses derived in the ordinarycourse of a commodity or option dealer'strading in section 1256 contracts and propertyrelated to these contracts are included in netearnings from self-employment. In addition,the rules relating to contributions to self-employment retirement plans apply. For in-formation on retirement plan contributions,see chapter 3 of Publication 535, BusinessExpenses, Publication 560, Retirement Plansfor Small Business, and Publication 590, In-dividual Retirement Arrangements (IRAs).

Basis ofInvestment Property Terms you may need to know (seeGlossary):

BasisFair market value Original issue discount (OID)

Basis is a way of measuring your investmentin property for tax purposes. You must knowthe basis of your property to determinewhether you have a gain or loss on its saleor other disposition.

Investment property you buy normally hasan original basis equal to its cost. If you getproperty in some way other than buying it,such as by gift or inheritance, its fair marketvalue may be important in figuring the basis.

Cost Basis The basis of property you buy is usually itscost. The cost is the amount you pay in cash,debt obligations, or other property or services.

Unstated interest. If you buy property undera deferred-payment plan that charges little orno interest, you may have to treat part of thepurchase price as interest. You must subtractthis amount, if any, from your cost to find yourbasis. For more information, see UnstatedInterest in Publication 537.

Basis Other Than Cost There are times when you must use a basisother than cost. In these cases, the fairmarket value or the adjusted basis of certainproperty may be used.

Fair market value. This is the price at whichthe property would change hands between abuyer and a seller, neither being forced to buyor sell and both having reasonable knowledgeof all the relevant facts. Sales of similarproperty, around the same date, may behelpful in figuring fair market value.

Property Received for ServicesIf you receive investment property for ser-vices, you must include the property's fairmarket value in income. The amount you in-clude in income then becomes your basis inthe property. If the services were performedfor a price that was agreed to beforehand, thisprice will be accepted as the fair market valueof the property if there is no evidence to thecontrary.

Restricted property. If you receive, as pay-ment for services, property that is subject tocertain restrictions, your basis in the propertygenerally is its fair market value when it be-comes substantially vested. Property be-comes substantially vested when it istransferable or is no longer subject to sub-stantial risk of forfeiture, whichever happensfirst. See Restricted Property in Publication525 for more information.

Bargain purchases. If you buy investmentproperty at less than fair market value, aspayment for services, you must include thedifference in income. Your basis in the prop-erty is the price you pay plus the amount youinclude in income.

Property Receivedin Taxable Trades If you received investment property in tradefor other property, the basis of the new prop-erty is its fair market value at the time of thetrade unless you received the property in anontaxable trade.

Example. You trade A Company stock forB Company stock having a fair market valueof $1,200. If the adjusted basis of the ACompany stock is less than $1,200, you havea taxable gain on the trade. If the adjustedbasis of the A company stock is more than$1,200, you have a deductible loss on thetrade. The basis of your B Company stock is$1,200. If you later sell the B Company stockfor $1,300, you will have a gain of $100.

Property Receivedin Nontaxable Trades If you have a nontaxable trade, you do notrecognize gain or loss until you dispose of theproperty you received in the trade. See Non-taxable Trades, later.

The basis of property you received in anontaxable or partly nontaxable trade is gen-erally the same as the adjusted basis of theproperty you gave up. Increase this amountby any cash you paid, additional costs youhad, and any gain recognized. Reduce thisamount by any cash or unlike property youreceived, any loss recognized, any liability ofyours that was assumed or treated as as-sumed.


Property ReceivedFrom Your Spouse If property is transferred to you from yourspouse (or former spouse, if the transfer isincident to your divorce), your basis is thesame as your spouse's or former spouse'sadjusted basis just before the transfer. SeeTransfers Between Spouses, later.

RECORDS

Recordkeeping. The transferor mustgive you the records necessary todetermine the adjusted basis and

holding period of the property as of the dateof the transfer.

Property Received as a Gift To figure your basis in property that you re-ceived as a gift, you must know its adjustedbasis to the donor just before it was given toyou, its fair market value at the time it wasgiven to you, the amount of any gift tax paidon it, and the date it was given to you.

Fair market value less than donor's ad-justed basis. If the fair market value of theproperty at the time of the gift was less thanthe donor's adjusted basis just before the gift,your basis for gain on its sale or other dis-position is the same as the donor's adjustedbasis plus or minus any required adjustmentsto basis during the period you hold the prop-erty. Your basis for loss is its fair marketvalue at the time of the gift plus or minus anyrequired adjustments to basis during the pe-riod you hold the property.

No gain or loss. If you use the basis forfiguring a gain and the result is a loss, andthen use the basis for figuring a loss and theresult is a gain, you will have neither a gainnor a loss.

Example. You receive a gift of investmentproperty having an adjusted basis of $10,000at the time of the gift. The fair market valueat the time of the gift is $9,000. You later sellthe property for $9,500. You have neither gainnor loss. Your basis for figuring gain is$10,000, and $10,000 minus $9,500 resultsin a $500 loss. Your basis for figuring loss is$9,000, and $9,500 minus $9,000 results ina $500 gain.

Fair market value equal to or more thandonor's adjusted basis. If the fair marketvalue of the property at the time of the giftwas equal to or more than the donor's ad-justed basis just before the gift, your basis forgain or loss on its sale or other dispositionis the donor's adjusted basis plus or minusany required adjustments to basis during theperiod you hold the property. Also, you maybe allowed to add to the donor's adjustedbasis all or part of any gift tax paid, dependingon the date of the gift.

Gift received before 1977. If you re-ceived property as a gift before 1977, yourbasis in the property is the donor's adjustedbasis increased by the total gift tax paid onthe gift. However, your basis cannot be morethan the fair market value of the gift at thetime it was given to you.

Example 1. You were given XYZ Com-pany stock in 1976. At the time of the gift, thestock had a fair market value of $21,000. Thedonor's adjusted basis was $20,000. The do-nor paid a gift tax of $500 on the gift. Your

basis for gain or loss is $20,500, the donor'sadjusted basis plus the amount of gift taxpaid.

Example 2. The facts are the same as inExample 1 except that the gift tax paid was$1,500. Your basis is $21,000, the donor'sadjusted basis plus the gift tax paid, but lim-ited to the fair market value of the stock at thetime of the gift.

Gift received after 1976. If you receivedproperty as a gift after 1976, your basis is thedonor's adjusted basis increased by the partof the gift tax paid that was for the net in-crease in value of the gift. You figure this partby multiplying the gift tax paid on the gift bya fraction. The numerator (top part) is the netincrease in value of the gift and the denomi-nator (bottom part) is the amount of the gift.

The net increase in value of the gift is thefair market value of the gift minus the donor'sadjusted basis. The amount of the gift is itsvalue for gift tax purposes after reduction byany annual exclusion and marital or charitablededuction that applies to the gift.

Example. In 2000, you received a gift ofproperty from your mother. At the time of thegift, the property had a fair market value of$100,000 and an adjusted basis to her of$40,000. The amount of the gift for gift taxpurposes was $90,000 ($100,000 minus the$10,000 annual exclusion), and your motherpaid a gift tax of $21,000. You figure yourbasis in the following way:

Part sale, part gift. If you get property in atransfer that is partly a sale and partly a gift,your basis is the larger of the amount youpaid for the property or the transferor's ad-justed basis in the property at the time of thetransfer. Add to that amount the amount ofany gift tax paid on the gift, as described inthe preceding discussion. For figuring loss,your basis is limited to the property's fairmarket value at the time of the transfer.

Gift tax information. For information on gifttax, see Publication 950, Introduction to Es-tate and Gift Taxes.

Inherited Property If you inherited property, your basis in thatproperty generally is its fair market value (itsappraised value on the federal estate tax re-turn) on:

1) The date of the decedent's death, or

2) The later alternate valuation date if theestate qualifies for, and elects to use,alternate valuation.

If no federal estate tax return was filed, usethe appraised value on the date of death forstate inheritance or transmission taxes.

Appreciated property you gave the dece-dent. Your basis in certain appreciatedproperty that you inherited is the decedent's

adjusted basis in the property immediatelybefore death rather than its fair market value.This applies to appreciated property that youor your spouse gave the decedent as a giftduring the one-year period ending on the dateof death. Appreciated property is any propertywhose fair market value on the day you gaveit to the decedent was more than its adjustedbasis.

More information. See Publication 551,Basis of Assets, for more information on thebasis of inherited property, including commu-nity property, a joint tenancy or tenancy by theentirety, a qualified joint interest, and a farmor business.

Adjusted Basis Before you can figure any gain or loss on asale, exchange, or other disposition of prop-erty or figure allowable depreciation, de-pletion, or amortization, you usually mustmake certain adjustments (increases and de-creases) to the basis of the property. The re-sult of these adjustments to the basis is theadjusted basis.

Adjustments to the basis of stocks andbonds are explained in the following dis-cussion. For information about other adjust-ments to basis, see Publication 551.

Stocks and Bonds The basis of stocks or bonds you own gen-erally is the purchase price plus the costs ofpurchase, such as commissions and record-ing or transfer fees. If you acquired stock orbonds other than by purchase, your basis isusually determined by fair market value or theprevious owner's adjusted basis as discussedearlier under Basis Other Than Cost.

The basis of stock must be adjusted forcertain events that occur after purchase. Forexample, if you receive more stock fromnontaxable stock dividends or stock splits,you must reduce the basis of your originalstock. You must also reduce your basis whenyou receive nontaxable distributions, becausethese are a return of capital.

Identifying stock or bonds sold. If you canadequately identify the shares of stock or thebonds you sold, their basis is the cost or otherbasis of the particular shares of stock orbonds.

Identification not possible. If you buyand sell securities at various times in varyingquantities and you cannot adequately identifythe shares you sell, the basis of the securitiesyou sell is the basis of the securities you ac-quired first. Except for certain mutual fundshares, discussed later, you cannot use theaverage price per share to figure gain or losson the sale of the shares.

Example. You bought 100 shares ofstock of XYZ Corporation in 1986 for $10 ashare. In January 1987 you bought another200 shares for $11 a share. In July 1987 yougave your son 50 shares. In December 1989you bought 100 shares for $9 a share. In April2000 you sold 130 shares. You cannot iden-tify the shares you disposed of, so you mustuse the stock you acquired first to figure thebasis. The shares of stock you gave your sonhad a basis of $500 (50 × $10). You figure thebasis of the 130 shares of stock you sold in2000 as follows:

Fair market value ..................................... $100,000Minus: Adjusted basis .............................. 40,000Net increase in value of gift ..................... $60,000

Gift tax paid ............................................. $21,000Multiplied by .667 ($60,000 ÷ $90,000) ... .667Gift tax due to net increase in value ....... $14,007Plus: Adjusted basis of property to yourmother ...................................................... 40,000Your basis in the property $54,007


Adequate identification. You will make anadequate identification if you show that cer-tificates representing shares of stock from alot that you bought on a certain date or for acertain price were delivered to your broker orother agent.

Broker holds stock. If you have left thestock certificates with your broker or otheragent, you will make an adequate identifica-tion if you:

1) Tell your broker or other agent the par-ticular stock to be sold or transferred atthe time of the sale or transfer, and

2) Receive a written confirmation of thisfrom your broker or other agent within areasonable time.

Single stock certificate. If you boughtstock in different lots at different times andyou hold a single stock certificate for thisstock, you will make an adequate identifica-tion if you:

1) Tell your broker or other agent the par-ticular stock to be sold or transferredwhen you deliver the certificate to yourbroker or other agent, and

2) Receive a written confirmation of thisfrom your broker or other agent within areasonable time.

Stock identified this way is the stock sold ortransferred even if stock certificates from adifferent lot are delivered to the broker orother agent.

If you sell part of the stock representedby a single certificate directly to the buyer in-stead of through a broker, you will make anadequate identification if you keep a writtenrecord of the particular stock that you intendto sell.

Bonds. These methods of identificationalso apply to bonds sold or transferred.

Stock in a mutual fund or REIT. The basisof stock in a regulated investment company(mutual fund) or a real estate investment trust(REIT) is generally figured in the same wayas the basis of other stock.

Mutual fund load charges. Your costbasis in mutual fund stock often includes asales fee, also known as a load charge. But,in certain cases, you cannot include the entireamount of a load charge in your basis if thecharge gives you a reinvestment right. Formore information, see Publication 564.

Choosing average basis for mutualfund stock. You can choose to use the av-erage basis of mutual fund stock if you ac-quired the stock at various times and pricesand left it on deposit in an account kept by acustodian or agent who acquires or redeemsthe stock. The methods you can use to figureaverage basis are explained in Publication564.

Undistributed capital gains. If you hadto include in your income any undistributedcapital gains of the mutual fund or REIT, in-crease your basis in the stock by the differ-ence between the amount you included andthe amount of tax paid for you by the fund orREIT. See Undistributed capital gains ofmutual funds and REITs under Capital GainDistributions in chapter 1.

50 shares (50 × $10) balance of stockbought in 1986 ............................................. $500

Automatic investment service. If you par-ticipate in an automatic investment service,your basis for each share of stock, includingfractional shares, bought by the bank or otheragent is the purchase price plus a share ofthe broker's commission.

Dividend reinvestment plans. If you par-ticipate in a dividend reinvestment plan andreceive stock from the corporation at a dis-count, your basis is the full fair market valueof the stock on the dividend payment date.You must include the amount of the discountin your income.

Public utilities. If, before 1986, you ex-cluded from income the value of stock youhad received under a qualified public utilityreinvestment plan, your basis in that stock iszero.

Stock dividends. Stock dividends are dis-tributions made by a corporation of its ownstock. Generally, stock dividends are not tax-able to you. However, see Distributions ofStock and Stock Rights under NontaxableDistributions in chapter 1 for some ex-ceptions. If the stock dividends are not taxa-ble, you must divide your basis for the oldstock between the old and new stock.

New and old stock identical. If the newstock you received as a nontaxable dividendis identical to the old stock on which the divi-dend was declared, divide the adjusted basisof the old stock by the number of shares ofold and new stock. The result is your basis foreach share of stock.

Example 1. You owned one share ofcommon stock that you bought for $45. Thecorporation distributed two new shares ofcommon stock for each share held. You thenhad three shares of common stock. Your ba-sis in each share is $15 ($45 ÷ 3).

Example 2. You owned two shares ofcommon stock. You had bought one for $30and the other for $45. The corporation dis-tributed two new shares of common stock foreach share held. You had six shares after thedistribution—three with a basis of $10 each($30 ÷ 3) and three with a basis of $15 each($45 ÷ 3).

New and old stock not identical. If thenew stock you received as a nontaxable divi-dend is not identical to the old stock on whichit was declared, the basis of the new stock iscalculated differently. Divide the adjusted ba-sis of the old stock between the old and thenew stock in the ratio of the fair market valueof each lot of stock to the total fair marketvalue of both lots on the date of distributionof the new stock.

Example. You bought a share of commonstock for $100. Later, the corporation distrib-uted a share of preferred stock for each shareof common stock held. At the date of distri-bution, your common stock had a fair marketvalue of $150 and the preferred stock had afair market value of $50. You figure the basisof the old and new stock by dividing your$100 basis between them. The basis of yourcommon stock is $75 ($150/$200 × $100),and the basis of the new preferred stock is$25 ($50/$200 × $100).

Stock bought at various times. Figurethe basis of stock dividends received on stockyou bought at various times and at differentprices by allocating to each lot of stock theshare of the stock dividends due to it.

Stock splits. Figure the basis of stocksplits in the same way as stock dividends ifidentical stock is distributed on the stock held.

Taxable stock dividends. If your stockdividend is taxable when you receive it, thebasis of your new stock is its fair market valueon the date of distribution. The basis of yourold stock does not change.

Stock rights. A stock right is a right to ac-quire a corporation's stock. It may be exer-cised, it may be sold if it has a market value,or it may expire. Stock rights are rarely taxa-ble when you receive them. See Distributionsof Stock and Stock Rights under NontaxableDistributions in chapter 1.

Taxable stock rights. If you receivestock rights that are taxable, the basis of therights is their fair market value at the time ofdistribution. The basis of the old stock doesnot change.

Nontaxable stock rights. If you receivenontaxable stock rights and allow them toexpire, they have no basis.

If you exercise or sell the nontaxable stockrights and if, at the time of distribution, thestock rights had a fair market value of 15%or more of the fair market value of the oldstock, you must divide the adjusted basis ofthe old stock between the old stock and thestock rights. Use a ratio of the fair marketvalue of each to the total fair market value ofboth at the time of distribution.

If the fair market value of the stock rightswas less than 15%, their basis is zero. How-ever, you can choose to divide the basis ofthe old stock between the old stock and thestock rights. To make the choice, attach astatement to your return for the year in whichyou received the rights, stating that youchoose to divide the basis of the stock.

Basis of new stock. If you exercise thestock rights, the basis of the new stock is itscost plus the basis of the stock rights exer-cised.

Example. You own 100 shares of ABCCompany stock, which cost you $22 pershare. The ABC Company gave you 10 non-taxable stock rights that would allow you tobuy 10 more shares at $26 per share. At thetime the stock rights were distributed, thestock had a market value of $30, not includingthe stock rights. Each stock right had a mar-ket value of $3. The market value of the stockrights was less than 15% of the market valueof the stock, but you chose to divide the basisof your stock between the stock and therights. You figure the basis of the rights andthe basis of the old stock as follows:

If you sell the rights, the basis for figuringgain or loss is $2.18 ($21.78 ÷ 10) per right.If you exercise the rights, the basis of thestock you acquire is the price you pay ($26)plus the basis of the right exercised ($2.18),or $28.18 per share. The remaining basis ofthe old stock is $21.78 per share.

80 shares (80 × $11) stock bought in Janu-ary 1987 ....................................................... 880Total basis of stock sold in 2000 $1,380

100 shares × $22 = $2,200, basis of old stock

100 shares × $30 = $3,000, market value of oldstock

10 rights × $3 = $30, market value of rights

($3,000 ÷ $3,030) × $2,200 = $2,178.22, newbasis of old stock

($30 ÷ $3,030) × $2,200 = $21.78, basis of rights


Investment property received in liqui-dation. In general, if you receive investmentproperty as a distribution in partial or com-plete liquidation of a corporation and if yourecognize gain or loss when you acquire theproperty, your basis in the property is its fairmarket value at the time of the distribution.

S corporation stock. You must increaseyour basis in stock of an S corporation byyour pro rata share of the following items.

• All income items of the S corporation, in-cluding tax-exempt income, that are sep-arately stated and passed through to youas a shareholder.

• The nonseparately stated income of theS corporation.

• The amount of the deduction for depletion(other than oil and gas depletion) that ismore than the basis of the property beingdepleted.

You must decrease your basis in stockof an S corporation by your pro rata share ofthe following items.

• Distributions by the S corporation thatwere not included in your income.

• All loss and deduction items of the Scorporation that are separately stated andpassed through to you.

• Any nonseparately stated loss of the Scorporation.

• Any expense of the S corporation that isnot deductible in figuring its taxable in-come and not properly chargeable to acapital account.

• The amount of your deduction for de-pletion of oil and gas wells to the extentthe deduction is not more than your shareof the adjusted basis of the wells.

However, your basis in the stock cannot bereduced below zero.

Specialized small business investmentcompany stock or partnership interest. Ifyou bought this stock or interest as replace-ment property for publicly traded securitiesyou sold at a gain, you must reduce the basisof the stock or interest by the amount of anypostponed gain on that sale. See Rollover ofGain From Publicly Traded Securities, later.

Qualified small business stock. If youbought this stock as replacement property forother qualified small business stock you soldat a gain, you must reduce the basis of thisreplacement stock by the amount of anypostponed gain on the earlier sale. See Gainson Qualified Small Business Stock, later.

Short sales. If you cannot deduct paymentsyou make to a lender in lieu of dividends onstock used in a short sale, the amount youpay to the lender is a capital expense, andyou must add it to the basis of the stock usedto close the short sale.

See Short Sales, later, for informationabout deducting payments in lieu of divi-dends.

Premiums on bonds. If you buy a bond ata premium, the premium is treated as part ofyour basis in the bond. If you choose to

amortize the premium paid on a taxable bond,you must reduce the basis of the bond by theamortized part of the premium each year overthe life of the bond.

Although you cannot deduct the premiumon a tax-exempt bond, you must amortize itto determine your adjusted basis in the bond.You must reduce the basis of the bond by thepremium you amortized for the period youheld the bond.

See Bond Premium Amortization in chap-ter 3 for more information.

Market discount on bonds. If you includemarket discount on a bond in income cur-rently, increase the basis of your bond by theamount of market discount you include in yourincome. See Market Discount Bonds inchapter 1 for more information.

Acquisition discount on short-term obli-gations. If you include acquisition discounton a short-term obligation in your incomecurrently, increase the basis of the obligationby the amount of acquisition discount you in-clude in your income. See Discount onShort-Term Obligations in chapter 1 for moreinformation.

Original issue discount (OID) on debt in-struments. Increase the basis of a debt in-strument by the amount of OID that you in-clude in your income. See Original IssueDiscount (OID) in chapter 1.

Discounted tax-exempt obligations.OID on tax-exempt obligations is generallynot taxable. However, when you dispose ofa tax-exempt obligation issued after Septem-ber 3, 1982, that you acquired after March 1,1984, you must accrue OID on the obligationto determine its adjusted basis. The accruedOID is added to the basis of the obligation todetermine your gain or loss.

For information on determining OID on along-term obligation, see Debt InstrumentsIssued After July 1, 1982, and Before 1985or Debt Instruments Issued After 1984,whichever applies, in Publication 1212 underFiguring OID on Long-Term DebtInstruments.

If the tax-exempt obligation has a maturityof 1 year or less, accrue OID under the rulesfor acquisition discount on short-term obli-gations. See Discount on Short-Term Obli-gations in chapter 1.

Stripped tax-exempt obligation. If youacquired a stripped tax-exempt bond or cou-pon after October 22, 1986, you must accrueOID on it to determine its adjusted basis whenyou dispose of it. For stripped tax-exemptbonds or coupons acquired after June 10,1987, part of this OID may be taxable. Youaccrue the OID on these obligations in themanner described in chapter 1 under StrippedBonds and Coupons.

Increase your basis in the stripped tax-exempt bond or coupon by the taxable andnontaxable accrued OID. Also increase yourbasis by the interest that accrued (but wasnot paid, and was not previously reflected inyour basis) before the date you sold the bondor coupon. In addition, for bonds acquiredafter June 10, 1987, add to your basis anyaccrued market discount not previously re-flected in basis.

How To FigureGain or Loss You figure gain or loss on a sale or trade ofproperty by comparing the amount you realizewith the adjusted basis of the property.

Gain. If the amount you realize from a saleor trade is more than the adjusted basis of theproperty you transfer, the difference is a gain.

Loss. If the adjusted basis of the propertyyou transfer is more than the amount you re-alize, the difference is a loss.

Amount realized. The amount you realizefrom a sale or trade of property is everythingyou receive for the property. This includes themoney you receive plus the fair market valueof any property or services you receive.

If you finance the buyer's purchase of yourproperty and the debt instrument does notprovide for adequate stated interest, the un-stated interest will reduce the amount real-ized. For more information, see Publication537.

Fair market value. Fair market value isthe price at which property would changehands between a buyer and a seller, neitherbeing forced to buy or sell and both havingreasonable knowledge of all the relevantfacts.

The fair market value of notes or otherdebt instruments you receive as a part of thesale price is usually the best amount you canget from selling them to, or discounting themwith, a bank or other buyer of debt instru-ments.

Example. You trade A Company stockwith an adjusted basis of $7,000 for B Com-pany stock with a fair market value of$10,000, which is your amount realized. Yourgain is $3,000 ($10,000 minus $7,000). If youalso receive a note for $6,000 that has a dis-count value of $4,000, your gain is $7,000($10,000 plus $4,000 minus $7,000).

Debt paid off. A debt against the prop-erty, or against you, that is paid off as a partof the transaction or that is assumed by thebuyer must be included in the amount real-ized. This is true even if neither you nor thebuyer is personally liable for the debt. Forexample, if you sell or trade property that issubject to a nonrecourse loan, the amountyou realize generally includes the full amountof the note assumed by the buyer even if theamount of the note is more than the fairmarket value of the property.

Example. You sell stock that you hadpledged as security for a bank loan of $8,000.Your basis in the stock is $6,000. The buyerpays off your bank loan and pays you $20,000in cash. The amount realized is $28,000($20,000 plus $8,000). Your gain is $22,000($28,000 minus $6,000).

Payment of cash. If you trade propertyand cash for other property, the amount yourealize is the fair market value of the propertyyou receive. Determine your gain or loss bysubtracting the cash you pay and the adjustedbasis of the property you traded in from theamount you realize. If the result is a positivenumber, it is a gain. If the result is a negativenumber, it is a loss.


No gain or loss. You may have to use abasis for figuring gain that is different from thebasis used for figuring loss. In this case, youmay have neither a gain nor a loss. See Nogain or loss in the discussion on the basis ofproperty you received as a gift under BasisOther Than Cost, earlier.

Nontaxable TradesThis section discusses trades that generallydo not result in a taxable gain or a deductibleloss. For more information on nontaxabletrades, see chapter 1 of Publication 544.

Like-Kind ExchangesIf you trade business or investment propertyfor other business or investment property ofa like kind, you do not pay tax on any gainor deduct any loss until you sell or disposeof the property you receive. To be nontaxable,a trade must meet all six of the followingconditions.

1) The property must be business or in-vestment property. You must hold boththe property you trade and the propertyyou receive for productive use in yourtrade or business or for investment.Neither property may be property usedfor personal purposes, such as yourhome or family car.

2) The property must not be held primarilyfor sale. The property you trade and theproperty you receive must not be prop-erty you sell to customers, such as mer-chandise.

3) The property must not be stocks, bonds,notes, choses in action, certificates oftrust or beneficial interest, or other se-curities or evidences of indebtedness orinterest, including partnership interests.However, you can have a nontaxabletrade of corporate stocks under a differ-ent rule, as discussed later.

4) There must be a trade of like property.The trade of real estate for real estate,or personal property for similar personalproperty, is a trade of like property. Thetrade of an apartment house for a storebuilding, or a panel truck for a pickuptruck, is a trade of like property. Thetrade of a piece of machinery for a storebuilding is not a trade of like property.Real property located in the UnitedStates and real property located outsidethe United States are not like property.Also, personal property used predomi-nantly within the United States and per-sonal property used predominantly out-side the United States are not likeproperty.

5) The property to be received must beidentified within 45 days after the dateyou transfer the property given up in thetrade.

6) The property to be received must be re-ceived by the earlier of:

a) The 180th day after the date onwhich you transfer the propertygiven up in the trade, or

b) The due date, including extensions,for your tax return for the year inwhich the transfer of the propertygiven up occurs.

If you trade property with a related partyin a like-kind exchange, a special rule mayapply. See Related Party Transactions, laterin this chapter. Also, see chapter 1 of Publi-cation 544 for more information on exchangesof business property and special rules forexchanges using qualified intermediaries orinvolving multiple properties.

Partly nontaxable exchange. If you receivecash or unlike property in addition to the likeproperty, and the preceding six conditions aremet, you have a partly nontaxable trade. Youare taxed on any gain you realize, but onlyup to the amount of the cash and the fairmarket value of the unlike property you re-ceive. You cannot deduct a loss.

Like property and unlike propertytransferred. If you give up unlike property inaddition to the like property, you must recog-nize gain or loss on the unlike property yougive up. The gain or loss is the differencebetween the adjusted basis of the unlikeproperty and its fair market value.

Like property and money transferred. Ifconditions (1) — (6) are met, you have anontaxable trade even if you pay money inaddition to the like property.

Basis of property received. You figure yourbasis in property received in a nontaxable orpartly nontaxable trade as explained earlierunder Basis Other Than Cost, earlier.

How to report. You must report the tradeof like property on Form 8824. If you figurea recognized gain or loss on Form 8824, re-port it on Schedule D of Form 1040 or onForm 4797, Sales of Business Property,whichever applies.

For information on using Form 4797, seechapter 4 of Publication 544.

Corporate StocksThe following trades of corporate stocksgenerally do not result in a taxable gain or adeductible loss.

Stock for stock of the same corporation.You can exchange common stock for com-mon stock or preferred stock for preferredstock in the same corporation without havinga recognized gain or loss. This is true for atrade between two stockholders as well as atrade between a stockholder and the corpo-ration.

Money or other property received. If inan otherwise nontaxable trade you receivemoney or other property in addition to stock,then your gain on the trade, if any, is taxed,but only up to the amount of the money orother property. Any loss is not recognized.

Nonqualified preferred stock. Nonqual-ified preferred stock is generally treated asproperty other than stock. Generally, this ap-plies to preferred stock with one or more ofthe following features.

• The holder has the right to require theissuer or a related person to redeem orpurchase the stock.

• The issuer or a related person is requiredto redeem or purchase the stock.

• The issuer or a related person has theright to redeem the stock, and on the is-sue date, it is more likely than not that theright will be exercised.

• The dividend rate on the stock varies withreference to interest rates, commodityprices, or similar indices.

For a detailed definition of nonqualified pre-ferred stock, see section 351(g)(2) of theInternal Revenue Code.

Corporate reorganizations. In some in-stances, you can trade common stock forpreferred stock, preferred stock for commonstock, or stock in one corporation for stock inanother corporation without having a recog-nized gain or loss. These trades must be partof mergers, recapitalizations, transfers tocontrolled corporations, bankruptcies, corpo-rate divisions, corporate acquisitions, or othercorporate reorganizations.

Convertible stocks and bonds. You gen-erally will not have a recognized gain or lossif you convert bonds into stock or preferredstock into common stock of the same corpo-ration according to a conversion privilege inthe terms of the bond or the preferred stockcertificate.

Example. In November, you bought for$1 a right issued by XYZ Corporation entitlingyou, on payment of $99, to subscribe to abond issued by that corporation.

On December 2, you subscribed to thebond, which was issued on December 9. Thebond contained a clause stating that youwould receive one share of XYZ Corporationcommon stock on surrender of one bond andthe payment of $50.

Later, you presented the bond and $50and received one share of XYZ Corporationcommon stock. You did not have a recog-nized gain or loss. This is true whether the fairmarket value of the stock was more or lessthan $150 on the date of the conversion.

The basis of your share of stock is $150($1 + $99 + $50). Your holding period is split.Your holding period for the part based on yourownership of the bond ($100 basis) beginson December 2. Your holding period for thepart based on your cash investment ($50 ba-sis) begins on the day after you acquired theshare of stock.

Bonds for stock of another corporation.Generally, if you convert the bonds of onecorporation into common stock of anothercorporation, according to the terms of thebond issue, you must recognize gain or lossup to the difference between the fair marketvalue of the stock received and the adjustedbasis of the bonds exchanged. In some in-stances, however, such as trades that arepart of mergers or other corporate reorgan-izations, you will have no recognized gain orloss if certain requirements are met. For moreinformation about the tax consequences ofconverting securities of one corporation intocommon stock of another corporation, undercircumstances such as those just described,consult the respective corporations and theterms of the bond issue. This information isalso available on the prospectus of the bondissue.

Property for stock of a controlled corpo-ration. If you transfer property to a corpo-ration solely in exchange for stock in thatcorporation, and immediately after the tradeyou are in control of the corporation, you or-dinarily will not recognize a gain or loss. Thisrule applies both to individuals and to groupswho transfer property to a corporation. It does


not apply if the corporation is an investmentcompany.

If you are in a bankruptcy or a similarproceeding and you transfer property to acontrolled corporation under a plan, otherthan a reorganization, you must recognizegain to the extent the stock you receive in theexchange is used to pay off your debts.

For this purpose, to be in control of acorporation, you or your group of transferorsmust own, immediately after the exchange,at least 80% of the total combined votingpower of all classes of stock entitled to voteand at least 80% of the outstanding sharesof each class of nonvoting stock of the cor-poration.

If this provision applies to you, you mustattach to your return a complete statementof all facts pertinent to the exchange.

Money or other property received. If,in an otherwise nontaxable trade of propertyfor corporate stock, you also receive moneyor property other than stock, you may havea taxable gain. However, you are taxed onlyup to the amount of money plus the fair mar-ket value of the other property you receive.The rules for figuring taxable gain in this sit-uation generally follow those for a partiallynontaxable exchange discussed earlier underLike-Kind Exchanges. If the property you giveup includes depreciable property, the taxablegain may have to be reported as ordinary in-come because of depreciation. (See chapter3 of Publication 544.) No loss is recognized.

Nonqualified preferred stock (describedearlier under Stock for stock of the samecorporation) received is generally treated asproperty other than stock.

Basis of stock or other property re-ceived. The basis of the stock you receiveis generally the adjusted basis of the propertyyou transfer. Increase this amount by anyamount that was treated as a dividend, plusany gain recognized on the trade. Decreasethis amount by any cash you received and thefair market value of any other property youreceived.

The basis of any other property you re-ceive is its fair market value on the date of thetrade.

Insurance Policiesand AnnuitiesYou will not have a recognized gain or loss ifyou trade:

1) A life insurance contract for another lifeinsurance contract or for an endowmentor annuity contract,

2) An endowment contract for an annuitycontract or for another endowment con-tract that provides for regular paymentsbeginning at a date not later than thebeginning date under the old contract,or

3) An annuity contract for another annuitycontract.

The insured or annuitant must be the sameunder both contracts. Exchanges of contractsnot included in this list, such as an annuitycontract for an endowment contract, or anannuity or endowment contract for a life in-surance contract, are taxable.

U.S. TreasuryNotes or BondsYou can trade certain issues of U.S. Treasuryobligations for other issues, designated by theSecretary of the Treasury, with no gain or lossrecognized on the trade.

See the discussion in chapter 1 underU.S. Treasury Bills, Notes, and Bonds for in-formation about income from these invest-ments.

Transfers BetweenSpousesGenerally, no gain or loss is recognized on atransfer of property from an individual to (orin trust for the benefit of) a spouse or, if inci-dent to a divorce, a former spouse. Thisnonrecognition rule does not apply if the re-cipient spouse or former spouse is a nonres-ident alien. The rule also does not apply to atransfer in trust to the extent the adjustedbasis of the property is less than the amountof the liabilities assumed plus any liabilitieson the property.

Any transfer of property to a spouse orformer spouse on which gain or loss is notrecognized is treated by the recipient as a giftand is not considered a sale or exchange.The recipient's basis in the property will bethe same as the adjusted basis of the giverimmediately before the transfer. This carry-over basis rule applies whether the adjustedbasis of the transferred property is less than,equal to, or greater than either its fair marketvalue at the time of transfer or any consider-ation paid by the recipient. This rule appliesfor purposes of determining loss as well asgain. Any gain recognized on a transfer intrust increases the basis.

A transfer of property is incident to a di-vorce if the transfer occurs within 1 year afterthe date on which the marriage ends, or if thetransfer is related to the ending of the mar-riage. For more information, see PropertySettlements in Publication 504, Divorced orSeparated Individuals.

Related PartyTransactionsSpecial rules apply to the sale or trade ofproperty between related parties.

Gain on Sale or Tradeof Depreciable Property Your gain from the sale or trade of propertyto a related party may be ordinary income,rather than capital gain, if the property canbe depreciated by the party receiving it. Seechapter 2 in Publication 544 for more infor-mation.

Like-Kind Exchanges Generally, if you trade business or investmentproperty for other business or investmentproperty of a like kind, no gain or loss is rec-ognized. See Like-Kind Exchanges, earlier,under Nontaxable Trades.

This rule also applies to trades of propertybetween related parties, defined next underLosses on Sales or Trades of Property.

However, if either you or the related partydisposes of the like property within 2 yearsafter the trade, you both must report any gainor loss not recognized on the original tradeon your return for the year in which the laterdisposition occurs.

This rule generally does not apply to:

• Dispositions due to the death of eitherrelated party,

• Involuntary conversions (see chapter 1of Publication 544), or

• Trades and later dispositions whose mainpurpose is not the avoidance of federalincome tax.

If a property holder's risk of loss on theproperty is substantially diminished duringany period, that period is not counted in de-termining whether the property was disposedof within 2 years. The property holder's riskof loss is substantially diminished by:

• The holding of a put on the property,

• The holding by another person of a rightto acquire the property, or

• A short sale or any other transaction.

Losses on Sales orTrades of PropertyYou cannot deduct a loss on the sale or tradeof property, other than a distribution in com-plete liquidation of a corporation, if the trans-action is directly or indirectly between you andthe following related parties.

1) Members of your family. This includesonly your brothers and sisters, half-brothers and half-sisters, spouse, an-cestors (parents, grandparents, etc.),and lineal descendants (children, grand-children, etc.).

2) A partnership in which you directly orindirectly own more than 50% of thecapital interest or the profits interest.

3) A corporation in which you directly orindirectly own more than 50% in valueof the outstanding stock (see Construc-tive ownership of stock, later).

4) A tax-exempt charitable or educationalorganization that is directly or indirectlycontrolled, in any manner or by anymethod, by you or by a member of yourfamily, whether or not this control is le-gally enforceable.

In addition, a loss on the sale or trade ofproperty is not deductible if the transaction isdirectly or indirectly between the followingrelated parties.

1) A grantor and fiduciary, or the fiduciaryand beneficiary, of any trust.

2) Fiduciaries of two different trusts, or thefiduciary and beneficiary of two differenttrusts, if the same person is the grantorof both trusts.

3) A trust fiduciary and a corporation ofwhich more than 50% in value of theoutstanding stock is directly or indirectlyowned by or for the trust, or by or for thegrantor of the trust.

4) A corporation and a partnership if thesame persons own more than 50% invalue of the outstanding stock of thecorporation and more than 50% of the


capital interest, or the profits interest, inthe partnership.

5) Two S corporations if the same personsown more than 50% in value of the out-standing stock of each corporation.

6) Two corporations, one of which is an Scorporation, if the same persons ownmore than 50% in value of the out-standing stock of each corporation.

7) An executor and a beneficiary of an es-tate (except in the case of a sale or tradeto satisfy a pecuniary bequest).

8) Two corporations that are members ofthe same controlled group (under certainconditions, however, these losses arenot disallowed but must be deferred).

9) Two partnerships if the same personsown, directly or indirectly, more than50% of the capital interests or the profitinterests in both partnerships.

Multiple property sales or trades. If yousell or trade to a related party a number ofblocks of stock or pieces of property in a lumpsum, you must figure the gain or loss sepa-rately for each block of stock or piece ofproperty. The gain on each item may be tax-able. However, you cannot deduct the losson any item. Also, you cannot reduce gainsfrom the sales of any of these items by losseson the sales of any of the other items.

Indirect transactions. You cannot deductyour loss on the sale of stock through yourbroker if, under a prearranged plan, a relatedparty buys the same stock you had owned.This does not apply to a trade between re-lated parties through an exchange that ispurely coincidental and is not prearranged.

Constructive ownership of stock. In de-termining whether a person directly or indi-rectly owns any of the outstanding stock of acorporation, the following rules apply.

Rule 1. Stock directly or indirectly ownedby or for a corporation, partnership, estate,or trust is considered owned proportionatelyby or for its shareholders, partners, or ben-eficiaries.

Rule 2. An individual is considered to ownthe stock that is directly or indirectly ownedby or for his or her family. Family includesonly brothers and sisters, half-brothers andhalf-sisters, spouse, ancestors, and linealdescendants.

Rule 3. An individual owning, other thanby applying rule 2, any stock in a corporationis considered to own the stock that is directlyor indirectly owned by or for his or her partner.

Rule 4. When applying rule 1, 2, or 3,stock constructively owned by a person underrule 1 is treated as actually owned by thatperson. But stock constructively owned by anindividual under rule 2 or rule 3 is not treatedas owned by that individual for again applyingeither rule 2 or rule 3 to make another personthe constructive owner of the stock.

Property received from a related party. Ifyou sell or trade at a gain property that youacquired from a related party, you recognizethe gain only to the extent that it is more thanthe loss previously disallowed to the relatedparty. This rule applies only if you are the or-iginal transferee and you acquired the prop-erty by purchase or exchange. This rule doesnot apply if the related party's loss was dis-

allowed because of the wash sale rules, de-scribed later under Wash Sales.

Example 1. Your brother sells you stockfor $7,600. His cost basis is $10,000. Yourbrother cannot deduct the loss of $2,400.Later, you sell the same stock to an unrelatedparty for $10,500, realizing a gain of $2,900.Your reportable gain is $500 — the $2,900gain minus the $2,400 loss not allowed toyour brother.

Example 2. If, in Example 1, you sold thestock for $6,900 instead of $10,500, yourrecognized loss is only $700 — your $7,600basis minus $6,900. You cannot deduct theloss that was not allowed to your brother.

Capital Gainsand Losses Terms you may need to know (seeGlossary):

Call Commodity future Conversion transaction Forward contract Limited partner Listed option Nonequity option Options dealerPut Regulated futures contract Section 1256 contract Straddle Wash sale

This section discusses the tax treatment ofgains and losses from different types of in-vestment transactions.

Character of gain or loss. You need toclassify your gains and losses as either ordi-nary or capital gains or losses. You then needto classify your capital gains and losses aseither short term or long term. If you havelong-term gains and losses, you must identifyyour 28% rate gains and losses. If you havea net capital gain, you must also identify anyunrecaptured section 1250 gain.

The correct classification and identificationhelps you figure the limit on capital losses andthe correct tax on capital gains. For informa-tion about determining whether your capitalgain or loss is short term or long term, seeHolding Period, later. For information aboutwhether your long-term gain or loss is a 28%rate gain or loss and about unrecapturedsection 1250 gain, see Reporting CapitalGains and Losses and Capital Gains TaxRates, later.

Capital or OrdinaryGain or LossIf you have a taxable gain or a deductible lossfrom a transaction, it may be either a capitalgain or loss or an ordinary gain or loss, de-pending on the circumstances. Generally, asale or trade of a capital asset (defined next)results in a capital gain or loss. A sale or tradeof a noncapital asset generally results in or-dinary gain or loss. Depending on the cir-cumstances, a gain or loss on a sale or tradeof property used in a trade or business may

be treated as either capital or ordinary, asexplained in Publication 544. In some situ-ations, part of your gain or loss may be acapital gain or loss, and part may be an ordi-nary gain or loss.

Capital Assets andNoncapital Assets For the most part, everything you own anduse for personal purposes, pleasure, or in-vestment is a capital asset. Some examplesare:

• Stocks or bonds held in your personalaccount,

• A house owned and used by you andyour family,

• Household furnishings,

• A car used for pleasure or commuting,

• Coin or stamp collections,

• Gems and jewelry, and

• Gold, silver, or any other metal.

Any property you own is a capital asset,except the following noncapital assets.

1) Property held mainly for sale to cus-tomers or property that will physicallybecome a part of the merchandise thatis for sale to customers.

2) Depreciable property used in yourtrade or business, even if fully depreci-ated.

3) Real property used in your trade orbusiness.

4) A copyright, a literary, musical, or ar-tistic composition, a letter or memo-randum, or similar property —

a) Created by your personal efforts,

b) Prepared or produced for you (inthe case of a letter, memorandum,or similar property), or

c) Acquired under circumstances (forexample, by gift) entitling you to thebasis of the person who created theproperty or for whom it was pre-pared or produced.

5) Accounts or notes receivable acquiredin the ordinary course of a trade orbusiness for services rendered or fromthe sale of any of the properties de-scribed in (1).

6) U.S. Government publications that youreceived from the government free or forless than the normal sales price, or thatyou acquired under circumstances enti-tling you to the basis of someone whoreceived the publications free or for lessthan the normal sales price.

7) Certain commodities derivative finan-cial instruments held, acquired, or en-tered into by commodities derivativesdealers after December 16, 1999. Formore information, see section 1221 ofthe Internal Revenue Code.

8) Hedging transactions entered into afterDecember 16, 1999, but only if thetransaction is clearly identified as ahedging transaction before the close ofthe day on which it was acquired, origi-nated, or entered into. For more infor-mation, see the definition of “hedgingtransaction” earlier, and the discussion


of hedging transactions under Commod-ity Futures, later.

9) Supplies of a type you regularly use orconsume in the ordinary course of yourtrade or business, that you held or ac-quired after December 16, 1999.

Investment property. Investment propertyis a capital asset. Any gain or loss from itssale or trade generally is a capital gain orloss.

Gold, silver, stamps, coins, gems, etc.These are capital assets except when theyare held for sale by a dealer. Any gain or lossfrom their sale or trade generally is a capitalgain or loss.

Stocks, stock rights, and bonds. All ofthese, including stock received as a dividend,are capital assets except when they are heldfor sale by a securities dealer. However, seeLosses on Section 1244 (Small Business)Stock and Losses on Small Business Invest-ment Company Stock, later.

Personal use property. Property held forpersonal use only, rather than for investment,is a capital asset, and you must report a gainfrom its sale as a capital gain. However, youcannot deduct a loss from selling personaluse property.

Discounted Debt Instruments Treat your gain or loss on the sale, redemp-tion, or retirement of a bond or other debt in-strument originally issued at a discount orbought at a discount as capital gain or loss,except as explained in the following dis-cussions.

Short-term government obligations. Treatgains on short-term federal, state, or localgovernment obligations (other than tax-exempt obligations) as ordinary income up toyour ratable share of the acquisition discount.This treatment applies to obligations that havea fixed maturity date not more than 1 yearfrom the date of issue. Acquisition discountis the stated redemption price at maturity mi-nus your basis in the obligation.

However, do not treat these gains as in-come to the extent you previously includedthe discount in income. See Discount onShort-Term Obligations in chapter 1 for moreinformation.

Short-term nongovernment obligations.Treat gains on short-term nongovernmentobligations as ordinary income up to yourratable share of OID. This treatment appliesto obligations that have a fixed maturity dateof not more than 1 year from the date of issue.

However, to the extent you previously in-cluded the discount in income, you do nothave to include it in income again. See Dis-count on Short-Term Obligations, in chapter1, for more information.

Tax-exempt state and local governmentbonds. If these bonds were originally issuedat a discount before September 4, 1982, oryou acquired them before March 2, 1984,treat your part of the OID as tax-exempt in-terest. To figure your gain or loss on the saleor trade of these bonds, reduce the amountrealized by your part of the OID.

If the bonds were issued after September3, 1982, and acquired after March 1, 1984,

increase the adjusted basis by your part of theOID to figure gain or loss. For more informa-tion on the basis of these bonds, see Dis-counted tax-exempt obligations under Stocksand Bonds, earlier in this chapter.

Any gain from market discount is usuallytaxable on disposition or redemption of tax-exempt bonds. If you bought the bonds beforeMay 1, 1993, the gain from market discountis capital gain. If you bought the bonds afterApril 30, 1993, the gain from market discountis ordinary income.

You figure market discount by subtractingthe price you paid for the bond from the sumof the original issue price of the bond and theamount of accumulated OID from the date ofissue that represented interest to any earlierholders. For more information, see MarketDiscount Bonds in chapter 1.

A loss on the sale or other disposition ofa tax-exempt state or local government bondis deductible as a capital loss.

Redeemed before maturity. If a stateor local bond that was issued before June9, 1980, is redeemed before it matures, theOID is not taxable to you.

If a state or local bond issued after June8, 1980, is redeemed before it matures, thepart of the OID that is earned while you holdthe bond is not taxable to you. However, youmust report the unearned part of the OID asa capital gain.

Example. On July 1, 1989, the date ofissue, you bought a 20-year, 6% municipalbond for $800. The face amount of the bondwas $1,000. The $200 discount was OID. Atthe time the bond was issued, the issuer hadno intention of redeeming it before it matured.The bond was callable at its face amountbeginning 10 years after the issue date.

The issuer redeemed the bond at the endof 11 years (July 1, 2000) for its face amountof $1,000 plus accrued annual interest of $60.The OID earned during the time you held thebond, $73, is not taxable. The $60 accruedannual interest also is not taxable. However,you must report the unearned part of the OID($127) as a capital gain.

Long-term debt instruments issued after1954 and before May 28, 1969 (or beforeJuly 2, 1982, if a government instrument).If you sell, trade, or redeem for a gain one ofthese debt instruments, the part of your gainthat is not more than your ratable share of theOID at the time of sale or redemption is ordi-nary income. The rest of the gain is capitalgain. If, however, there was an intention tocall the debt instrument before maturity, allof your gain that is not more than the entireOID is treated as ordinary income at the timeof the sale. This treatment of taxable gain alsoapplies to corporate instruments issued afterMay 27, 1969, under a written commitmentthat was binding on May 27, 1969, and at alltimes thereafter.

Example 1. You bought a 30-year, 6%government bond for $700 at original issueon April 1, 1982, and sold it for $800 on April20, 2000. The redemption price is $1,000. Atthe time of original issue, there was no in-tention to call the bond before maturity. Youhave held the bond for 216 full months. Donot count the additional days that are lessthan a full month. The number of completemonths from date of issue to date of maturityis 360 (30 years). The fraction 216/360multiplied by the discount of $300 ($1,000 −$700) is equal to $180. This is your ratable

share of OID for the period you owned thebond. You must treat any part of the gain upto $180 as ordinary income. As a result, your$100 gain is treated as ordinary income.

Example 2. If, in Example 1, you sold thebond for $900, you would have a gain of$200. Of that amount, $180 is ordinary in-come and $20 is long-term capital gain.

Long-term debt instruments issued afterMay 27, 1969 (or after July 1, 1982, if agovernment instrument). If you hold one ofthese debt instruments, you must include apart of the OID in your gross income eachyear that you own the instrument. Your basisin that debt instrument is increased by theamount of OID that you have included in yourgross income. See Original Issue Discount(OID) in chapter 1.

If you sell or trade the debt instrumentbefore maturity, your gain is a capital gain.However, if at the time the instrument wasoriginally issued there was an intention to callit before its maturity, your gain generally isordinary income to the extent of the entireOID reduced by any amounts of OID previ-ously includible in your income. In this case,the rest of the gain is a capital gain.

An intention to call a debt instrument be-fore maturity means there is a written or oralagreement or understanding not provided forin the debt instrument between the issuer andoriginal holder that the issuer will redeem thedebt instrument before maturity. In the caseof debt instruments that are part of an issue,the agreement or understanding must be be-tween the issuer and the original holders ofa substantial amount of the debt instrumentsin the issue.

Example 1. On February 4, 1998, youbought at original issue for $7,600, JonesCorporation's 10-year, 5% bond which has astated redemption price at maturity of$10,000. On February 3, 2000, you sold thebond to Susan Green for $9,040. Assume youhave included $334 of the OID in your grossincome and increased your basis in the bondby that amount. This includes the amountaccrued for 2000. Your basis is now $7,934.If at the time of the original issue there wasno intention to call the bond before maturity,your gain of $1,106 ($9,040 amount realizedminus $7,934 adjusted basis) is a long-termcapital gain.

Example 2. If, in Example 1, at the timeof original issue there was an intention to callthe bond before maturity, your entire gain isordinary income. You figure this as follows:

Because the amount in (3) is more than yourgain of $1,106, your entire gain is ordinaryincome.

Market discount bonds. If the debt instru-ment has market discount and you chose toinclude the discount in income as it accrued,increase your basis in the debt instrument bythe accrued discount to figure capital gain orloss on its disposition. If you did not chooseto include the discount in income as it ac-crued, you must report gain as ordinary in-terest income up to the instrument's accruedmarket discount. See Market Discount Bonds

1) Entire OID ($10,000 stated redemptionprice at maturity minus $7,600 issueprice) ....................................................... $2,400

2) Minus: Amount previously includedin income ................................................. 334

3) Maximum amount of ordinary income .... $2,066


in chapter 1. The rest of the gain is capitalgain.

However, a different rule applies if youdispose of a market discount bond that was:

1) Issued before July 19, 1984, and

2) Purchased by you before May 1, 1993.

In that case, any gain is treated as interestincome up to the amount of your deferred in-terest deduction for the year you dispose ofthe bond. The rest of the gain is capital gain.(Deferred interest deduction for market dis-count bonds is discussed in chapter 3 underWhen To Deduct Investment Interest.)

Report the sale or trade of a market dis-count bond on Schedule D (Form 1040), line1 or line 8. If the sale or trade results in a gainand you did not choose to include marketdiscount in income currently, enter “AccruedMarket Discount” on the next line in column(a) and the amount of the accrued marketdiscount as a loss in column (f). Also reportthe amount of accrued market discount incolumn (f) as interest income on Schedule B(Form 1040), line 1, and identify it as “Ac-crued Market Discount.”

Retirement of debt instrument. Anyamount that you receive on the retirement ofa debt instrument is treated in the same wayas if you had sold or traded that instrument.

Notes of individuals. If you hold an obli-gation of an individual that was issued withOID after March 1, 1984, you generally mustinclude the OID in your income currently, andyour gain or loss on its sale or retirement isgenerally capital gain or loss. An exceptionto this treatment applies if the obligation is aloan between individuals and all of the fol-lowing requirements are met.

1) The lender is not in the business oflending money.

2) The amount of the loan, plus the amountof any outstanding prior loans, is$10,000 or less.

3) Avoiding federal tax is not one of theprincipal purposes of the loan.

If the exception applies, or the obligationwas issued before March 2, 1984, you do notinclude the OID in your income currently.When you sell or redeem the obligation, thepart of your gain that is not more than youraccrued share of the OID at that time is ordi-nary income. The rest of the gain, if any, iscapital gain. Any loss on the sale or redemp-tion is capital loss.

Bearer Obligations You cannot deduct any loss on an obligationrequired to be in registered form that is in-stead held in bearer form. In addition, anygain on the sale or other disposition of theobligation is ordinary income. However, if theissuer was subject to a tax when the obli-gation was issued, then you can deduct anyloss, and any gain may qualify for capital gaintreatment.

Obligations required to be in registeredform. Any obligation must be in registeredform unless:

1) It is issued by a natural person,

2) It is not of a type offered to the public,

3) It has a maturity at the date of issue ofnot more than 1 year, or

4) It was issued before 1983.

Deposit in Insolvent orBankrupt Financial Institution If you lose money you have on deposit in aqualified financial institution that becomes in-solvent or bankrupt, you may be able to de-duct your loss in one of three ways.

1) Ordinary loss,

2) Casualty loss, or

3) Nonbusiness bad debt (short-term capi-tal loss).

Ordinary loss or casualty loss. If you canreasonably estimate your loss, you canchoose to treat the estimated loss as eitheran ordinary loss or a casualty loss in thecurrent year. Either way, you claim the lossas an itemized deduction.

If you claim an ordinary loss, report it asa miscellaneous itemized deduction on line22 of Schedule A (Form 1040). The maximumamount you can claim is $20,000 ($10,000 ifyou are married filing separately) reduced byany expected state insurance proceeds. Yourloss is subject to the 2%-of-adjusted-gross-income limit. You cannot choose to claim anordinary loss if any part of the deposit isfederally insured.

If you claim a casualty loss, attach Form4684, Casualties and Thefts, to your return.Each loss must be reduced by $100. Yourtotal casualty losses for the year are reducedby 10% of your adjusted gross income.

You cannot choose either of these meth-ods if:

1) You own at least 1% of the financial in-stitution,

2) You are an officer of the institution, or

3) You are related to such an owner or of-ficer. You are related if you and theowner or officer are “related parties,” asdefined earlier under Related PartyTransactions, or if you are the aunt, un-cle, nephew, or niece of the owner orofficer.

If the actual loss that is finally determinedis more than the amount you deducted as anestimated loss, you can claim the excess lossas a bad debt. If the actual loss is less thanthe amount deducted as an estimated loss,you must include in income (in the final de-termination year) the excess loss claimed.See Recoveries, in Publication 525, Taxableand Nontaxable Income.

Nonbusiness bad debt. If you do not chooseto deduct your estimated loss as a casualtyloss or an ordinary loss, you wait until theyear the amount of the actual loss is deter-mined and deduct it as a nonbusiness baddebt in that year. Report it as a short-termcapital loss on Schedule D (Form 1040), asexplained under Nonbusiness Bad Debts,later.

Sale of Annuity The part of any gain on the sale of an annuitycontract before its maturity date that is basedon interest accumulated on the contract isordinary income.

Conversion TransactionsGenerally, all or part of a gain on a conversiontransaction is treated as ordinary income.This applies to gain on the disposition or othertermination of any position you held as partof a conversion transaction that you enteredinto after April 30, 1993.

A conversion transaction is any trans-action that meets both of these tests.

1) Substantially all of your expected returnfrom the transaction is due to the timevalue of your net investment. In otherwords, the return on your investment is,in substance, like interest on a loan.

2) The transaction is one of the following.

a) A straddle as defined underStraddles, later, but including anyset of offsetting positions on stock.

b) Any transaction in which you ac-quire property (whether or not ac-tively traded) at substantially thesame time that you contract to sellthe same property, or substantiallyidentical property, at a price set inthe contract.

c) Any other transaction that is mar-keted or sold as producing capitalgains from a transaction describedin (1).

Amount treated as ordinary income. Theamount of gain treated as ordinary income isthe smaller of:

1) The gain recognized on the dispositionor other termination of the position, or

2) The “applicable imputed incomeamount.”

Applicable imputed income amount. Fig-ure this amount as follows.

1) Figure the amount of interest that wouldhave accrued on your net investment inthe conversion transaction for the periodending on the earlier of:

a) The date when you dispose of theposition, or

b) The date when the transactionstops being a conversion trans-action.

To figure this amount, use an interestrate equal to 120% of the “applicablerate,” defined later.

2) Subtract from (1) the amount treated asordinary income from any earlier dispo-sition or other termination of a positionheld as part of the same conversiontransaction.

Applicable rate. If the term of the con-version transaction is indefinite, the applica-ble rate is the federal short-term rate in effectunder section 6621(b) of the Internal RevenueCode during the period of the conversiontransaction, compounded daily.

In all other cases, the applicable rate is the“applicable federal rate” determined as if theconversion transaction were a debt instru-ment and compounded semi-annually.

The rates discussed above are publishedby the IRS in the Internal Revenue Bulletin.Or, you can contact the IRS to get theserates. See chapter 5 for the number to call.


Net investment. To determine your net in-vestment in a conversion transaction, includethe fair market value of any position at thetime it becomes part of the transaction. Thismeans that your net investment generally willbe the total amount you invested, less anyamount you received for entering into theposition (for example, a premium you re-ceived for writing a call).

Position with built-in loss. A special ruleapplies when a position with a built-in lossbecomes part of a conversion transaction. Abuilt-in loss is any loss that you would haverealized if you had disposed of or otherwiseterminated the position at its fair market valueat the time it became part of the conversiontransaction.

When applying the conversion transactionrules to a position with a built-in loss, use theposition's fair market value at the time it be-came part of the transaction. But, when youdispose of or otherwise terminate the positionin a transaction in which you recognize gainor loss, you must recognize the built-in loss.The conversion transaction rules do not affectwhether the built-in loss is treated as an or-dinary or capital loss.

Netting rule for certain conversion trans-actions. Before determining the amount ofgain treated as ordinary income, you can netcertain gains and losses from positions of thesame conversion transaction. To do this, youhave to dispose of all the positions within a14-day period that is within a single tax year.You cannot net the built-in loss against thegain.

RECORDS

You can net gains and losses only ifyou identify the conversion trans-action as an identified netting trans-

action on your books and records. Each po-sition of the conversion transaction must beidentified before the end of the day on whichthe position becomes part of the conversiontransaction. For conversion transactions en-tered into before February 20, 1996, this re-quirement is met if the identification wasmade by that date.

Options dealers and commodities traders.Special rules apply to options dealers andcommodities traders. See section 1258(d)(5)of the Internal Revenue Code.

How to report. Use Form 6781, Gains andLosses From Section 1256 Contracts andStraddles, to report conversion transactions.See the instructions for lines 11 and 13 ofForm 6781.

Commodity Futures A commodity futures contract is a standard-ized, exchange-traded contract for the saleor purchase of a fixed amount of a commodityat a future date for a fixed price.

If the contract is a regulated futures con-tract, the rules described earlier under Sec-tion 1256 Contracts Marked To Market, applyto it.

The termination of a commodity futurescontract generally results in capital gain orloss unless the contract is a hedging trans-action.

Hedging transaction. A futures contract thatis a hedging transaction generally producesordinary gain or loss. A futures contract is ahedging transaction if you enter into the con-tract in the ordinary course of your business

primarily to manage the risk of interest rateor price changes or currency fluctuations onborrowings, ordinary property, or ordinaryobligations. (Generally, ordinary property orobligations are those that cannot producecapital gain or loss under any circumstances.)For example, the offset or exercise of a fu-tures contract that protects against pricechanges in your business inventory results inan ordinary gain or loss.

For more information about hedgingtransactions, see section 1.1221–2 of theregulations. Also, see Hedging Transactionsunder Section 1256 Contracts Marked toMarket, earlier.

RECORDS

If you have numerous transactions inthe commodity futures market duringthe year, the burden of proof is on you

to show which transactions are hedgingtransactions. Clearly identify any hedgingtransactions on your books and records be-fore the end of the day you entered into thetransaction. It may be helpful to have sepa-rate brokerage accounts for your hedging andnonhedging transactions. For specific re-quirements concerning identification of hedg-ing transactions and the underlying item,items, or aggregate risk that is being hedged,see section 1.1221–2(e) of the regulations.

Gains From Certain ConstructiveOwnership TransactionsIf you have a gain from a constructive own-ership transaction entered into after July 11,1999, involving a financial asset (discussedlater) and the gain normally would be treatedas long-term capital gain, all or part of thegain may be treated instead as ordinary in-come. In addition, if any gain is treated asordinary income, your tax is increased by aninterest charge.

Constructive ownership transactions. Thefollowing are constructive ownership trans-actions.

1) A notional principal contract (discussedbelow) in which you have the right toreceive substantially all of the investmentyield on a financial asset and you areobligated to reimburse substantially allof any decline in value of the financialasset.

2) A forward or futures contract to acquirea financial asset.

3) The holding of a call option and writingof a put option on a financial asset atsubstantially the same strike price andmaturity date.

This provision does not apply if all thepositions are marked to market. Marked tomarket rules for section 1256 contracts arediscussed in detail under Section 1256 Con-tracts Marked to Market, earlier.

Financial asset. A financial asset, for thispurpose, is any equity interest in a pass-through entity. Pass-through entities includepartnerships, S corporations, trusts, regulatedinvestment companies, and real estate in-vestment trusts.

Amount of ordinary income. Long-termcapital gain is treated as ordinary income tothe extent it is more than the net underlyinglong-term capital gain. The net underlyinglong-term capital gain is the amount of netcapital gain you would have realized if youacquired the asset for its fair market value on

the date the constructive ownership trans-action was opened, and sold the asset for itsfair market value on the date the transactionwas closed. If you do not establish theamount of net underlying long-term capitalgain by clear and convincing evidence, it istreated as zero.

More information. For more information,see section 1260 of the Internal RevenueCode.

Losses on Section 1244(Small Business) Stock You can deduct as an ordinary loss, ratherthan as a capital loss, a loss on the sale,trade, or worthlessness of section 1244 stock.Report the loss on Form 4797, Sales ofBusiness Property, line 10.

Any gain on section 1244 stock is a capitalgain if the stock is a capital asset in yourhands. Do not offset gains against losses thatare within the ordinary loss limit, explainedlater in this discussion, even if the trans-actions are in stock of the same company.Report the gain on Schedule D of Form 1040.

If you must figure a net operating loss, anyordinary loss from the sale of section 1244stock is a business loss.

Ordinary loss limit. The amount that youcan deduct as an ordinary loss is limited to$50,000 each year. On a joint return the limitis $100,000, even if only one spouse has thistype of loss. If your loss is $110,000 and yourspouse has no loss, you can deduct $100,000as an ordinary loss on a joint return. The re-maining $10,000 is a capital loss.

Section 1244 (small business) stock. Thisis stock that was issued for money or property(other than stock and securities) in a domesticsmall business corporation. During its 5 mostrecent tax years before the loss, this corpo-ration must have derived more than 50% ofits gross receipts from other than royalties,rents, dividends, interest, annuities, and gainsfrom sales and trades of stocks or securities.If the corporation was in existence for at least1 year, but less than 5 years, the 50% testapplies to the tax years ending before theloss. If the corporation was in existence lessthan 1 year, the 50% test applies to the entireperiod the corporation was in existence be-fore the day of the loss. However, if the cor-poration's deductions (other than the net op-erating loss and dividends receiveddeductions) were more than its gross incomeduring this period, this 50% test does not ap-ply.

The corporation must have been largelyan operating company for ordinary loss treat-ment to apply.

If the stock was issued before July 19,1984, the stock must be common stock. If is-sued after July 18, 1984, the stock may beeither common or preferred. For more infor-mation about the requirements of a smallbusiness corporation or the qualifications ofsection 1244 stock, see section 1244 of theInternal Revenue Code and its regulations.

The stock must be issued to the persontaking the loss. You must be the originalowner of the stock to be allowed ordinary losstreatment. To claim a deductible loss on stockissued to your partnership, you must havebeen a partner when the stock was issuedand have remained so until the time of theloss. You add your distributive share of the


partnership loss to any individual section1244 stock loss you may have before apply-ing the ordinary loss limit.

Stock distributed by partnership. Ifyour partnership distributes the stock to you,you cannot treat any later loss on that stockas an ordinary loss.

Stock sold through underwriter. Stocksold through an underwriter is not section1244 stock unless the underwriter only actedas a selling agent for the corporation.

Stock dividends and reorganizations.Stock you receive as a stock dividend quali-fies as section 1244 stock if:

1) You receive it from a small businesscorporation in which you own stock, and

2) The stock you own meets the require-ments when the stock dividend is dis-tributed.

If you trade your section 1244 stock fornew stock in the same corporation in a reor-ganization that qualifies as a recapitalizationor that is only a change in identity, form, orplace of organization, the new stock is section1244 stock if the stock you trade meets therequirements when the trade occurs.

If you hold section 1244 stock and otherstock in the same corporation, not all of thestock you receive as a stock dividend or in areorganization will qualify as section 1244stock. Only that part based on the section1244 stock you hold will qualify.

Example. Your basis for 100 shares ofX common stock is $1,000. These sharesqualify as section 1244 stock. If, as a non-taxable stock dividend, you receive 50 moreshares of common stock, the basis of whichis determined from the 100 shares you own,the 50 shares are also section 1244 stock.

If you also own stock in the corporationthat is not section 1244 stock when you re-ceive the stock dividend, you must divide theshares you receive as a dividend between thesection 1244 stock and the other stock. Onlythe shares from the former can be section1244 stock.

Contributed property. To determine ordi-nary loss on section 1244 stock you receivein a trade for property, you have to reduce thebasis of the stock if:

1) The adjusted basis (for figuring loss) ofthe property, immediately before thetrade, was more than its fair marketvalue, and

2) The basis of the stock is determined bythe basis of the property.

Reduce the basis of the stock by the differ-ence between the adjusted basis of theproperty and its fair market value at the timeof the trade. You reduce the basis only tofigure the ordinary loss. Do not reduce thebasis of the stock for any other purpose.

Example. You transfer property with anadjusted basis of $1,000 and a fair marketvalue of $250 to a corporation for its section1244 stock. The basis of your stock is $1,000,but to figure the ordinary loss under theserules, the basis of your stock is $250 ($1,000minus $750). If you later sell the section 1244stock for $200, your $800 loss is an ordinaryloss of $50 and a capital loss of $750.

Contributions to capital. If the basis of yoursection 1244 stock has increased, throughcontributions to capital or otherwise, you musttreat this increase as applying to stock that isnot section 1244 stock when you figure anordinary loss on its sale.

Example. You buy 100 shares of section1244 stock for $10,000. You are the originalowner. You later make a $2,000 contributionto capital that increases the total basis of the100 shares to $12,000. You then sell the 100shares for $9,000 and have a loss of $3,000.You can deduct only $2,500 ($3,000 ×$10,000/$12,000) as an ordinary loss underthese rules. The remaining $500 is a capitalloss.

RECORDS

Recordkeeping. You must keep rec-ords sufficient to show your stockqualifies as section 1244 stock. Your

records must also distinguish your section1244 stock from any other stock you own inthe corporation.

Losses on Small BusinessInvestment Company StockA small business investment company (SBIC)is one that is licensed and operated under theSmall Business Investment Act of 1958.

If you are an investor in SBIC stock, youcan deduct as an ordinary loss, rather than acapital loss, a loss from the sale, trade, orworthlessness of that stock. A gain from thesale or trade of that stock is a capital gain.Do not offset your gains and losses, even ifthey are on stock of the same company.

How to report. You report this type of ordi-nary loss on line 10, Part II, of Form 4797. Inaddition to the information required by theform, you must include the name and addressof the company that issued the stock. Reporta capital gain from the sale of SBIC stock onSchedule D of Form 1040.

Short sale. If you close a short sale of SBICstock with other SBIC stock that you boughtonly for that purpose, any loss you have onthe sale is a capital loss. See Short Sales,later in this chapter, for more information.

Holding Period If you sold or traded investment property, youmust determine your holding period for theproperty. Your holding period determineswhether any capital gain or loss was a short-term or a long-term capital gain or loss.

Long-term or short-term. If you hold in-vestment property more than 1 year, anycapital gain or loss is a long-term capital gainor loss. If you hold the property 1 year orless, any capital gain or loss is a short-termcapital gain or loss.

To determine how long you held the in-vestment property, begin counting on the dateafter the day you acquired the property. Theday you disposed of the property is part ofyour holding period.

Example. If you bought investmentproperty on February 5, 1999, and sold it onFebruary 5, 2000, your holding period is notmore than 1 year and you have a short-termcapital gain or loss. If you sold it on February

6, 2000, your holding period is more than 1year and you have a long-term capital gainor loss.

Securities traded on an established mar-ket. For securities traded on an establishedsecurities market, your holding period beginsthe day after the trade date you bought thesecurities, and ends on the trade date yousold them.

CAUTION!

Do not confuse the trade date with thesettlement date, which is the date bywhich the stock must be delivered and

payment must be made.

Example. You are a cash method, cal-endar year taxpayer. You sold stock at a gainon December 29, 2000. According to the rulesof the stock exchange, the sale was closedby delivery of the stock 3 trading days afterthe sale, on January 4, 2001. You receivedpayment of the sale price on that same day.Report your gain on your 2000 return, eventhough you received the payment in 2001.The gain is long term or short term dependingon whether you held the stock more than 1year. Your holding period ended on Decem-ber 29. If you had sold the stock at a loss, youwould also report it on your 2000 return.

U.S. Treasury notes and bonds. The hold-ing period of U.S. Treasury notes and bondssold at auction on the basis of yield starts theday after the Secretary of the Treasury,through news releases, gives notification ofacceptance to successful bidders. The hold-ing period of U.S. Treasury notes and bondssold through an offering on a subscriptionbasis at a specified yield starts the day afterthe subscription is submitted.

Automatic investment service. In deter-mining your holding period for shares boughtby the bank or other agent, full shares areconsidered bought first and any fractionalshares are considered bought last. Yourholding period starts on the day after thebank's purchase date. If a share was boughtover more than one purchase date, yourholding period for that share is a split holdingperiod. A part of the share is considered tohave been bought on each date that stockwas bought by the bank with the proceeds ofavailable funds.

Nontaxable trades. If you acquire invest-ment property in a trade for other investmentproperty and your basis for the new propertyis determined, in whole or in part, by yourbasis in the old property, your holding periodfor the new property begins on the day fol-lowing the date you acquired the old property.

Property received as a gift. If you receivea gift of property and your basis is determinedby the donor's adjusted basis, your holdingperiod is considered to have started on thesame day the donor's holding period started.

If your basis is determined by the fairmarket value of the property, your holdingperiod starts on the day after the date of thegift.

Inherited property. If you inherit investmentproperty, your capital gain or loss on any laterdisposition of that property is treated as along-term capital gain or loss. This is true re-gardless of how long you actually held theproperty.


Real property bought. To figure how longyou have held real property bought under anunconditional contract, begin counting on theday after you received title to it or on the dayafter you took possession of it and assumedthe burdens and privileges of ownership,whichever happened first. However, takingdelivery or possession of real property underan option agreement is not enough to start theholding period. The holding period cannotstart until there is an actual contract of sale.The holding period of the seller cannot endbefore that time.

Real property repossessed. If you sell realproperty but keep a security interest in it, andthen later repossess the property under theterms of the sales contract, your holding pe-riod for a later sale includes the period youheld the property before the original sale andthe period after the repossession. Your hold-ing period does not include the time betweenthe original sale and the repossession. Thatis, it does not include the period during whichthe first buyer held the property.

Stock dividends. The holding period forstock you received as a taxable stock divi-dend begins on the date of distribution.

The holding period for new stock you re-ceived as a nontaxable stock dividend beginson the same day as the holding period of theold stock. This rule also applies to stock ac-quired in a spin-off, which is a distribution ofstock or securities in a controlled corporation.

Nontaxable stock rights. Your holding pe-riod for nontaxable stock rights begins on thesame day as the holding period of theunderlying stock. The holding period for stockacquired through the exercise of stock rightsbegins on the date the right was exercised.

Section 1256 contracts. Gains or losses onsection 1256 contracts open at the end of theyear, or terminated during the year, aretreated as 60% long term and 40% short term,regardless of how long the contracts wereheld. See Section 1256 Contracts Marked toMarket, earlier.

Option property. Your holding period forproperty you acquire when you exercise anoption begins the day after you exercise theoption.

Wash sales. Your holding period for sub-stantially identical stock or securities you ac-quire in a wash sale includes the period youheld the old stock or securities.

Qualified small business stock. Your hold-ing period for stock you acquired in a tax-freerollover of gain from a sale of qualified smallbusiness stock, described later, includes theperiod you held the old stock.

Commodity futures. Futures transactions inany commodity subject to the rules of a boardof trade or commodity exchange are longterm if the contract was held for more than 6months.

Your holding period for a commodity re-ceived in satisfaction of a commodity futurescontract, other than a regulated futures con-tract subject to Internal Revenue Code sec-tion 1256, includes your holding period for thefutures contract if you held the contract as acapital asset.

Loss on mutual fund or REIT stock held 6months or less. If you hold stock in a reg-ulated investment company (commonlycalled a mutual fund) or real estate invest-ment trust (REIT) for 6 months or less andthen sell it at a loss (other than under a peri-odic liquidation plan), special rules may apply.

Capital gain distributions received.The loss (after reduction for any exempt-interest dividends you received, as explainednext) is treated as a long-term capital loss upto the total of any capital gain distributionsyou received and your share of any undis-tributed capital gains. Any remaining loss isshort-term capital loss.

Exempt-interest dividends on mutualfund stock. If you received exempt-interestdividends on the stock, at least part of yourloss is disallowed. You can deduct only theamount of loss that is more than the exempt-interest dividends.

Nonbusiness Bad Debts If someone owes you money that you cannotcollect, you have a bad debt. You may beable to deduct the amount owed to you whenyou figure your tax for the year the debt be-comes worthless.

There are two kinds of bad debts — busi-ness and nonbusiness. A business bad debt,generally, is one that comes from operatingyour trade or business and is deductible asa business loss. All other bad debts arenonbusiness bad debts and are deductibleas short-term capital losses.

Example. An architect made personalloans to several friends who were not clients.She could not collect on some of these loans.They are deductible only as nonbusiness baddebts because the architect was not in thebusiness of lending money and the loans donot have any relationship to her business.

Business bad debts. For information onbusiness bad debts of an employee, seePublication 529. For information on otherbusiness bad debts, see chapter 11 of Publi-cation 535.

Deductible nonbusiness bad debts. To bedeductible, nonbusiness bad debts must betotally worthless. You cannot deduct a partlyworthless nonbusiness debt.

Genuine debt required. A debt must begenuine for you to deduct a loss. A debt isgenuine if it arises from a debtor-creditor re-lationship based on a valid and enforceableobligation to repay a fixed or determinablesum of money.

Loan or gift. For a bad debt, you mustshow that there was an intention at the timeof the transaction to make a loan and not agift. If you lend money to a relative or friendwith the understanding that it may not be re-paid, it is considered a gift and not a loan.You cannot take a bad debt deduction for agift. There cannot be a bad debt unless thereis a true creditor-debtor relationship betweenyou and the person or organization that owesyou the money.

When minor children borrow from theirparents to pay for their basic needs, there isno genuine debt. A bad debt cannot be de-ducted for such a loan.

Basis in bad debt required. To deducta bad debt, you must have a basis in it — thatis, you must have already included theamount in your income or loaned out your

cash. For example, you cannot claim a baddebt deduction for court-ordered child supportnot paid to you by your former spouse. If youare a cash method taxpayer (most individualsare), you generally cannot take a bad debtdeduction for unpaid salaries, wages, rents,fees, interest, dividends, and similar items.

When deductible. You can take a bad debtdeduction only in the year the debt becomesworthless. You do not have to wait until a debtis due to determine whether it is worthless.A debt becomes worthless when there is nolonger any chance that the amount owed willbe paid.

It is not necessary to go to court if you canshow that a judgment from the court wouldbe uncollectible. You must only show that youhave taken reasonable steps to collect thedebt. Bankruptcy of your debtor is generallygood evidence of the worthlessness of atleast a part of an unsecured and unpreferreddebt.

If your bad debt is the loss of a deposit ina financial institution, see Loss on deposits inan insolvent or bankrupt financial institution,earlier.

Filing a claim for refund. If you do notdeduct a bad debt on your original return forthe year it becomes worthless, you can file aclaim for a credit or refund due to the baddebt. To do this, use Form 1040X to amendyour return for the year the debt becameworthless. You must file it within 7 years fromthe date your original return for that year hadto be filed, or 2 years from the date you paidthe tax, whichever is later. (Claims not dueto bad debts or worthless securities generallymust be filed within 3 years from the date areturn is filed, or 2 years from the date the taxis paid.) For more information about filing aclaim, see Publication 556, Examination ofReturns, Appeal Rights, and Claims for Re-fund.

Loan guarantees. If you guarantee a debtthat becomes worthless, you cannot take abad debt deduction for your payments on thedebt unless you can show either that yourreason for making the guarantee was to pro-tect your investment or that you entered theguarantee transaction with a profit motive. Ifyou make the guarantee as a favor to friendsand do not receive any consideration in re-turn, your payments are considered a gift andyou cannot take a deduction.

Example 1. Henry Lloyd, an officer andprincipal shareholder of the Spruce Corpo-ration, guaranteed payment of a bank loanthe corporation received. The corporationdefaulted on the loan and Henry made fullpayment. Because he guaranteed the loan toprotect his investment in the corporation,Henry can take a nonbusiness bad debt de-duction.

Example 2. Milt and John are co-workers.Milt, as a favor to John, guarantees a noteat their local credit union. John does not paythe note and declares bankruptcy. Milt paysoff the note. However, since he did not enterinto the guarantee agreement to protect aninvestment or to make a profit, Milt cannottake a bad debt deduction.

Deductible in year paid. Unless youhave rights against the borrower, discussednext, a payment you make on a loan youguaranteed is deductible in the year youmake the payment.


Rights against the borrower. When youmake payment on a loan that you guaranteed,you may have the right to take the place ofthe lender (the right of subrogation). The debtis then owed to you. If you have this right, orsome other right to demand payment from theborrower, you cannot take a bad debt de-duction until these rights become totallyworthless.

Debts owed by political parties. You can-not take a nonbusiness bad debt deductionfor any worthless debt owed to you by:

1) A political party,

2) A national, state, or local committee ofa political party, or

3) A committee, association, or organiza-tion that either accepts contributions orspends money to influence elections.

Mechanics' and suppliers' liens. Workersand material suppliers may file liens againstproperty because of debts owed by a builderor contractor. If you pay off the lien to avoidforeclosure and loss of your property, you areentitled to repayment from the builder orcontractor. If the debt is uncollectible, youcan take a bad debt deduction.

Insolvency of contractor. You can take abad debt deduction for the amount you de-posit with a contractor if the contractor be-comes insolvent and you are unable to re-cover your deposit. If the deposit is for workunrelated to your trade or business, it is anonbusiness bad debt deduction.

Secondary liability on home mortgage. Ifthe buyer of your home assumes your mort-gage, you may remain secondarily liable forrepayment of the mortgage loan. If the buyerdefaults on the loan and the house is thensold for less than the amount outstanding onthe mortgage, you may have to make up thedifference. You can take a bad debt deductionfor the amount you pay to satisfy the mort-gage, if you cannot collect it from the buyer.

Worthless securities. If you own securitiesthat become totally worthless, you can takea deduction for a loss, but not for a bad debt.See Worthless Securities under What Is aSale or Trade, earlier in this chapter.

How to report bad debts. Deduct nonbusi-ness bad debts as short-term capital losseson Schedule D (Form 1040).

In Part I, line 1 of Schedule D, enter thename of the debtor and “statement attached”in column (a). Enter the amount of the baddebt in parentheses in column (f). Use aseparate line for each bad debt.

For each bad debt, attach a statement toyour return that contains:

1) A description of the debt, including theamount, and the date it became due,

2) The name of the debtor, and any busi-ness or family relationship between youand the debtor,

3) The efforts you made to collect the debt,and

4) Why you decided the debt wasworthless. For example, you could showthat the borrower has declared bank-ruptcy, or that legal action to collectwould probably not result in payment ofany part of the debt.

S corporation shareholder. If you are ashareholder in an S corporation, your shareof any nonbusiness bad debt will be shownon a schedule attached to your Schedule K–1(Form 1120S) that you receive from the cor-poration.

Recovery of a bad debt. If you deducted abad debt and in a later tax year you recover(collect) all or part of it, you may have to in-clude the amount you recover in your grossincome. However, you can exclude fromgross income the amount recovered up to theamount of the deduction that did not reduceyour tax in the year deducted. See Recov-eries in Publication 525.

Short Sales A short sale occurs when you agree to sellproperty you do not own (or own but do notwish to sell). You make this type of sale in twosteps.

1) You sell short. You borrow property anddeliver it to a buyer.

2) You close the sale. At a later date, youeither buy substantially identical propertyand deliver it to the lender or make de-livery out of property that you held at thetime of the sale.

You do not realize gain or loss until deliveryof property to close the short sale. You willhave a capital gain or loss if the property usedto close the short sale is a capital asset.

Exception if property becomes worthless.A different rule applies if the property soldshort becomes substantially worthless. In thatcase, you must recognize gain as if the shortsale were closed when the property becamesubstantially worthless.

Exception for constructive sales. Enteringinto a short sale may cause you to be treatedas having made a constructive sale of prop-erty. In that case, you will have to recognizegain on the date of the constructive sale. Fordetails, see Constructive Sales of Appreci-ated Financial Positions, earlier.

Example. On May 1, 2000, you bought100 shares of Baker Corporation stock for$1,000. On September 3, 2000, you soldshort 100 shares of similar Baker stock for$1,600. You made no other transactions in-volving Baker stock for the rest of 2000 andthe first 30 days of 2001. Your short sale istreated as a constructive sale of an appreci-ated financial position because a sale of yourBaker stock on the date of the short salewould have resulted in a gain. You recognizea $600 short-term capital gain from the con-structive sale and your new holding period inthe Baker stock begins on September 3.

Short-Term or Long-TermCapital Gain or LossAs a general rule, you determine whether youhave short-term or long-term capital gain orloss on a short sale by the amount of time youactually hold the property eventually deliveredto the lender to close the short sale.

Example. Even though you do not ownany stock of the Ace Corporation, you con-tract to sell 100 shares of it, which you borrowfrom your broker. After 13 months, when theprice of the stock has risen, you buy 100

shares of Ace Corporation stock and imme-diately deliver them to your broker to closeout the short sale. Your loss is a short-termcapital loss because your holding period forthe delivered property is less than one day.

Special rules. Special rules may apply toshort sales of stocks, securities, and com-modity futures (other than certain straddles).These rules limit the circumstances for treat-ing capital gain as long term and capital lossas short term by taking into account certainsubstantially identical property you held onthe date of the short sale or acquired after-wards. But if the amount of property you soldshort is more than the amount of that sub-stantially identical property, the special rulesdo not apply to the gain or loss on the excess.

Special rules for gains and holding pe-riod. If you held the substantially identicalproperty for 1 year or less on the date of theshort sale, or if you acquired the substantiallyidentical property after the short sale and bythe date of closing the short sale, then:

Rule 1. Your gain, if any, when you close theshort sale is a short-term capital gain, and

Rule 2. The holding period of the substantiallyidentical property begins on the date of theclosing of the short sale or on the date ofthe sale of this property, whichever comesfirst.

Special rule for treatment of losses. If,on the date of the short sale, you held sub-stantially identical property for more than 1year, any loss you realize on the short saleis a long-term capital loss, even if you heldthe property used to close the sale for 1 yearor less. Certain losses on short sales of stockor securities are also subject to wash saletreatment. For information, see Wash Sales,later.

Mixed straddles. Under certain elections,you can avoid the treatment of loss from ashort sale as long term under the special rule.These elections are for positions that are partof a mixed straddle. See Other elections un-der Mixed Straddles, later, for more informa-tion about these elections.

Reporting Substitute Payments If any broker transferred your securities foruse in a short sale, or similar transaction, andreceived certain substitute dividend paymentson your behalf while the short sale was open,that broker must give you a Form 1099–MISCor a similar statement, reporting the amountof these payments. Form 1099–MISC mustbe used for those substitute payments totaling$10 or more that are known on the payment'srecord date to be in lieu of an exempt-interestdividend, a capital gain dividend, a return ofcapital distribution, or a dividend subject to aforeign tax credit, or that are in lieu of tax-exempt interest. Do not treat these substitutepayments as dividends or interest. Instead,report the substitute payments shown onForm 1099–MISC as “Other income” on line21 of Form 1040.

Substitute payment. A substitute paymentmeans a payment in lieu of:

1) Tax-exempt interest (including OID) thathas accrued while the short sale wasopen, and

2) A dividend, if the ex-dividend date is af-ter the transfer of stock for use in a short


sale and before the closing of the shortsale.

Short Sale Expenses If you borrow stock to make a short sale, youmay have to remit to the lender payments inlieu of the dividends distributed while youmaintain your short position. You can deductthese payments only if you hold the short saleopen at least 46 days (more than 1 year in thecase of an extraordinary dividend as definedbelow) and you itemize your deductions.

You deduct these expenses as investmentinterest on Schedule A (Form 1040). See In-terest Expenses in chapter 3 for more infor-mation.

If you close the short sale by the 45th dayafter the date of the short sale (1 year or lessin the case of an extraordinary dividend), youcannot deduct the payment in lieu of the div-idend that you make to the lender. Instead,you must increase the basis of the stock usedto close the short sale by that amount.

To determine how long a short sale is keptopen, do not include any period during whichyou hold, have an option to buy, or are undera contractual obligation to buy substantiallyidentical stock or securities.

If your payment is made for a liquidatingdistribution or nontaxable stock distribution,or if you buy more shares equal to a stockdistribution issued on the borrowed stockduring your short position, you have a capitalexpense. You must add the payment to thecost of the stock sold short.

Exception. If you close the short sale within45 days, the deduction for amounts you payin lieu of dividends will be disallowed only tothe extent the payments are more than theamount that you receive as ordinary incomefrom the lender of the stock for the use ofcollateral with the short sale. This exceptiondoes not apply to payments in place of ex-traordinary dividends.

Extraordinary dividends. If the amount ofany dividend you receive on a share of pre-ferred stock equals or exceeds 5% (10% inthe case of other stock) of the amount real-ized on the short sale, the dividend you re-ceive is an extraordinary dividend.

Wash Sales You cannot deduct losses from sales ortrades of stock or securities in a wash sale.

A wash sale occurs when you sell or tradestock or securities at a loss and within 30days before or after the sale you:

1) Buy substantially identical stock or se-curities,

2) Acquire substantially identical stock orsecurities in a fully taxable trade, or

3) Acquire a contract or option to buy sub-stantially identical stock or securities.

If you sell stock and your spouse or a corpo-ration you control buys substantially identicalstock, you also have a wash sale.

If your loss was disallowed because of thewash sale rules, add the disallowed loss tothe cost of the new stock or securities. Theresult is your basis in the new stock or secu-rities. This adjustment postpones the lossdeduction until the disposition of the newstock or securities. Your holding period for thenew stock or securities begins on the same

day as the holding period of the stock or se-curities sold.

Example 1. You buy 100 shares of Xstock for $1,000. You sell these shares for$750 and within 30 days from the sale youbuy 100 shares of the same stock for $800.Because you bought substantially identicalstock, you cannot deduct your loss of $250on the sale. However, you add the disallowedloss ($250) to the cost of the new stock($800) to obtain your basis of the new stock,which is $1,050.

Example 2. You are an employee of acorporation that has an incentive pay plan.Under this plan, you are given 10 shares ofthe corporation's stock as a bonus award.You include the fair market value of the stockin your gross income as additional pay. Youlater sell these shares at a loss. If you receiveanother bonus award of substantially identicalstock within 30 days of the sale, you cannotdeduct your loss on the sale.

Options and futures contracts. The washsale rules apply to losses from sales or tradesof contracts and options to acquire or sellstock or securities. They do not apply tolosses from sales or trades of commodity fu-tures contracts and foreign currencies. SeeCoordination of Loss Deferral Rules andWash Sale Rules under Straddles, later, forinformation about the tax treatment of losseson the disposition of positions in a straddle.

Warrants. The wash sale rules apply ifyou sell common stock at a loss and, at thesame time, buy warrants for common stockof the same corporation. But if you sell war-rants at a loss and, at the same time, buycommon stock in the same corporation, thewash sale rules apply only if the warrants andstock are considered substantially identical,as discussed next.

Substantially identical. In determiningwhether stock or securities are substantiallyidentical, you must consider all the facts andcircumstances in your particular case. Ordi-narily, stocks or securities of one corporationare not considered substantially identical tostocks or securities of another corporation.However, they may be substantially identicalin some cases. For example, in a reorgan-ization, the stocks and securities of the pred-ecessor and successor corporations may besubstantially identical.

Similarly, bonds or preferred stock of acorporation are not ordinarily consideredsubstantially identical to the common stockof the same corporation. However, where thebonds or preferred stock are convertible intocommon stock of the same corporation, therelative values, price changes, and other cir-cumstances may make these bonds or pre-ferred stock and the common stock substan-tially identical. For example, preferred stockis substantially identical to the common stockif the preferred stock:

1) Is convertible into common stock,

2) Has the same voting rights as the com-mon stock,

3) Is subject to the same dividend re-strictions,

4) Trades at prices that do not vary signif-icantly from the conversion ratio, and

5) Is unrestricted as to convertibility.

More or less stock bought than sold. If thenumber of shares of substantially identicalstock or securities you buy within 30 daysbefore or after the sale is either more or lessthan the number of shares you sold, you mustdetermine the particular shares to which thewash sale rules apply. You do this by match-ing the shares bought with an equal numberof the shares sold. Match the shares boughtin the same order that you bought them, be-ginning with the first shares bought. Theshares or securities so matched are subjectto the wash sale rules.

Example 1. You bought 100 shares ofM stock on September 24, 1999, for $5,000.On December 21, 1999, you bought 50shares of substantially identical stock for$2,750. On December 28, 1999, you bought25 shares of substantially identical stock for$1,125. On January 4, 2000, you sold for$4,000 the 100 shares you bought in Sep-tember. You have a $1,000 loss on the sale.However, because you bought 75 shares ofsubstantially identical stock within 30 days ofthe sale, you cannot deduct the loss ($750)on 75 shares. You can deduct the loss ($250)on the other 25 shares. The basis of the 50shares bought on December 21, 1999, is in-creased by two-thirds (50 ÷ 75) of the $750disallowed loss. The new basis of thoseshares is $3,250 ($2,750 + $500). The basisof the 25 shares bought on December 28,1999, is increased by the rest of the loss to$1,375 ($1,125 + $250).

Example 2. You bought 100 shares ofM stock on September 24, 1999. On Febru-ary 1, 2000, you sold those shares at a$1,000 loss. On each of the 4 days fromFebruary 15, 2000, to February 18, 2000, youbought 50 shares of substantially identicalstock. You cannot deduct your $1,000 loss.You must add half the disallowed loss ($500)to the basis of the 50 shares bought on Feb-ruary 15. Add the other half ($500) to thebasis of the shares bought on February 16.

Loss and gain on same day. Loss from awash sale of one block of stock or securitiescannot be used to reduce any gains on iden-tical blocks sold the same day.

Example. During 1995, you bought 100shares of X stock on each of three occasions.You paid $158 a share for the first block of100 shares, $100 a share for the secondblock, and $95 a share for the third block. OnDecember 23, 2000, you sold 300 shares ofX stock for $125 a share. On January 6, 2001,you bought 250 shares of identical X stock.You cannot deduct the loss of $33 a shareon the first block because within 30 days afterthe date of sale you bought 250 identicalshares of X stock. In addition, you cannot re-duce the gain realized on the sale of thesecond and third blocks of stock by this loss.

Dealers. The wash sale rules do not applyto a dealer in stock or securities if the loss isfrom a transaction made in the ordinarycourse of business.

Short sales. The wash sale rules apply to aloss realized on a short sale if you sell, orenter into another short sale of, substantiallyidentical stock or securities within a periodbeginning 30 days before the date the shortsale is complete and ending 30 days after thatdate.


For purposes of the wash sale rules, ashort sale is considered complete on the datethe short sale is entered into, if:

1) On that date, you own stock or securitiesidentical to those sold short (or by thatdate you enter into a contract or optionto acquire that stock or those securities),and

2) You later deliver the stock or securitiesto close the short sale.

Otherwise, a short sale is not consideredcomplete until the property is delivered toclose the sale.

Example. On June 2, you buy 100 sharesof stock for $1,000. You sell short 100 sharesof the stock for $750 on October 6. On Octo-ber 7, you buy 100 shares of the same stockfor $750. You close the short sale on No-vember 17 by delivering the shares boughton June 2. You cannot deduct the $250 loss($1,000 − $750) because the date of enteringinto the short sale (October 6) is consideredthe date the sale is complete for wash salepurposes and you bought substantially iden-tical stock within 30 days from that date.

Residual Interests in a REMIC. The washsale rules generally will apply to the sale ofyour residual interest in a real estate mort-gage investment conduit (REMIC) if, duringthe period beginning 6 months before the saleof the interest and ending 6 months after thatsale, you acquire any residual interest in anyREMIC or any interest in a taxable mortgagepool that is comparable to a residual interest.REMICs are discussed in chapter 1.

How to report. Report a wash sale or tradeon line 1 or line 8 of Schedule D (Form 1040),whichever is appropriate. Show the fullamount of the loss in parentheses in column(f). On the next line, enter “Wash Sale” incolumn (a) and the amount of the loss notallowed as a positive amount in column (f).

OptionsOptions are generally subject to the rulesdescribed in this section. If the option is partof a straddle, the loss deferral rules coveredlater under Straddles may also apply. Forspecial rules that apply to nonequity optionsand dealer equity options, see Section 1256Contracts Marked to Market, earlier.

Gain or loss from the sale or trade of anoption to buy or sell property that is a capitalasset in your hands, or would be if you ac-quired it, is capital gain or loss. If the propertyis not, or would not be, a capital asset, thegain or loss is ordinary gain or loss.

Example 1. You purchased an option tobuy 100 shares of XYZ Company stock. Thestock increases in value and you sell the op-tion for more than you paid for it. Your gainis capital gain because the stock underlyingthe option would have been a capital asset inyour hands.

Example 2. The facts are the same as inExample 1, except that the stock decreasesin value and you sell the option for less thanyou paid for it. Your loss is a capital loss.

Section 1231 transactions. If you hold anoption more than 1 year to buy or sell propertythat is (or would be) used for business or toproduce rents or royalties, the gain or loss onits sale or trade is a section 1231 gain or loss.

For information on its treatment, see Section1231 Gains and Losses in chapter 3 of Pub-lication 544.

Option not exercised. If you do not exercisean option to buy or sell, and you have a loss,you are considered to have sold or traded theoption on the date that it expired.

Writer of option. If you write (grant) an op-tion, how you report your gain or loss de-pends on whether it was exercised.

If you are not in the business of writingoptions and an option you write on stocks,securities, commodities, or commodity futuresis not exercised, the amount you receive is ashort-term capital gain.

If an option requiring you to buy or sellproperty is exercised, see Writers of calls andputs, later.

Section 1256 contract options. Gain or lossis recognized on the exercise of an option ona section 1256 contract. Section 1256 con-tracts are defined under Section 1256 Con-tracts Marked to Market, earlier.

Cash settlement option. A cash settlementoption is treated as an option to buy or sellproperty. A cash settlement option is any op-tion that on exercise is settled in, or could besettled in, cash or property other than theunderlying property.

How to report. Gain or loss from the closingor expiration of an option that is not a section1256 contract, but that is a capital asset inyour hands, is reported on Schedule D (Form1040).

If an option you purchased expired, enterthe expiration date in column (c) and write“Expired” in column (d).

If an option that you wrote expired, enterthe expiration date in column (b) and write“Expired” in column (e).

Calls and Puts Calls and puts are options on securities andare covered by the rules just discussed foroptions. The following are specific applica-tions of these rules to holders and writers ofoptions that are bought, sold, or “closed out”in transactions on a national securities ex-change, such as the Chicago Board OptionsExchange. (But see Section 1256 ContractsMarked to Market, earlier, for special rulesthat may apply to nonequity options anddealer equity options.) These rules are alsopresented in Table 4–1.

Calls and puts are issued by writers(grantors) to holders for cash premiums. Theyare ended by exercise, closing transaction,or lapse.

A call option is the right to buy from thewriter of the option, at any time before aspecified future date, a stated number ofshares of stock at a specified price. Con-versely, a put option is the right to sell to thewriter, at any time before a specified futuredate, a stated number of shares at a specifiedprice.

Holders of calls and puts. If you buy a callor a put, you may not deduct its cost. It is acapital expenditure.

If you sell the call or the put before youexercise it, the difference between its costand the amount you receive for it is either along-term or short-term capital gain or loss,depending on how long you held it.

If the option expires, its cost is either along-term or short-term capital loss, depend-ing on your holding period, which ends on theexpiration date.

If you exercise a call, add its cost to thebasis of the stock you bought. If you exercisea put, reduce your amount realized on thesale of the underlying stock by the cost of theput when figuring your gain or loss. Any gainor loss on the sale of the underlying stock islong term or short term depending on yourholding period for the underlying stock.

Put option as short sale. Buying a putoption is generally treated as a short sale, andthe exercise, sale, or expiration of the put isa closing of the short sale. See Short Sales,earlier. If you have held the underlying stockfor 1 year or less at the time you buy the put,any gain on the exercise, sale, or expirationof the put is a short-term capital gain. Thesame is true if you buy the underlying stockafter you buy the put but before its exercise,sale, or expiration. Your holding period for theunderlying stock begins on the earliest of:

1) The date you dispose of the stock,

2) The date you exercise the put,

3) The date you sell the put, or

4) The date the put expires.

Writers of calls and puts. If you write(grant) a call or a put, do not include theamount you receive for writing it in your in-come at the time of receipt. Carry it in a de-ferred account until:

1) Your obligation expires,

2) You sell, in the case of a call, or buy, inthe case of a put, the underlying stockwhen the option is exercised, or

3) You engage in a closing transaction.

If your obligation expires, the amount youreceived for writing the call or put is short-term capital gain.

If a call you write is exercised and you sellthe underlying stock, increase your amountrealized on the sale of the stock by theamount you received for the call when figuringyour gain or loss. The gain or loss is long termor short term depending on your holding pe-riod of the stock.

If a put you write is exercised and you buythe underlying stock, decrease your basis inthe stock by the amount you received for theput. Your holding period for the stock beginson the date you buy it, not on the date youwrote the put.

If you enter into a closing transaction bypaying an amount equal to the value of thecall or put at the time of the payment, thedifference between the amount you pay andthe amount you receive for the call or put isa short-term capital gain or loss.

Examples of non-dealer transactions.

1) Expiration. Ten XYZ call options wereissued on April 8, 2000, for $4,000.These equity options expired in Decem-ber 2000, without being exercised. If youwere a holder (buyer) of the options, youwould recognize a short-term capital lossof $4,000 on Schedule D of your 2000return. If you were a writer of the options,you would recognize a short-term capitalgain of $4,000 on Schedule D of your2000 return.


2) Closing transaction. The facts are thesame as in (1), except that on May 10,2000, the options were sold for $6,000.If you were the seller, you would recog-nize a short-term capital gain of $2,000on Schedule D of your 2000 return. Ifyou were the writer of the options andyou bought them back, you would rec-ognize a short-term capital loss of$2,000 on Schedule D of your 2000 re-turn.

3) Exercise. The facts are the same as in(1), except that the options were exer-cised on May 27, 2000. The buyer addsthe cost of the options to the basis of thestock bought through the exercise of theoptions. The writer adds the amount re-ceived from writing the options to theamount realized from selling the stock.

4) Section 1256 contracts. The facts arethe same as in (1), except the optionswere nonequity options, subject to therules for section 1256 contracts. If youwere a buyer of the options, you wouldrecognize a short-term capital loss of$1,600, and a long-term capital loss of$2,400. If you were a writer of theoptions, you would recognize a short-term capital gain of $1,600, and a long-term capital gain of $2,400. See Section1256 Contracts Marked to Market, ear-lier, for more information.

Straddles This section discusses the loss deferral rulesthat apply to the sale or other disposition ofpositions in a straddle. These rules do notapply to the straddles described under Ex-ceptions, later.

A straddle is any set of offsetting positionson personal property. For example, a straddlemay consist of a security and a written optionto buy and a purchased option to sell on thesame number of shares of the security, withthe same exercise price and period.

Personal property. This is any property ofa type that is actively traded. It includes stockoptions and contracts to buy stock, but gen-erally does not include stock.

Straddle rules for stock. Although stockis generally excluded from the definition ofpersonal property when applying the straddlerules, it is included in the following two situ-ations.

1) The stock is part of a straddle in whichat least one of the offsetting positions iseither:

a) An option to buy or sell the stockor substantially identical stock orsecurities, or

b) A position on substantially similaror related property (other thanstock).

2) The stock is in a corporation formed oravailed of to take positions in personalproperty that offset positions taken byany shareholder.

Position. A position is an interest in personalproperty. A position can be a forward or fu-tures contract or an option.

An interest in a loan that is denominatedin a foreign currency is treated as a positionin that currency. For the straddle rules, for-

Table 4–1. Puts and Calls

Puts

When a put: If you are the holder: If you are the writer:

Is exercised

Expires

Is sold by the holder

Reduce your amount realizedfrom sale of the underlyingstock by the cost of the put.

Report the cost of the put asa capital loss.*

Report the difference betweenthe cost of the put and theamount you receive for it as acapital gain or loss.*

Reduce your basis in thestock you buy by the amountyou received for the put.

Report the amount youreceived for the put as ashort-term capital gain.

This does not affect you. (Butif you buy back the put,report the difference betweenthe amount you pay and theamount you received for theput as a short-term capitalgain or loss.)

Calls

When a call:

Add the cost of the call toyour basis in the stockpurchased.

Report the cost of the call asa capital loss on the date itexpires.*

Report the difference betweenthe cost of the call and theamount you receive for it as acapital gain or loss.*

Increase your amount realizedon sale of the stock by theamount you received for thecall.

Report the amount youreceived for the call as ashort-term capital gain.

This does not affect you. (Butif you buy back the call,report the difference betweenthe amount you pay and theamount you received for thecall as a short-term capitalgain or loss.)

If you are the holder: If you are the writer:

Is exercised

Expires

Is sold by the holder

* See Holders of calls and puts and Writers of calls and puts in the accompanying text to find whether yourgain or loss is short term or long term.

eign currency for which there is an activeinterbank market is considered to beactively-traded personal property. See alsoForeign currency contract under Section 1256Contracts Marked to Market, earlier.

Offsetting position. This is a position thatsubstantially reduces any risk of loss you mayhave from holding another position. However,if a position is part of a straddle that is not anidentified straddle (described later), do nottreat it as offsetting to a position that is partof an identified straddle.

Presumed offsetting positions. If youestablish two or more positions, an offsettingposition will be presumed under any of thefollowing conditions, unless otherwise re-butted.

1) The positions are established in thesame personal property (or in a contractfor this property), and the value of oneor more positions varies inversely withthe value of one or more of the otherpositions.

2) The positions are in the same personalproperty, even if this property is in asubstantially changed form, and the po-sitions' values vary inversely as de-scribed in the first condition.

3) The positions are in debt instrumentswith a similar maturity, and the positions'values vary inversely as described in thefirst condition.

4) The positions are sold or marketed asoffsetting positions, whether or not thepositions are called a straddle, spread,butterfly, or any similar name.

5) The aggregate margin requirement forthe positions is lower than the sum of themargin requirements for each position ifheld separately.

Related persons. To determine if two ormore positions are offsetting, you will betreated as holding any position that yourspouse holds during the same period. If youtake into account part or all of the gain or lossfor a position held by a flowthrough entity,such as a partnership or trust, you are alsoconsidered to hold that position.

Loss Deferral RulesGenerally, you can deduct a loss on the dis-position of one or more positions only to theextent that the loss is more than any unrec-ognized gain you have on offsetting positions.Unused losses are treated as sustained in thenext tax year.


Unrecognized gain. This is:

1) The amount of gain you would have hadon an open position if you had sold it onthe last business day of the tax year atits fair market value, and

2) The amount of gain realized on a posi-tion if, as of the end of the tax year, gainhas been realized, but not recognized.

Example. On July 1, 2000, you enteredinto a straddle. On December 16, 2000, youclosed one position of the straddle at a lossof $15,000. On December 31, 2000, the endof your tax year, you have an unrecognizedgain of $12,750 in the offsetting open posi-tion. On your 2000 return, your deductibleloss on the position you closed is limited to$2,250 ($15,000 − $12,750). You must carryforward to 2001 the unused loss of $12,750.

Exceptions. The loss deferral rules just de-scribed do not apply to:

1) A straddle that is an identified straddleat the end of the tax year,

2) Certain straddles consisting of qualifiedcovered call options and the stock tobe purchased under the options,

3) Hedging transactions, described ear-lier under Section 1256 ContractsMarked to Market, and

4) Straddles consisting entirely of section1256 contracts, as described earlierunder Section 1256 Contracts Marked toMarket (but see Identified straddle, next).

Identified straddle. An identified straddleis not subject to the loss deferral rules justdescribed. Instead, losses from positions inan identified straddle are deferred until youdispose of all the positions in the straddle.

Any straddle (other than a straddle de-scribed in (2) or (3) above) is an identifiedstraddle if all of the following conditions exist.

1) You clearly identified the straddle onyour records before the close of the dayon which you acquired it.

2) All of the original positions that youidentify were acquired on the same day.

3) All of the positions included in item (2)were disposed of on the same day dur-ing the tax year, or none of the positionswere disposed of by the end of the taxyear.

4) The straddle is not part of a largerstraddle.

Qualified covered call options and op-tioned stock. A straddle is not subject to theloss deferral rules for straddles if both of thefollowing are true.

1) All of the offsetting positions consist ofone or more qualified covered calloptions and the stock to be purchasedfrom you under the options.

2) The straddle is not part of a largerstraddle.

But see Special year-end rule, later, for anexception.

A qualified covered call option is any op-tion you grant to purchase stock you hold (orstock you acquire in connection with grantingthe option), but only if all of the following aretrue.

1) The option is traded on a national secu-rities exchange or other market ap-proved by the Secretary of the Treasury.

2) The option is granted more than 30 daysbefore its expiration date.

3) The option is not a deep-in-the-moneyoption.

4) You are not an options dealer whogranted the option in connection withyour activity of dealing in options.

5) Gain or loss on the option is capital gainor loss.

A deep-in-the-money option is an optionwith a strike price lower than the lowestqualified benchmark (LQB). The strike priceis the price at which the option is to be exer-cised. The LQB is the highest available strikeprice that is less than the applicable stockprice. However, the LQB for an option witha term of more than 90 days and a strike priceof more than $50 is the second highestavailable strike price that is less than the ap-plicable stock price. Strike prices are listed inthe financial section of many newspapers.

The availability of strike prices for equityoptions with flexible terms does not affect thedetermination of the LQB for an option that isnot an equity option with flexible terms.

The applicable stock price for any stockfor which an option has been granted is:

1) The closing price of the stock on themost recent day on which that stock wastraded before the date on which the op-tion was granted, or

2) The opening price of the stock on theday on which the option was granted,but only if that price is greater than 110%of the price determined in (1).

If the applicable stock price is $25 or less,the LQB will be treated as not less than 85%of the applicable stock price. If the applicablestock price is $150 or less, the LQB will betreated as not less than an amount that is $10below the applicable stock price.

Example. On May 13, 2000, you heldXYZ stock and you wrote an XYZ/Septembercall option with a strike price of $120. Theclosing price of one share of XYZ stock onMay 12, 2000, was $1301/4. The strike pricesof all XYZ/September call options offered onMay 13, 2000, were as follows: $110, $115,$120, $125, $130, and $135. Because theoption has a term of more than 90 days, theLQB is $125, the second highest strike pricethat is less than $1301/4, the applicable stockprice. The call option is a deep-in-the-moneyoption because its strike price is lower thanthe LQB. Therefore, the option is not a qual-ified covered call option, and the loss deferralrules apply if you closed out the option or thestock at a loss during the year.

Capital loss on qualified covered calloptions. If you hold stock and you write aqualified covered call option on that stock witha strike price less than the applicable stockprice, treat any loss from the option as long-term capital loss if, at the time the loss wasrealized, gain on the sale or exchange of thestock would be treated as long-term capitalgain. The holding period of the stock does notinclude any period during which you are thewriter of the option.

Special year-end rule. The loss deferralrules for straddles apply if all of the followingare true.

1) The qualified covered call options areclosed or the stock is disposed of at aloss during any tax year.

2) Gain on disposition of the stock or gainon the options is includible in gross in-come in a later tax year.

3) The stock or options were held less than30 days after the closing of the optionsor the disposition of the stock.

How To Report Gainsand Losses (Form 6781) Report each position (whether or not it is partof a straddle) on which you have unrecog-nized gain at the end of the tax year and theamount of this unrecognized gain in Part IIIof Form 6781. Use Part II of Form 6781 tofigure your gains and losses on straddlesbefore entering these amounts on ScheduleD (Form 1040). Include a copy of Form 6781with your income tax return.

Coordination of Loss DeferralRules and Wash Sale Rules Rules similar to the wash sale rules apply toany disposition of a position or positions of astraddle. First apply Rule 1, explained next,then apply Rule 2. However, Rule 1 appliesonly if stocks or securities make up a positionthat is part of the straddle. If a position in thestraddle does not include stock or securities,use Rule 2.

Rule 1. You cannot deduct a loss on thedisposition of shares of stock or securitiesthat make up the positions of a straddle if,within a period beginning 30 days before thedate of that disposition and ending 30 daysafter that date, you acquired substantiallyidentical stock or securities. Instead, the losswill be carried over to the following tax year,subject to any further application of Rule 1 inthat year. This rule will also apply if you en-tered into a contract or option to acquire thestock or securities within the time period de-scribed above. See Loss carryover, later, formore information about how to treat the lossin the following tax year.

Dealers. If you are a dealer in stock orsecurities, this loss treatment will not apply toany losses you sustained in the ordinarycourse of your business.

Example. You are not a dealer in stockor securities. On December 2, 2000, youbought stock in XX Corporation (XX stock)and an offsetting put option. On December13, 2000, there was $20 of unrealized gain inthe put option and you sold the XX stock ata $20 loss. By December 16, 2000, the valueof the put option had declined, eliminating allunrealized gain in the position. On December16, 2000, you bought a second XX stock po-sition that is substantially identical to the XXstock you sold on December 13, 2000. At theend of the year there is no unrecognized gainin the put option or in the XX stock. Underthese circumstances, the $20 loss will bedisallowed for 2000 under Rule 1 because,within a period beginning 30 days before De-cember 13, 2000, and ending 30 days afterthat date, you bought stock substantiallyidentical to the XX stock you sold.

Rule 2. You cannot deduct a loss on thedisposition of less than all of the positions ofa straddle (your loss position) to the extentthat any unrecognized gain at the close of the


tax year in one or more of the following posi-tions is more than the amount of any lossdisallowed under Rule 1:

1) Successor positions,

2) Offsetting positions to the loss position,or

3) Offsetting positions to any successorposition.

Successor position. A successor posi-tion is a position that is or was at any timeoffsetting to a second position, if both of thefollowing conditions are met.

1) The second position was offsetting to theloss position that was sold.

2) The successor position is entered intoduring a period beginning 30 days be-fore, and ending 30 days after, the saleof the loss position.

Example 1. On November 1, 2000, youentered into offsetting long and short posi-tions in non-section 1256 contracts. On No-vember 12, 2000, you disposed of the longposition at a $10 loss. On November 14,2000, you entered into a new long position(successor position) that is offsetting to theretained short position, but that is not sub-stantially identical to the long position dis-posed of on November 12, 2000. You heldboth positions through year end, at which timethere was $10 of unrecognized gain in thesuccessor long position and no unrecognizedgain in the offsetting short position. Underthese circumstances, the entire $10 loss willbe disallowed for 2000 because there is $10of unrecognized gain in the successor longposition.

Example 2. The facts are the same as inExample 1, except that at year end you have$4 of unrecognized gain in the successor longposition and $6 of unrecognized gain in theoffsetting short position. Under these circum-stances, the entire $10 loss will be disallowedfor 2000 because there is a total of $10 ofunrecognized gain in the successor long po-sition and offsetting short position.

Example 3. The facts are the same as inExample 1, except that at year end you have$8 of unrecognized gain in the successor longposition and $8 of unrecognized loss in theoffsetting short position. Under these circum-stances, $8 of the total $10 realized loss willbe disallowed for 2000 because there is $8of unrecognized gain in the successor longposition.

Loss carryover. If you have a disallowedloss that resulted from applying Rule 1 andRule 2, you must carry it over to the next taxyear and apply Rule 1 and Rule 2 to thatcarryover loss. For example, a loss disal-lowed in 1999 under Rule 1 will not be al-lowed in 2000, unless the substantially iden-tical stock or securities (which caused theloss to be disallowed in 1999) were disposedof during 2000. In addition, the carryover losswill not be allowed in 2000 if Rule 1 or Rule2 disallows it.

Example. The facts are the same as inthe example under Rule 1 above, except thaton December 31, 2001, you sell the XX stockat a $20 loss and there is $40 of unrecog-nized gain in the put option. Under these cir-cumstances, you cannot deduct in 2001 eitherthe $20 loss disallowed in 2000 or the $20

loss you incurred for the December 31, 2001,sale of XX stock. Rule 1 does not apply be-cause the substantially identical XX stock wassold during the year and no substantiallyidentical stock or securities were boughtwithin the 61–day period. However, Rule 2does apply because there is $40 of unrecog-nized gain in the put option, an offsetting po-sition to the loss positions.

Capital loss carryover. If the sale of aloss position would have resulted in a capitalloss, you treat the carryover loss as a capitalloss on the date it is allowed, even if youwould treat the gain or loss on any successorpositions as ordinary income or loss. Like-wise, if the sale of a loss position (in the caseof section 1256 contracts) would have re-sulted in a 60% long-term capital loss and a40% short-term capital loss, you treat thecarryover loss under the 60/40 rule, even ifyou would treat any gain or loss on any suc-cessor positions as 100% long-term or short-term capital gain or loss.

Exceptions. The rules for coordinatingstraddle losses and wash sales do not applyto the following loss situations.

1) Loss on the sale of one or more posi-tions in a hedging transaction. (Hedgingtransactions are described under Sec-tion 1256 Contracts Marked to Market,earlier.)

2) Loss on the sale of a loss position in amixed straddle account. (See the dis-cussion later on the mixed straddle ac-count election.)

3) Loss on the sale of a position that is partof a straddle consisting only of section1256 contracts.

Holding Period andLoss Treatment Rules The holding period of a position in a straddlegenerally begins no earlier than the date onwhich the straddle ends (the date you nolonger hold an offsetting position). This ruledoes not apply to any position you held morethan 1 year before you established thestraddle. But see Exceptions, later.

Example. On March 6, 1999, you ac-quired gold. On January 4, 2000, you enteredinto an offsetting short gold forward contract(nonregulated futures contract). On April 1,2000, you disposed of the short gold forwardcontract at no gain or loss. On April 8, 2000,you sold the gold at a gain. Because the goldhad been held for 1 year or less before theoffsetting short position was entered into, theholding period for the gold begins on April 1,2000, the date the straddle ended. Gain rec-ognized on the sale of the gold will be treatedas short-term capital gain.

Loss treatment. Treat the loss on the saleof one or more positions (the loss position)of a straddle as a long-term capital loss if bothof the following are true.

1) You held (directly or indirectly) one ormore offsetting positions to the loss po-sition on the date you entered into theloss position.

2) You would have treated all gain or losson one or more of the straddle positionsas long-term capital gain or loss if youhad sold these positions on the day youentered into the loss position.

Mixed straddles. Special rules apply toa loss position that is part of a mixed straddleand that is a non-section 1256 position. Amixed straddle is a straddle:

1) That is not part of a larger straddle,

2) In which all positions are held as capitalassets,

3) In which at least one (but not all) of thepositions is a section 1256 contract, and

4) For which the mixed straddle election(Election A, discussed later) has notbeen made.

Treat the loss as 60% long-term capital lossand 40% short-term capital loss, if all of thefollowing conditions apply.

1) Gain or loss from the sale of one or moreof the straddle positions that are section1256 contracts would be considered gainor loss from the sale or exchange of acapital asset.

2) The sale of no position in the straddle,other than a section 1256 contract,would result in a long-term capital gainor loss.

3) You have not made a straddle-by-straddle identification election (ElectionB) or mixed straddle account election(Election C), both discussed later.

Example. On March 1, 2000, you enteredinto a long gold forward contract. On July 15,2000, you entered into an offsetting short goldregulated futures contract. You did not makean election to offset gains and losses frompositions in a mixed straddle. On August 9,2000, you disposed of the long forward con-tract at a loss. Because the gold forwardcontract was part of a mixed straddle and thedisposition of this non-section 1256 positionwould not result in long-term capital loss, theloss recognized on the termination of the goldforward contract will be treated as a 60%long-term and 40% short-term capital loss.

Exceptions. The special holding period andloss treatment for straddle positions does notapply to positions that:

1) Constitute part of a hedging transaction,

2) Are included in a straddle consisting onlyof section 1256 contracts, or

3) Are included in a mixed straddle account(Election C), discussed later.

Mixed StraddlesIf you disposed of a position in a mixedstraddle and make one of the elections de-scribed in the following discussions, reportyour gain or loss as indicated in those dis-cussions. If you do not make any of theelections, report your gain or loss in Part IIof Form 6781. If you disposed of the section1256 component of the straddle, enter therecognized loss (line 10, column (h)) or yourgain (line 12, column (f)) in Part I of Form6781, on line 1. Do not include it on line 11or 13 (Part II).

Mixed straddle election (Election A). Youcan elect out of the marked to market rules,discussed under Section 1256 ContractsMarked to Market, earlier, for all section 1256contracts that are part of a mixed straddle.Instead, the gain and loss rules for straddles


will apply to these contracts. However, if youmake this election for an option on a section1256 contract, the gain or loss treatment dis-cussed earlier under Options will apply, sub-ject to the gain and loss rules for straddles.

You can make this election if:

1) At least 1 (but not all) of the positions isa section 1256 contract, and

2) Each position forming part of thestraddle is clearly identified as being partof that straddle on the day the first sec-tion 1256 contract forming part of thestraddle is acquired.

If you make this election, it will apply forall later years as well. It cannot be revokedwithout the consent of the IRS. If you madethis election, check box A of Form 6781. Donot report the section 1256 component in PartI.

Other elections. You can avoid the 60%long-term capital loss treatment required fora non-section 1256 loss position that is partof a mixed straddle, described earlier, if youchoose either of the two following electionsto offset gains and losses for these positions.

1) Election B. Make a separate identifica-tion of the positions of each mixedstraddle for which you are electing thistreatment (the straddle-by-straddle iden-tification method).

2) Election C. Establish a mixed straddleaccount for a class of activities for whichgains and losses will be recognized andoffset on a periodic basis.

These two elections are alternatives to themixed straddle election. You can choose onlyone of the three elections. Use Form 6781 toindicate your election choice by checking boxA, B, or C, whichever applies.

Straddle-by-straddle identificationelection (Election B). Under this election,you must clearly identify each position that ispart of the identified mixed straddle by theearlier of:

1) The close of the day the identified mixedstraddle is established, or

2) The time the position is disposed of.

If you dispose of a position in the mixedstraddle before the end of the day on whichthe straddle is established, this identificationmust be made by the time you dispose of theposition. You are presumed to have properlyidentified a mixed straddle if independentverification is used.

The basic tax treatment of gain or lossunder this election depends on which side ofthe straddle produced the total net gain orloss. If the net gain or loss from the straddleis due to the section 1256 contracts, gain orloss is treated as 60% long-term capital gainor loss and 40% short-term capital gain orloss. Enter the net gain or loss in Part I ofForm 6781 and identify the election bychecking box B.

If the net gain or loss is due to the non-section 1256 positions, gain or loss is short-term capital gain or loss. Enter the net gainor loss on Part I of Schedule D and identifythe election.

For the specific application of the rules ofthis election, see regulations section1.1092(b)–3T.

Example. On April 1, you entered into anon-section 1256 position and an offsettingsection 1256 contract. You also made a validelection to treat this straddle as an identifiedmixed straddle. On April 8, you disposed ofthe non-section 1256 position at a $600 lossand the section 1256 contract at an $800gain. Under these circumstances, the $600loss on the non-section 1256 position will beoffset against the $800 gain on the section1256 contract. The net gain of $200 from thestraddle will be treated as 60% long-termcapital gain and 40% short-term capital gainbecause it is due to the section 1256 contract.

Mixed straddle account (Election C).A mixed straddle account is an account fordetermining gains and losses from all posi-tions held as capital assets in a designatedclass of activities at the time you elected toestablish the account. You must establish aseparate mixed straddle account for eachseparate designated class of activities.

Generally, you must determine gain orloss for each position in a mixed straddle ac-count as of the close of each business dayof the tax year. You offset the net section1256 contracts against the net non-section1256 positions to determine the “daily accountnet gain or loss.”

If the daily account amount is due to non-section 1256 positions, the amount is treatedas short-term capital gain or loss. If the dailyaccount amount is due to section 1256 con-tracts, the amount is treated as 60% long-term and 40% short-term capital gain or loss.

On the last business day of the tax year,you determine the “annual account net gainor loss” for each account by netting the dailyaccount amounts for that account for the taxyear. The “total annual account net gain orloss” is determined by netting the annual ac-count amounts for all mixed straddle accountsthat you had established.

The net amounts keep their long-term orshort-term classification. However, no morethan 50% of the total annual account net gainfor the tax year can be treated as long-termcapital gain. Any remaining gain is treated asshort-term capital gain. Also, no more than40% of the total annual account net loss canbe treated as short-term capital loss. Any re-maining loss is treated as long-term capitalloss.

The election to establish one or moremixed straddle accounts for each tax yearmust be made by the due date (without ex-tensions) of your income tax return for theimmediately preceding tax year. If you begintrading in a new class of activities during a taxyear, you must make the election for the newclass of activities by the later of either:

1) The due date of your return for the im-mediately preceding tax year (withoutextensions), or

2) 60 days after you entered into the firstmixed straddle in the new class of activ-ities.

You make the election on Form 6781 bychecking box C. Attach Form 6781 to yourincome tax return for the immediately pre-ceding tax year, or file it within 60 days, if thatapplies. Report the annual account net gainor loss from a mixed straddle account in PartII of Form 6781. In addition, you must attacha statement to Form 6781 specifically desig-nating the class of activities for which a mixedstraddle account is established.

For the specific application of the rules ofthis election, see regulations section1.1092(b)–4T.

Interest expense and carrying chargesrelating to mixed straddle account posi-tions. You cannot deduct interest and car-rying charges that are allocable to any posi-tions held in a mixed straddle account. Treatthese charges as an adjustment to the annualaccount net gain or loss and allocate themproportionately between the net short-termand the net long-term capital gains or losses.

To find the amount of interest and carryingcharges that is not deductible and that mustbe added to the annual account net gain orloss, apply the rules described in chapter 3under Interest expense and carrying chargeson straddles to the positions held in the mixedstraddle account.

Rollover of GainFrom PubliclyTraded SecuritiesYou may qualify for a tax-free rollover of cer-tain gains from the sale of publicly tradedsecurities. This means that if you buy certainreplacement property and make the choicedescribed in this section, you postpone partor all of your gain.

You postpone the gain by adjusting thebasis of the replacement property as de-scribed in Basis of replacement property,later. This postpones your gain until the yearyou dispose of the replacement property.

You qualify to make this choice if you meetall the following tests.

1) You sell publicly traded securities at again. Publicly traded securities are se-curities traded on an established securi-ties market.

2) Your gain from the sale is a capital gain.

3) During the 60-day period beginning onthe date of the sale, you buy replace-ment property. This replacement prop-erty must be either common stock or apartnership interest in a specializedsmall business investment company(SSBIC). This is any partnership or cor-poration licensed by the Small BusinessAdministration under section 301(d) ofthe Small Business Investment Act of1958, as in effect on May 13, 1993.

Amount of gain recognized. If you makethe choice described in this section, you mustrecognize gain only up to the followingamount:

1) The amount realized on the sale, minus

2) The cost of any common stock or part-nership interest in an SSBIC that youbought during the 60-day period begin-ning on the date of sale (and did notpreviously take into account on an earliersale of publicly traded securities).

If this amount is less than the amount of yourgain, you can postpone the rest of your gain,subject to the limit described next. If thisamount is equal to or more than the amountof your gain, you must recognize the fullamount of your gain.

Limit on gain postponed. The amountof gain you can postpone each year is limitedto the smaller of:


1) $50,000 ($25,000 if you are married andfile a separate return), or

2) $500,000 ($250,000 if you are marriedand file a separate return), minus theamount of gain you postponed for allearlier years.

Basis of replacement property. You mustsubtract the amount of postponed gain fromthe basis of your replacement property.

How to report and postpone gain. Reportthe entire gain realized from the sale on line1 or line 8 of Schedule D (Form 1040),whichever is appropriate. To make the choiceto postpone gain, enter “SSBIC Rollover” incolumn (a) of the line directly below the lineon which you reported the gain. Enter theamount of gain postponed in column (f). Enterit as a loss (in parentheses).

Your choice is revocable with the consentof the IRS.

For more information on how to postponegain, see the Schedule D (Form 1040) in-structions.

Gains on QualifiedSmall Business StockThis section discusses two provisions of thelaw that may apply to gain from the sale ortrade of qualified small business stock. Youmay qualify for a tax-free rollover of all orpart of the gain. You may be able to excludepart of the gain from your income.

Qualified small business stock. This isstock that meets all the following tests.

1) It must be stock in a C corporation.

2) It must have been originally issued afterAugust 10, 1993.

3) As of the date the stock was issued, thecorporation must have been a qualifiedsmall business, defined later.

4) You must have acquired the stock at itsoriginal issue, directly or through anunderwriter, in exchange for money orother property (not including stock), oras pay for services provided to the cor-poration (other than services performedas an underwriter of the stock). In certaincases, your stock may also meet this testif you acquired it from another personwho met this test, or through a conver-sion or trade of qualified small businessstock that you held.

5) The corporation must have met the ac-tive business test, defined later, andmust have been a C corporation duringsubstantially all the time you held thestock.

6) Within the period beginning 2 years be-fore and ending 2 years after the stockwas issued, the corporation cannot havebought more than a de minimis amountof its stock from you or a related party.

7) Within the period beginning 1 year be-fore and ending 1 year after the stockwas issued, the corporation cannot havebought more than a de minimis amountof its stock from anyone, unless the totalvalue of the stock it bought is 5% or lessof the total value of all its stock.

For more information about tests 6 and 7, seethe regulations under section 1202 of theInternal Revenue Code.

Qualified small business. This is a C cor-poration with total gross assets of $50 millionor less at all times after August 9, 1993, andbefore it issued the stock. The corporation'stotal gross assets immediately after it issuedthe stock must also be $50 million or less.

When figuring the corporation's total grossassets, you must also count the assets of anypredecessor of the corporation. In addition,you must treat all corporations that aremembers of the same parent-subsidiary con-trolled group as one corporation.

Active business test. A corporation meetsthis test for any period of time if, during thatperiod, both the following are true.

1) It was an eligible corporation, definedbelow.

2) It used at least 80% (by value) of its as-sets in the active conduct of at least onequalified trade or business, definedbelow.

Exception for SSBIC. Any specializedsmall business investment company (SSBIC)is treated as meeting the active business test.An SSBIC is an eligible corporation that is li-censed to operate under section 301(d) of theSmall Business Investment Act of 1958 as ineffect on May 13, 1993.

Eligible corporation. This is any U.S.corporation other than:

1) A Domestic International Sales Corpo-ration (DISC) or a former DISC,

2) A corporation that has made, or whosesubsidiary has made, an election undersection 936 of the Internal RevenueCode, concerning the Puerto Rico andpossession tax credit,

3) A regulated investment company,

4) A real estate investment trust (REIT),

5) A real estate mortgage investmentconduit (REMIC),

6) A financial asset securitization invest-ment trust (FASIT), or

7) A cooperative.

Qualified trade or business. This is anytrade or business other than:

1) One involving services performed in thefields of health, law, engineering, archi-tecture, accounting, actuarial science,performing arts, consulting, athletics, fi-nancial services, or brokerage services,

2) One whose principal asset is the repu-tation or skill of one or more employees,

3) Any banking, insurance, financing, leas-ing, investing, or similar business,

4) Any farming business (including thebusiness of raising or harvesting trees),

5) Any business involving the productionor extraction of products for which per-centage depletion can be claimed, or

6) Any business of operating a hotel, motel,restaurant, or similar business.

Section 1045 Rollover You may qualify for a tax-free rollover ofcapital gain from the sale of qualified smallbusiness stock held more than 6 months. Thismeans that, if you buy certain replacementstock and make the choice described in thissection, you postpone part or all of your gain.

You postpone the gain by adjusting thebasis of the replacement stock as describedin Basis of replacement stock, below. Thispostpones your gain until the year you dis-pose of the replacement stock.

You can make this choice if you meet allthe following tests.

1) You buy replacement stock during the60-day period beginning on the date ofthe sale.

2) The replacement stock is qualified smallbusiness stock.

3) The replacement stock continues tomeet the active business requirement forsmall business stock for at least the first6 months after you buy it.

Amount of gain recognized. If you makethe choice described in this section, you mustrecognize the capital gain only up to the fol-lowing amount:

1) The amount realized on the sale, minus

2) The cost of any qualified small businessstock you bought during the 60-day pe-riod beginning on the date of sale (anddid not previously take into account onan earlier sale of qualified small businessstock).

If this amount is less than the amount of yourcapital gain, you can postpone the rest of thatgain. If this amount equals or is more than theamount of your capital gain, you must recog-nize the full amount of your gain.

Basis of replacement stock. You mustsubtract the amount of postponed gain fromthe basis of your replacement stock.

Holding period of replacement stock. Yourholding period for the replacement stock in-cludes your holding period for the stock sold,except for the purpose of applying the6-month holding period requirement forchoosing to roll over the gain on its sale.

How to report gain. Report the entire gainrealized from the sale on line 1 or line 8 ofSchedule D (Form 1040), whichever is ap-propriate. To make the choice to postponethe gain, enter “Section 1045 Rollover” incolumn (a) of the line directly below the lineon which you reported the gain. Enter theamount of gain postponed in column (f). En-ter it as a loss (in parentheses).

Section 1202 ExclusionYou generally can exclude from your incomeone-half of your gain from the sale or tradeof qualified small business stock held by youfor more than 5 years. The taxable part ofyour gain equal to your section 1202 exclu-sion is a 28% rate gain. See Capital Gain TaxRates, later.

SSBIC stock. If the stock is specialized smallbusiness investment company (SSBIC) stockthat you bought as replacement property forpublicly traded securities you sold at a gain,you must reduce the basis of the stock by the


amount of any postponed gain on that earliersale, as explained earlier under Rollover ofGain From Publicly Traded Securities. But donot reduce your basis by that amount whenfiguring your section 1202 exclusion.

Limit on eligible gain. The amount of yourgain from the stock of any one issuer that iseligible for the exclusion in 2000 is limited tothe greater of:

1) Ten times your basis in all qualified stockof the issuer that you sold or exchangedduring the year, or

2) $10 million ($5 million for married indi-viduals filing separately) minus theamount of gain from the stock of thesame issuer that you used to figure yourexclusion in earlier years.

How to report gain. Report the entire gainrealized from the sale in column (f) of line 8of Schedule D (Form 1040). Report anamount equal to the excluded gain in column(g). Directly below the line on which you re-port the gain, enter “Section 1202 exclusion”in column (a) and enter the amount of theexclusion in column (f). Enter it as a loss (inparentheses).

More information. For information about ad-ditional requirements that may apply, seesection 1202 of the Internal Revenue Code.

Reporting CapitalGains and LossesThis section discusses how to report yourcapital gains and losses on Schedule D (Form1040). Enter your sales and trades of stocks,bonds, etc., and real estate (if not required tobe reported on another form) on line 1 of PartI or line 8 of Part II, as appropriate. Includeall these transactions even if you did not re-ceive a Form 1099–B or 1099–S (or substi-tute statement). You can use Schedule D–1as a continuation schedule to report moretransactions.

Be sure to add all sales price entries incolumn (d) on lines 1 and 2 and lines 8 and9 and enter the totals on lines 3 and 10. Thenadd the following amounts reported to you for2000 on Forms 1099–B and Forms 1099–S(or on substitute statements):

1) Proceeds from transactions involvingstocks, bonds, and other securities, and

2) Gross proceeds from real estate trans-actions (other than the sale of your mainhome if you had no taxable gain) notreported on another form or schedule.

If this total is more than the total of lines 3 and10, attach a statement to your return ex-plaining the difference.

Installment sales. If you will receive any ofthe proceeds from the sale of your investmentproperty after the year of sale, you may havean installment sale. Generally, you report gainfrom an installment sale using the installmentmethod. Under this method, you report partof the gain each year that you receive a pay-ment. For information, see Publication 537,Installment Sales.

Stock or securities. You cannot use theinstallment method to report a gain from thesale of stock or securities traded on an es-

tablished securities market. You must reportthe entire gain in the year of sale (the year inwhich the trade date occurs).

At-risk rules. Special at-risk rules apply tomost income-producing activities. Theserules limit the amount of loss you can deductto the amount you risk losing in the activity.The at-risk rules also apply to a loss from thesale or trade of an asset used in an activityto which the at-risk rules apply. For more in-formation, see Publication 925, Passive Ac-tivity and At-Risk Rules. Use Form 6198, At-Risk Limitations, to figure the amount of lossyou can deduct.

Passive activity gains and losses. If youhave gains or losses from a passive activity,you may also have to report them on Form8582. In some cases, the loss may be limitedunder the passive activity rules. Refer to Form8582 and its separate instructions for moreinformation about reporting capital gains andlosses from a passive activity.

Form 1099–B transactions. If you soldproperty, such as stocks, bonds, or certaincommodities, through a broker, you shouldreceive Form 1099–B or an equivalent state-ment from the broker. Use the Form 1099–Bor equivalent statement to complete ScheduleD.

Report the gross proceeds shown in box2 of Form 1099–B as the gross sales pricein column (d) of either line 1 or line 8 ofSchedule D, whichever applies. However, ifthe broker advises you, in box 2 of Form1099–B, that gross proceeds (gross salesprice) less commissions and option premiumswere reported to the IRS, enter that net salesprice in column (d) of either line 1 or line 8of Schedule D, whichever applies.

If the net amount is entered in column (d),do not include the commissions and optionpremiums in column (e).

Section 1256 contracts and straddles.Use Form 6781 to report gains and lossesfrom section 1256 contracts and straddlesbefore entering these amounts on ScheduleD. Include a copy of Form 6781 with yourincome tax return.

Market discount bonds. Report the saleor trade of a market discount bond onSchedule D (Form 1040), line 1 or line 8. Ifthe sale or trade results in a gain and you didnot choose to include market discount in in-come currently, enter “Accrued Market Dis-count” on the next line in column (a) and theamount of the accrued market discount as aloss in column (f). Also report the amount ofaccrued market discount as interest incomeon Schedule B (Form 1040), line 1, andidentify it as “Accrued Market Discount.”

Form 1099–S transactions. If you sold ortraded reportable real estate, you generallyshould receive from the real estate reportingperson a Form 1099–S, Proceeds From RealEstate Transactions, showing the gross pro-ceeds.

“Reportable real estate” is defined as anypresent or future ownership interest in any ofthe following:

1) Improved or unimproved land, includingair space,

2) Inherently permanent structures, includ-ing any residential, commercial, or in-dustrial building,

3) A condominium unit and its accessoryfixtures and common elements, includingland, and

4) Stock in a cooperative housing corpo-ration (as defined in section 216 of theInternal Revenue Code).

A “real estate reporting person” could in-clude the buyer's attorney, your attorney, thetitle or escrow company, a mortgage lender,your broker, the buyer's broker, or the personacquiring the biggest interest in the property.

Your Form 1099–S will show the grossproceeds from the sale or exchange in box2. Follow the instructions for Schedule D toreport these transactions, and include themon line 1 or 8 as appropriate.

It is unlawful for any real estate reportingperson to separately charge you for comply-ing with the requirement to file Form 1099–S.

Sale of property bought at various times.If you sell a block of stock or other propertythat you bought at various times, report theshort-term gain or loss from the sale on oneline in Part I of Schedule D and the long-termgain or loss on one line in Part II. Write “Var-ious” in column (b) for the “Date acquired.”See the Comprehensive Example later in thischapter.

Sale expenses. Add to your cost or otherbasis any expense of sale such as broker'sfees, commissions, state and local transfertaxes, and option premiums. Enter this ad-justed amount in column (e) of either Part Ior Part II of Schedule D, whichever applies,unless you reported the net sales priceamount in column (d).

Short-term gains and losses. Capital gainor loss on the sale or trade of investmentproperty held 1 year or less is a short-termcapital gain or loss. You report it in Part I ofSchedule D. If the amount you report in col-umn (f) is a loss, show it in parentheses.

You combine your share of short-termcapital gain or loss from partnerships, S cor-porations, and fiduciaries, and any short-termcapital loss carryover, with your other short-term capital gains and losses to figure yournet short-term capital gain or loss on line 7of Schedule D.

Long-term gains and losses. A capital gainor loss on the sale or trade of investmentproperty held more than 1 year is a long-termcapital gain or loss. You report it in Part II ofSchedule D. If the amount you report in col-umn (f) is a loss, show it in parentheses.

You also report the following in Part II ofSchedule D:

1) Undistributed long-term capital gainsfrom a regulated investment company(mutual fund) or real estate investmenttrust (REIT),

2) Your share of long-term capital gains orlosses from partnerships, S corporations,and fiduciaries,

3) All capital gain distributions from mutualfunds and REITs not reported directly online 10 of Form 1040A or line 13 of Form1040, and

4) Long-term capital loss carryovers.

The result after combining these itemswith your other long-term capital gains and


losses is your net long-term capital gain orloss (line 16 of Schedule D).

28% rate gain or loss. Enter in column(g) the amount, if any, from column (f) that isa 28% rate gain or loss. Enter any loss inparentheses.

A 28% rate gain or loss is:

• Any collectibles gain or loss, or

• The part of your gain on qualified smallbusiness stock that is equal to the section1202 exclusion.

For more information, see Capital Gain TaxRates, later.

Capital gain distributions only. You donot have to file Schedule D if all of the fol-lowing are true.

1) The only amounts you would have toreport on Schedule D are capital gaindistributions from box 2a of Form1099–DIV (or substitute statement).

2) You do not have an amount in box 2b,2c, or 2d of any Form 1099–DIV (orsubstitute statement).

3) You do not file Form 4952 or, if you do,the amount on line 4e of that form is notmore than zero.

If all the above statements are true, reportyour capital gain distributions directly on line13 of Form 1040 and check the box on thatline. Also, use the Capital Gain Tax Work-sheet in the Form 1040 instructions to figureyour tax.

You can report your capital gain distribu-tions on line 10 of Form 1040A, instead of onForm 1040, if both of the following are true.

1) None of the Forms 1099–DIV (or substi-tute statements) you received have anamount in box 2b, 2c, or 2d.

2) You do not have to file Form 1040 forany other reason. (For example, youmust not have any other capital gainsor any capital losses.)

Total net gain or loss. To figure your totalnet gain or loss, combine your net short-termcapital gain or loss (line 7) with your netlong-term capital gain or loss (line 16). Enterthe result on line 17, Part III of Schedule D.If your losses are more than your gains, seeCapital Losses, next. If both lines 16 and 17are gains and line 39 of Form 1040 is morethan zero, see Capital Gain Tax Rates, later.

Capital Losses If your capital losses are more than yourcapital gains, you can claim a capital lossdeduction. Report the deduction on line 13of Form 1040, enclosed in parentheses.

Limit on deduction. Your allowable capitalloss deduction, figured on Schedule D, is thelesser of:

1) $3,000 ($1,500 if you are married andfile a separate return), or

2) Your total net loss as shown on line 17of Schedule D.

You can use your total net loss to reduce yourincome dollar for dollar, up to the $3,000 limit.

Capital loss carryover. If you have a totalnet loss on line 17 of Schedule D that is morethan the yearly limit on capital loss de-ductions, you can carry over the unused partto the next year and treat it as if you had in-curred it in that next year. If part of the lossis still unused, you can carry it over to lateryears until it is completely used up.

When you figure the amount of any capitalloss carryover to the next year, you must takethe current year's allowable deduction intoaccount, whether or not you claimed it.

When you carry over a loss, it remainslong term or short term. A long-term capitalloss you carry over to the next tax year willreduce that year's long-term capital gainsbefore it reduces that year's short-term capitalgains.

Figuring your carryover. The amountof your capital loss carryover is the amountof your total net loss that is more than thelesser of:

1) Your allowable capital loss deduction forthe year, or

2) Your taxable income increased by yourallowable capital loss deduction for theyear and your deduction for personalexemptions.

If your deductions are more than yourgross income for the tax year, use your neg-ative taxable income in computing the amountin item (2).

Complete the Capital Loss CarryoverWorksheet in the Schedule D (Form 1040)instructions to determine the part of yourcapital loss for 2000 that you can carry overto 2001.

Example. Bob and Gloria sold securitiesin 2000. The sales resulted in a capital lossof $7,000. They had no other capital trans-actions. Their taxable income was $26,000.On their joint 2000 return, they can deduct$3,000. The unused part of the loss, $4,000($7,000 − $3,000), can be carried over to2001.

If their capital loss had been $2,000, theircapital loss deduction would have been$2,000. They would have no carryover to2001.

Use short-term losses first. When youfigure your capital loss carryover, use yourshort-term capital losses first, even if you in-curred them after a long-term capital loss. Ifyou have not reached the limit on the capitalloss deduction after using the short-termcapital loss, use the long-term capital lossesuntil you reach the limit.

Decedent's capital loss. A capital losssustained by a decedent during his or her lasttax year (or carried over to that year from anearlier year) can be deducted only on the finalreturn filed for the decedent. The capital losslimits discussed earlier still apply in this situ-ation. The decedent's estate cannot deductany of the loss or carry it over to followingyears.

Joint and separate returns. If you andyour spouse once filed separate returns andare now filing a joint return, combine yourseparate capital loss carryovers. However, ifyou and your spouse once filed a joint returnand are now filing separate returns, any cap-ital loss carryover from the joint return can bededucted only on the return of the spousewho actually had the loss.

Capital Gain Tax Rates The 31%, 36%, and 39.6% income tax ratesfor individuals do not apply to a net capitalgain. In most cases, the 15% and 28% ratesdo not apply either. Instead, your net capitalgain is taxed at a lower capital gain rate.

The term “net capital gain” means theamount by which your net long-term capitalgain for the year is more than your net short-term capital loss.

The capital gain rate may be 10%, 20%,25%, or 28%, or a combination of those rates,as shown in Table 4–2.

The capital gain rate does not apply if it ishigher than your regular tax rate.

Example. You have a net capital gainfrom selling collectibles, so the capital gainrate on the gain would be 28%. Because youare single and your taxable income is$25,000, your regular tax rate is 15%. All yourtaxable income will be taxed at the 15% rate.The 28% rate does not apply.

Investment interest deducted. If you claima deduction for investment interest, you mayhave to reduce the amount of your net capitalgain that is eligible for the capital gain taxrates. Reduce it by the amount of the netcapital gain you choose to include in invest-ment income when figuring the limit on yourinvestment interest deduction. This is doneon lines 20–22 of Schedule D. For more in-formation about the limit on investment inter-est, see Interest Expenses in chapter 3.

Using the Capital Gain RatesThe part of a net capital gain that is subjectto each rate is determined under the followingrules.

1) In each of the following groups, long-term capital gains are netted with long-term capital losses.

a) A 28% group, consisting of collect-ibles gains and losses, gain onqualified small business stock equalto the section 1202 exclusion, andlong-term capital loss carryovers.

b) A 25% group, consisting ofunrecaptured section 1250 gain.

c) A 20% group, consisting of gainsand losses that are not in the 28%or 25% group.

2) A net short-term capital loss reduces anynet gain from the 28% group, then anygain from the 25% group, and finally anynet gain from the 20% group.

3) A net loss from the 28% group reducesany gain from the 25% group, and thenany net gain from the 20% group.

4) A net loss from the 20% group reducesany net gain from the 28% group, andthen any gain from the 25% group.

Collectibles gain or loss. This is gain orloss from the sale or trade of a work of art,rug, antique, metal (such as gold, silver, andplatinum bullion), gem, stamp, coin, or alco-holic beverage held more than 1 year.

Collectibles gain includes gain from thesale of an interest in a partnership, S corpo-ration, or trust attributable to unrealized ap-preciation of collectibles.


Table 4–2. What Is Your Capital Gain Tax Rate?

IF your net capital gain is from. . .

Collectibles gain

1 15%, if your regular tax rate is 15%.

THEN your capital gain rate is . . .

28%1

Gain on qualified small business stock equal to the section 1202exclusion

28%1

Unrecaptured section 1250 gain

Other gain, and your regular tax rate is 28% or higher

25%1

20%

10%2Other gain, and your regular tax rate is 15%

2 The 10% rate applies only to the part of your net capital gain that would be taxed at 15% if there were no capital gain rates.

Gain on qualified small business stock. Ifyou realized a gain from qualified small busi-ness stock that you held more than 5 years,you generally can exclude one-half of yourgain from your income. The taxable part ofyour gain equal to your section 1202 exclu-sion is a 28% rate gain. See Gains on Qual-ified Small Business Stock, earlier in thischapter.

Unrecaptured section 1250 gain. Gener-ally, this is any part of your capital gain fromselling section 1250 property (real property)that is due to depreciation (but not more thanyour net section 1231 gain), reduced by anynet loss in the 28% group. Use the worksheetin the Schedule D instructions to figure yourunrecaptured section 1250 gain. For moreinformation about section 1250 property andsection 1231 gain, see chapter 3 of Publica-tion 544.

Using Schedule D. You apply these rulesby using Part IV of Schedule D (Form 1040)to figure your tax.

You will need to use Part IV if both of thefollowing are true.

1) You have a net capital gain. You havea net capital gain if both lines 16 and 17of Schedule D are gains. (Line 16 is yournet long-term capital gain or loss. Line17 is your net long-term capital gain orloss combined with any net short-termcapital gain or loss.)

2) Your taxable income on Form 1040, line39, is more than zero.

See the Comprehensive Example, later,for an example of how to figure your tax onSchedule D using the capital gain rates.

Using Capital Gain Tax Worksheet. Ifyou have capital gain distributions but do nothave to file Schedule D (Form 1040), figureyour tax using the Capital Gain Tax Work-sheet in the instructions for Form 1040A orForm 1040, whichever you file. For more in-formation, see Capital gain distributions only,earlier.

Alternative minimum tax. These capitalgain rates are also used in figuring alternativeminimum tax.

Changes for Years After 2000After 2000, there will be changes in the capitalgain rates.

2001. Beginning in the year 2001, the 10%capital gain rate will be lowered to 8% for“qualified 5-year gain.”

2006. Beginning in the year 2006, the 20%capital gain rate will be lowered to 18% forqualified 5-year gain from property with aholding period that begins after 2000.

Taxpayers who own certain stock on Jan-uary 1, 2001, can choose to treat the stockas sold and repurchased on January 2, 2001,if they pay tax for 2001 on any resulting gain.

Qualified 5-year gain. This is long-termcapital gain from the sale of property that youheld for more than 5 years and that wouldotherwise be subject to the 10% or 20%capital gain rate.

Comprehensive ExampleEmily Jones is single and, in addition towages from her job, she has income fromstocks and other securities. For the 2000 taxyear, she had the following capital gains andlosses, which she reports on Schedule D. Herfilled-in Schedule D is shown at the end of thisexample.

Capital gains and losses—Schedule D.Emily sold stock in two different companiesthat she held for less than a year. In June,she sold 100 shares of Trucking Co. stockthat she had bought in February. She had anadjusted basis of $1,150 in the stock and soldit for $400, for a loss of $750. In July, she sold25 shares of Computer Co. stock that shebought in June. She had an adjusted basis inthe stock of $2,000 and sold it for $2,500, fora gain of $500. She reports these short-termtransactions on line 1 in Part I of ScheduleD.

Emily had three other stock sales that shereports as long-term transactions on line 8 inPart II of Schedule D. In February, she sold60 shares of Car Co. for $2,100. She had in-herited the Car stock from her father. Its fairmarket value at the time of his death was$2,500, which became her basis. Her losson the sale is $400. Because she had inher-ited the stock, her loss is a long-term loss,regardless of how long she and her fatheractually held the stock. She enters the loss incolumn (f) of line 8.

In June, she sold 500 shares of FurnitureCo. stock for $5,000. She had bought 100 ofthose shares in 1989, for $1,000. She hadbought 100 more shares in 1991 for $2,200,and an additional 300 shares in 1993 for$1,500. Her total basis in the stock is $4,700.She has a $300 ($5,000 − $4,700) gain onthis sale, which she enters in column (f) of line8.

In December, she sold 20 shares of ToyCo. stock for $4,100. This was qualified smallbusiness stock that she had bought in Sep-tember 1995. Her basis is $1,100, so she has

a $3,000 gain, which she enters in column (f)of line 8. Because she held the stock morethan 5 years, she has a $1,500 section 1202exclusion. She enters that amount in column(g) as a 28% rate gain and claims the exclu-sion on the line below by entering $1,500 asa loss in column (f).

She received a Form 1099–B (not shown)from her broker for each of these trans-actions. The entries shown in box 2 of theseforms total $14,100.

Reconciliation of Forms 1099–B. Emilymakes sure that the total of the amounts re-ported in column (d) of lines 3 and 10 ofSchedule D is not less than the total of theamounts shown on the Forms 1099–B shereceived from her broker. For 2000, the totalof lines 3 and 10 of Schedule D is $14,100,which is the same amount reported by thebroker on Forms 1099–B.

Form 6781. During 2000, Emily had arealized loss from a regulated futures contractof $11,000. She also had an unrealizedmarked to market gain on open contracts of$27,000 at the end of 2000. She had reportedan unrealized marked to market gain of$1,000 on her 1999 tax return. (This $1,000must be subtracted from her 2000 profit.)These amounts are shown in boxes 6, 7, and8 of the Form 1099–B she received from herbroker. Box 9 shows her combined profit of$15,000 ($27,000 − $1,000 − $11,000). Shereports this gain in Part I of Form 6781 (notshown). She shows 40% as short-term gainon line 4 of Schedule D and 60% as long-termgain on line 11 of Schedule D.

The Form 1099–B that Emily receivedfrom her broker, XYZ Trading Co., is shownlater.

Capital loss carryover from 1999. Emilyhas a capital loss carryover to 2000 of $800,of which $300 is short-term capital loss, and$500 is long-term capital loss. She entersthese amounts on lines 6 and 14 of ScheduleD.

She kept the completed Capital LossCarryover Worksheet in her 1999 ScheduleD instructions (not shown), so she couldproperly report her loss carryover for the 2000tax year without refiguring it.

Tax computation. Because Emily has gainson both lines 16 and 17 of Schedule D andhas taxable income, she uses Part IV ofSchedule D to figure her tax. After enteringthe gain from line 17 on line 13 of her Form1040, she completes the rest of Form 1040through line 39. She enters the amount fromthat line, $30,000, on line 19 of Schedule D.After filling out the rest of Part IV, she figuresher tax is $4,434. This is less than the tax shewould have figured without using Part IV ofSchedule D, $4,995.


Emily Jones 111 00 1111

100 shTrucking Co.25 shComputer Co.

2-12-00

6-29-00

6-12-00

7-30-00

400

2,500

1,150

2,000 500

2,900

6,000

300

60 shCar Co.500 shFurniture Co.20 shToy Co.

INHERITED

VARIOUS

9-20-95

2-3-00

6-29-00

12-15-00

2,100

5,000

4,100

11,200

2,500

4,700

1,100

300

500

1,500

(750)

5,450

(400)

3,000

9,000

500

9,900

1,000

Section 1202exclusion (1,500)

*28% rate gain or loss includes all “collectibles gains and losses” (as defined on page D-6) and up to 50% of the eligible gainon qualified small business stock (see page D-4).

OMB No. 1545-0074SCHEDULE D Capital Gains and Losses(Form 1040)

� Attach to Form 1040. � See Instructions for Schedule D (Form 1040).Department of the TreasuryInternal Revenue Service

AttachmentSequence No. 12� Use Schedule D-1 for more space to list transactions for lines 1 and 8.

Your social security numberName(s) shown on Form 1040

Short-Term Capital Gains and Losses—Assets Held One Year or Less(f) Gain or (loss)

Subtract (e) from (d)

(e) Cost orother basis

(see page D-6)

(a) Description of property(Example: 100 sh. XYZ Co.)

(d) Sales price(see page D-6)

(c) Date sold(Mo., day, yr.)

1

Enter your short-term totals, if any, fromSchedule D-1, line 2

2

Total short-term sales price amounts.Add column (d) of lines 1 and 2

33

5

Short-term gain from Form 6252 and short-term gain or (loss) from Forms 4684,6781, and 8824

5

66

Net short-term gain or (loss) from partnerships, S corporations, estates, and trustsfrom Schedule(s) K-1

7

Short-term capital loss carryover. Enter the amount, if any, from line 8 of your1999 Capital Loss Carryover Worksheet

Net short-term capital gain or (loss). Combine column (f) of lines 1 through 6 �

Long-Term Capital Gains and Losses—Assets Held More Than One Year

8

Enter your long-term totals, if any, fromSchedule D-1, line 9

9

10 Total long-term sales price amounts.Add column (d) of lines 8 and 9 10

11Gain from Form 4797, Part I; long-term gain from Forms 2439 and 6252; andlong-term gain or (loss) from Forms 4684, 6781, and 8824

11

1212

13

Net long-term gain or (loss) from partnerships, S corporations, estates, and trustsfrom Schedule(s) K-1

14

Capital gain distributions. See page D-1

15 15

14

16

Long-term capital loss carryover. Enter in both columns (f) and (g) the amount, ifany, from line 13 of your 1999 Capital Loss Carryover Worksheet ( )

Combine column (g) of lines 8 through 14

Net long-term capital gain or (loss). Combine column (f) of lines 8 through 14 � 16

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule D (Form 1040) 2000Cat. No. 11338H

( )

44

Part I

Part II7

13

(b) Dateacquired

(Mo., day, yr.)

2

9

(99)

(f) Gain or (loss)Subtract (e) from (d)

(e) Cost orother basis

(see page D-6)

(a) Description of property(Example: 100 sh. XYZ Co.)

(d) Sales price(see page D-6)

(c) Date sold(Mo., day, yr.)

(b) Dateacquired

(Mo., day, yr.)

(g) 28% rate gain or(loss)

(see instr. below)*

Next: Go to Part III on the back.

( )

2000


15,350

30,000

8,90021,100

26,250

21,10020,10021,100

3,169

26,25021,1005,150

515

8,9005,1503,750

750

30,00030,000

-0--0-

4,4344,995

4,434

9,900—

9,9006,4501,000

-0-1,000

Schedule D (Form 1040) 2000

Summary of Parts I and IICombine lines 7 and 16. If a loss, go to line 18. If a gain, enter the gain on Form 1040, line 1317 17

( )18

Next: Skip Part IV below. Instead, complete Form 1040 through line 37. Then, complete theCapital Loss Carryover Worksheet on page D-6 if:

Part III

● The loss on line 17 or● ($3,000) or, if married filing separately, ($1,500)

Page 2

18

Next: Complete Form 1040 through line 39. Then, go to Part IV to figure your tax if:

If line 17 is a loss, enter here and as a (loss) on Form 1040, line 13, the smaller of these losses:

Tax Computation Using Maximum Capital Gains RatesPart IV

20Enter your taxable income from Form 1040, line 39

22

Enter the smaller of line 15 or line 23, but not less than zero23

If you are filing Form 4952, enter the amount from Form 4952, line 4e

24

Add lines 24 and 25

25

Subtract line 26 from line 22. If zero or less, enter -0-26272829

30313233

34353637

383940

424344454647

48495051525354

Subtract line 39 from line 38 �

Add lines 33, 37, 41, 47, and 51Figure the tax on the amount on line 19. Use the Tax Table or Tax Rate Schedules, whichever appliesTax on all taxable income (including capital gains). Enter the smaller of line 52 or line 53 hereand on Form 1040, line 40

24

25

19

262728

29

303132

33

3435

4344

4950

515253

54

21Enter the smaller of line 16 or line 17 of Schedule D

Enter your unrecaptured section 1250 gain, if any, from line 17 of theworksheet on page D-8

Subtract line 21 from line 20. If zero or less, enter -0-Combine lines 7 and 15. If zero or less, enter -0-

20212223

● Both lines 16 and 17 are gains and● Form 1040, line 39, is more than zero.

● The loss on line 17 exceeds the loss on line 18 or● Form 1040, line 37, is a loss.

Subtract line 27 from line 19. If zero or less, enter -0-Enter the smaller of:

Enter the smaller of line 28 or line 29Subtract line 22 from line 19. If zero or less, enter -0-Enter the larger of line 30 or line 31 �

Figure the tax on the amount on line 32. Use the Tax Table or Tax Rate Schedules, whichever applies

Enter the smaller of line 22 or line 25Add lines 22 and 32Enter the amount from line 19Subtract line 44 from line 43. If zero or less, enter -0-Subtract line 45 from line 42. If zero or less, enter -0- �

Multiply line 46 by 25% (.25)

Enter the amount from line 19Add lines 32, 36, 40, and 46Subtract line 49 from line 48Multiply line 50 by 28% (.28)

Enter the amount from line 29Enter the amount from line 30Subtract line 35 from line 34 �

Multiply line 36 by 10% (.10)

Enter the smaller of line 19 or line 27Enter the amount from line 36

4546

47

48

19

3637

383940

41

42

● The amount on line 19 or● $26,250 if single; $43,850 if married filing jointly or qualifying widow(er);

$21,925 if married filing separately; or $35,150 if head of household �

Note. If the amounts on lines 29 and 30 are the same, skip lines 34 through 37 and go to line 38.

41 Multiply line 40 by 20% (.20)

Note. If line 24 is zero or blank, skip lines 48 through 51 and go to line 52.

Note. If line 26 is zero or blank, skip lines 42 through 51 and go to line 52.

Note. If the amounts on lines 19 and 29 are the same, skip lines 38 through 51 and go to line 52.

Schedule D (Form 1040) 2000

Otherwise, stop here.

-0--0-

-0-

1,000

31,00030,000


XYZ Trading Co.203 Bond St.Any City, PA 18605

10-1111111 111-00-1111

Emily Jones

8307 Daisy Lane

Hometown, AL 36309

RFC

(11,000)

27,000

1,000

15,000

PAYER’S name, street address, city, state, ZIP code, and telephone no. Date of sale1a Proceeds FromBroker and

Barter ExchangeTransactions

CUSIP No.1b

Stocks, bonds, etc.2 Reportedto IRS

Gross proceeds

$ Gross proceeds less commissions and option premiums

PAYER’S Federal identification number RECIPIENT’S identification number Bartering3 Federal income tax withheld4

$ $RECIPIENT’S name Description5

Regulated Futures Contracts

Street address (including apt. no.) Unrealized profit or (loss) onopen contracts—12/31/99

7Profit or (loss) realized in2000

6

City, state, and ZIP code $ $Aggregate profit or (loss)9Unrealized profit or (loss) on

open contracts—12/31/20008


$ $

Department of the Treasury - Internal Revenue ServiceForm 1099-B (Keep for your records.)

�Copy B

For RecipientThis is important tax

information and isbeing furnished to the

Internal RevenueService. If you are

required to file a return,a negligence penalty orother sanction may beimposed on you if thisincome is taxable and


reported.

CORRECTED (if checked)OMB No. 1545-0715

Form 1099-B2000

Special Rules forTraders in SecuritiesSpecial rules apply if you are a trader in se-curities in the business of buying and sellingsecurities for your own account. To be en-gaged in business as a trader in securities,you must meet all the following conditions.

• You must seek to profit from daily marketmovements in the prices of securities andnot from dividends, interest, or capitalappreciation.

• Your activity must be substantial.

• You must carry on the activity with conti-nuity and regularity.

The following facts and circumstancesshould be considered in determining if youractivity is a securities trading business.

1) Typical holding periods for securitiesbought and sold.

2) The frequency and dollar amount of yourtrades during the year.

3) The extent to which you pursue the ac-tivity to produce income for a livelihood.

4) The amount of time you devote to theactivity.

If your trading activities are not a busi-ness, you are considered an investor, and nota trader. It does not matter whether you callyourself a trader or a “day trader.”

Note. You may be a trader in some se-curities and have other securities you hold forinvestment. The special rules discussed heredo not apply to the securities held for invest-

ment. You must keep detailed records to dis-tinguish the securities. The securities held forinvestment must be identified as such in yourrecords on the day you got them (for example,by holding them in a separate brokerage ac-count).

How To ReportTransactions from trading activities result incapital gains and losses and must be reportedon Schedule D (Form 1040). Losses fromthese transactions are subject to the limit oncapital losses explained earlier in this chapter.

Mark-to-market election made. If you madethe mark-to-market election, you should re-port all gains and losses from trading as or-dinary gains and losses in Part II of Form4797, instead of as capital gains and losseson Schedule D. In that case, securities heldat the end of the year in your business as atrader are marked to market by treating themas if they were sold (and reacquired) for fairmarket value on the last business day of theyear. But do not mark to market any securi-ties you held for investment. Report salesfrom those securities on Schedule D, notForm 4797.

Expenses. Interest expense and other in-vestment expenses that an investor woulddeduct on Schedule A (Form 1040) are de-ducted by a trader on Schedule C (Form1040), Profit or Loss From Business, if theexpenses are from the trading business.Commissions and other costs of acquiring ordisposing of securities are not deductible butmust be used to figure gain or loss. The limiton investment interest expense, which ap-plies to investors, does not apply to interestpaid or incurred in a trading business.

Self-employment tax. Gains and losses fromselling securities as part of a trading businessare not subject to self-employment tax. Thisis true whether the election is made or not.

How To Make theMark-to-Market ElectionTo make the mark-to-market election for2001, you must file a statement by April 16,2001. This statement should be attached toeither your 2000 individual income tax returnor a request for an extension of time to filethat return. The statement must include thefollowing information.

1) That you are making an election undersection 475(f) of the Internal RevenueCode.

2) The first tax year for which the electionis effective.

3) The trade or business for which you aremaking the election.

If you are not required to file a 2000 in-come tax return, you make the election byplacing the above statement in your booksand records no later than March 15, 2001.Attach a copy of the statement to your 2001return.

After making the election to change to themark-to-market method of accounting, youmust change your method of accounting forsecurities under Revenue Procedure 99–49.Revenue Procedure 99–49 requires you to fileForm 3115, Application for Change in Ac-counting Method. Follow its instructions. La-bel the Form 3115 as filed under “Section 10Aof the APPENDIX of Rev. Proc. 99–49.”

Once you make the election, it will applyto 2001 and all later tax years, unless you getpermission from IRS to revoke it. The effectof making the election is described underMark-to-market election made, earlier.

For more information on this election, seeRevenue Procedure 99–17, 1999–1 CB 503.


5.How ToGet Tax Help

You can get help with unresolved tax is-sues, order free publications and forms, asktax questions, and get more information fromthe IRS in several ways. By selecting themethod that is best for you, you will havequick and easy access to tax help.

Contacting your Taxpayer Advocate. If youhave attempted to deal with an IRS problemunsuccessfully, you should contact your Tax-payer Advocate.

The Taxpayer Advocate represents yourinterests and concerns within the IRS byprotecting your rights and resolving problemsthat have not been fixed through normalchannels. While Taxpayer Advocates cannotchange the tax law or make a technical taxdecision, they can clear up problems that re-sulted from previous contacts and ensure thatyour case is given a complete and impartialreview.

To contact your Taxpayer Advocate:

• Call the Taxpayer Advocate at1–877–777–4778.

• Call the IRS at 1–800–829–1040.

• Call, write, or fax the Taxpayer Advocateoffice in your area.

• Call 1–800–829–4059 if you are aTTY/TDD user.

For more information, see Publication1546, The Taxpayer Advocate Service of theIRS.

Free tax services. To find out what servicesare available, get Publication 910, Guide toFree Tax Services. It contains a list of free taxpublications and an index of tax topics. It alsodescribes other free tax information services,including tax education and assistance pro-grams and a list of TeleTax topics.

Personal computer. With your per-sonal computer and modem, you canaccess the IRS on the Internet at

www.irs.gov . While visiting our web site, youcan select:

• Frequently Asked Tax Questions (locatedunder Taxpayer Help & Ed) to find an-swers to questions you may have.

• Forms & Pubs to download forms andpublications or search for forms andpublications by topic or keyword.

• Fill-in Forms (located under Forms &Pubs) to enter information while the formis displayed and then print the completedform.

• Tax Info For You to view Internal Reve-nue Bulletins published in the last fewyears.

• Tax Regs in English to search regulationsand the Internal Revenue Code (underUnited States Code (USC)).

• Digital Dispatch and IRS Local News Net(both located under Tax Info For Busi-ness) to receive our electronic newslet-ters on hot tax issues and news.

• Small Business Corner (located underTax Info For Business) to get informationon starting and operating a small busi-ness.

You can also reach us with your computerusing File Transfer Protocol at ftp.irs.gov .

TaxFax Service. Using the phoneattached to your fax machine, you canreceive forms and instructions by

calling 703–368–9694. Follow the directionsfrom the prompts. When you order forms,enter the catalog number for the form youneed. The items you request will be faxed toyou.

Phone. Many services are availableby phone.

• Ordering forms, instructions, and publi-cations. Call 1–800–829–3676 to ordercurrent and prior year forms, instructions,and publications.

• Asking tax questions. Call the IRS withyour tax questions at 1–800–829–1040.

• TTY/TDD equipment. If you have accessto TTY/TDD equipment, call 1–800–829–4059 to ask tax questions or to orderforms and publications.

• TeleTax topics. Call 1–800–829–4477 tolisten to pre-recorded messages coveringvarious tax topics.

Evaluating the quality of our telephoneservices. To ensure that IRS representativesgive accurate, courteous, and professionalanswers, we evaluate the quality of our tele-phone services in several ways.

• A second IRS representative sometimesmonitors live telephone calls. That persononly evaluates the IRS assistor and doesnot keep a record of any taxpayer's nameor tax identification number.

• We sometimes record telephone calls toevaluate IRS assistors objectively. Wehold these recordings no longer than oneweek and use them only to measure thequality of assistance.

• We value our customers' opinions.Throughout this year, we will be survey-

ing our customers for their opinions onour service.

Walk-in. You can walk in to manypost offices, libraries, and IRS officesto pick up certain forms, instructions,

and publications. Also, some libraries and IRSoffices have:

• An extensive collection of products avail-able to print from a CD-ROM or photo-copy from reproducible proofs.

• The Internal Revenue Code, regulations,Internal Revenue Bulletins, and Cumula-tive Bulletins available for research pur-poses.

Mail. You can send your order forforms, instructions, and publicationsto the Distribution Center nearest to

you and receive a response within 10 work-days after your request is received. Find theaddress that applies to your part of thecountry.

• Western part of U.S.:Western Area Distribution CenterRancho Cordova, CA 95743–0001

• Central part of U.S.:Central Area Distribution CenterP.O. Box 8903Bloomington, IL 61702–8903

• Eastern part of U.S. and foreign ad-dresses:Eastern Area Distribution CenterP.O. Box 85074Richmond, VA 23261–5074

CD-ROM. You can order IRS Publi-cation 1796, Federal Tax Products onCD-ROM, and obtain:

• Current tax forms, instructions, and pub-lications.

• Prior-year tax forms, instructions, andpublications.

• Popular tax forms which may be filled inelectronically, printed out for submission,and saved for recordkeeping.

• Internal Revenue Bulletins.

The CD-ROM can be purchased fromNational Technical Information Service (NTIS)by calling 1–877–233–6767 or on the Internetat www.irs.gov/cdorders. The first releaseis available in mid-December and the finalrelease is available in late January.

IRS Publication 3207, The Business Re-source Guide, is an interactive CD-ROM thatcontains information important to small busi-nesses. It is available in mid-February. Youcan get one free copy by calling1–800–829–3676.

Chapter 5 How To Get Tax Help

Glossary

The definitions in this glos-sary are the meanings of theterms as used in this publication.The same term used in anotherpublication may have a slightlydifferent meaning.

Accrual method: An account-ing method under which you re-port your income when you earnit, whether or not you have re-ceived it. You generally deductyour expenses when you incur aliablity for them, rather thanwhen you pay them.

At-risk rules: Rules that limitthe amount of loss you may de-duct to the amount you risk los-ing in the activity.

Basis: Basis is the amount ofyour investment in property fortax purposes. The basis of prop-erty you buy is usually the cost.Basis is used to figure gain orloss on the sale or disposition ofinvestment property.

Below-market loan: A demandloan (defined later) on which in-terest is payable at a rate belowthe applicable federal rate, or aterm loan where the amountloaned is more than the presentvalue of all payments due underthe loan.

Call: An option that entitles thepurchaser to buy, at any timebefore a specified future date,property such as a stated num-ber of shares of stock at a spec-ified price.

Cash method: An accountingmethod under which you reportyour income in the year in whichyou actually or constructively re-ceive it. You generally deductyour expenses in the year youpay them.

Commodities trader: A personwho is actively engaged in trad-ing section 1256 contracts andis registered with a domesticboard of trade designated as acontract market by the Com-modities Futures Trading Com-mission.

Commodity future: A contractmade on a commodity exchange,calling for the sale or purchaseof a fixed amount of a commodityat a future date for a fixed price.

Conversion transaction: Anytransaction that you entered intoafter April 30, 1993 that meetsboth of these tests.

1) Substantially all of your ex-pected return from thetransaction is due to thetime value of your net in-vestment.

2) The transaction is one ofthe following.

a) A straddle, includingany set of offsettingpositions on stock.

b) Any transaction inwhich you acquireproperty (whether ornot actively traded) atsubstantially the sametime that you contractto sell the same prop-erty or substantiallyidentical property at aprice set in the con-tract.

c) Any other transactionthat is marketed orsold as producing cap-ital gains from a trans-action described in (1).

Demand loan: A loan payablein full at any time upon demandby the lender.

Dividend: A distribution ofmoney or other property madeby a corporation to its share-holders out of its earnings andprofits.

Equity option: Any option:

1) To buy or sell stock, or

2) That is valued directly orindirectly by reference toany stock, group of stocks,or stock index.

Fair market value: The priceat which property would changehands between a willing buyerand a willing seller, both havingreasonable knowledge of therelevant facts.

Forgone interest: The amountof interest that would be payablefor any period if interest accruedat the applicable federal rate andwas payable annually on De-cember 31, minus any interestpayable on the loan for that pe-riod.

Forward contract: A contractto deliver a substantially fixedamount of property (includingcash) for a substantially fixedprice.

Futures contract: Anexchange-traded contract to buyor sell a specified commodity orfinancial instrument at a speci-fied price at a specified futuredate. See also Commodity fu-ture.

Gift loan: Any below-marketloan where the forgone interestis in the nature of a gift.

Interest: Compensation for theuse or forbearance of money.

Investment interest: The inter-est you paid or accrued onmoney you borrowed that isallocable to property held for in-vestment.

Limited partner: A partnerwhose participation in partner-ship activities is restricted, andwhose personal liability for part-nership debts is limited to theamount of money or other prop-erty that he or she contributedor may have to contribute.

Listed option: Any option thatis traded on, or subject to therules of, a qualified board or ex-change.

Marked to market rule: Thetreatment of each section 1256contract (defined later) held by ataxpayer at the close of the yearas if it were sold for its fair mar-ket value on the last businessday of the year.

Market discount: The statedredemption price of a bond atmaturity minus your basis in thebond immediately after you ac-quire it. Market discount ariseswhen the value of a debt obli-gation decreases after its issuedate.

Market discount bond: Anybond having market discountexcept:

1) Short-term obligations withfixed maturity dates of up to1 year from the date of is-sue,

2) Tax-exempt obligations thatyou bought before May 1,1993,

3) U.S. savings bonds, and

4) Certain installment obli-gations.

Nominee: A person who re-ceives, in his or her name, in-come that actually belongs tosomeone else.

Nonequity option: Any listedoption that is not an equity op-tion, such as debt options, com-modity futures options, currencyoptions, and broad-based stockindex options.

Options dealer: Any personregistered with an appropriatenational securities exchange asa market maker or specialist inlisted options.

Original issue discount (OID):The amount by which the statedredemption price at maturity of adebt instrument is more than itsissue price.

Passive activity: An activity in-volving the conduct of a trade orbusiness in which you do not

materially participate and anyrental activity. However, therental of real estate is not apassive activity if both of the fol-lowing are true.

1) More than one-half of thepersonal services you per-form during the year in alltrades or businesses areperformed in real propertytrades or businesses inwhich you materially partic-ipate.

2) You perform more than 750hours of services during theyear in real property tradesor businesses in which youmaterially participate.

Portfolio income: Gross in-come from interest, dividends,annuities, or royalties that is notderived in the ordinary course ofa trade or business. It includesgains from the sale or trade ofproperty (other than an interestin a passive activity) producingportfolio income or held for in-vestment.

Premium: The amount by whichyour cost or other basis in a bondright after you get it is more thanthe total of all amounts payableon the bond after you get it (otherthan payments of qualified statedinterest).

Private activity bond: A bondthat is part of a state or localgovernment bond issue of which:

1) More than 10% of the pro-ceeds are to be used for aprivate business use, and

2) More than 10% of the pay-ment of the principal or in-terest is:

a) Secured by an interestin property to be usedfor a private businessuse (or payments forthe property), or

b) Derived from pay-ments for property (orborrowed money) usedfor a private businessuse.

Put: An option that entitles thepurchaser to sell, at any timebefore a specified future date,property such as a stated num-ber of shares of stock at a spec-ified price.

Real estate mortgage invest-ment conduit (REMIC): An en-tity that is formed for the purposeof holding a fixed pool of mort-gages secured by interests inreal property, with multipleclasses of interests held by in-vestors. These interests may beeither regular or residual.

Regulated futures contract: Asection 1256 contract that:

1) Provides that amounts thatmust be deposited to, ormay be withdrawn from,your margin account de-pend on daily market con-ditions (a system of markingto market), and

2) Is traded on, or subject tothe rules of, a qualifiedboard of exchange, such asa domestic board of tradedesignated as a contractmarket by the CommodityFutures Trading Commis-sion or any board of tradeor exchange approved bythe Secretary of the Treas-ury.

Restricted stock: Stock you getfor services you perform that isnontransferable and is subject toa substantial risk of forfeiture.

Section 1256 contract: Any:

1) Regulated futures contract,

2) Foreign currency contractas defined in chapter 4 un-der Section 1256 ContractsMarked to Market,

3) Nonequity option, or

4) Dealer equity option.

Short sale: The sale of propertythat you generally do not own.You borrow the property to de-liver to a buyer and, at a laterdate, you buy substantially iden-

tical property and deliver it to thelender.

Straddle: Generally, a set ofoffsetting positions on personalproperty. A straddle may consistof a security and a written optionto buy and a purchased optionto sell on the same number ofshares of the security, with thesame exercise price and period.

Stripped preferred stock:Stock that meets the followingtests.

1) There has been a sepa-ration in ownership betweenthe stock and any dividendon the stock that has notbecome payable.

2) The stock:

a) Is limited and preferredas to dividends,

b) Does not participate incorporate growth toany significant extent,and

c) Has a fixed redemptionprice.

Term loan: Any loan that is nota demand loan.

Wash sale: A sale of stock orsecurities at a loss within 30days before or after you buy oracquire in a fully taxable trade,or acquire a contract or option tobuy, substantially identical stockor securities.

Index

A Accounting fees ......................... 32

Accrual method ............... 7, 15, 34 Accuracy-related penalty ....... 4, 27

Acquisition discount ....... 15, 42, 46 Acquisition premium .................. 13 Adjusted basis ........................... 40

Alaska Permanent Funddividends (See also In-terest expenses: Limiton investment interest) 21, 30, 31

Amortization of bond premium .. 31 Annuities:

Borrowing on ........................ 33Bought with life insurance pro-

ceeds ............................... 11 Interest on ........................ 5, 47 Nontaxable trades ................ 44 Sale of .................................. 47 Single-premium .................... 33 Trade for ............................... 36

Appreciated financial position ... 37Assistance (See Tax help)

At-risk rules ......................... 29, 59 Attorney fees ............................. 32

Automatic investment ser-vice ........................... 32, 41, 49

B Backup withholding ..................... 3 Bad debts .................................. 50 Bargain purchases .................... 39 Basis:

Adjusted ............................... 40 Cost ...................................... 39

Discounted debt instruments 42 Investment property ............. 39

Other than cost .................... 39Real estate investment trust

(REIT) .............................. 19REMIC, residual interest ...... 23Stocks and bonds .... 19, 20, 40 Bearer obligations ............... 13, 47 Bonds:Accrued interest on .............. 18Amortization of premium ...... 31

Arbitrage ............................... 11 Basis ..................................... 40 Capital asset ........................ 46 Convertible ........................... 43 Coupon ................................. 15 Coupons, stripped ................ 13 Federally guaranteed ........... 11 Market dis-count ....... 12, 14, 42, 46, 59 Mortgage revenue ................ 11 Premiums on ........................ 42 Private activity ...................... 11

Redemption or retirement of 36 Registered ...................... 11, 47

Sold between interest dates 11State and local ..................... 46State or local government .... 11

Stripped .......................... 11, 13 Traded flat .............................. 6 U.S. savings ..................... 7, 16

U.S. Treasury ........... 10, 44, 49 Brokerage fees .......................... 33

CCalls and puts ........................... 53

Capital assets ............................ 45Capital gain distributions

(See also Interest ex-penses: Limit on in-vestment interest) ...... 19, 21, 30

Capital gain tax computation ..... 60Capital gains and losses:

Constructive ownership trans-actions ............................. 48 Investment property ............. 46 Long term ....................... 49, 59

Losses, limit on .................... 60 Reporting .............................. 59

Short term ...................... 49, 59Capital loss carryover ................ 60Cash method ................... 7, 15, 34Certificate of deposit ................. 13

Children: Gifts to .................................... 4

Investment income of ............. 3Owner of U.S. savings bond .. 8

Related parties ..................... 44 Clerical help ............................... 32

Collateralized debt obligations(CDOs) ........................... 22, 23 Comments ................................... 2 Commissions, trustee's ............. 33 Commodity futures .............. 48, 50 Community property .................... 8

Constructive ownership trans-actions .................................. 48 Constructive receipt ................... 15 Constructive sales ..................... 37 Conversion transactions ............ 47

Convertible stocks and bonds ... 43Corporate distributions: (See

also Dividends) Capital gain .......................... 19 Liquidating ...................... 19, 42 Nontaxable ........................... 19

Return of capital ................... 19 Stock rights .................... 19, 41

Undistributed capital gains ... 19 Cost basis .................................. 39

D Day traders ................................ 64

Decedents ....................... 8, 36, 60Deposits, loss on ....................... 47Discount on debt instruments:

Market dis-count ....... 12, 14, 42, 46, 59

Original issue discount(OID) ......................... 11, 12

Sales or redemptions ........... 46 Short-term obligations .......... 15

Stripped bonds and coupons 13 Dividend reinvestmentplan ........................... 19, 32, 41

Dividends: (See also Corporatedistributions)

Exempt-interest .................... 20 Extraordinary ........................ 52 Form 1099–DIV .................... 18

How to report ....................... 21Incorrect Form 1099 ............. 18

Insurance policies ................ 20 Nominees ............................. 21

On restricted stock ............... 21On stock sold ....................... 18

Ordinary ................................ 19 Patronage ............................. 21

Received in January ............ 18Reinvestment plans .. 19, 32, 41

Scrip ..................................... 20 Stock .............................. 41, 50

Vs. sale or trade ................... 36 Divorce ...................................... 44

EEducation Savings Bond Program 9

Endowment contract ............ 13, 33Estate income received by benefi-

ciary ........................................ 3Expenses of producing income . 32

F Face-amount certificates ........... 13

Fair market value ................ 39, 42Federal guarantee on bonds ..... 11Fees to buy or sell .................... 33Financial asset securitization in-

vestment trust (FASIT) ......... 23 Foreign currencytransactions .................... 37, 54 Foreign income ............................ 2 Form:

1041 ..................................... 25 1065 ..................................... 24

1066 (Schedule Q) ......... 23, 33 1096 ............................... 18, 21 1099–B ........................... 36, 59 1099–DIV ....................... 18, 21

1099–INT .......... 4, 9, 16, 22, 23 1099–MISC .................... 18, 51

1099–OID ........... 12, 16, 22, 23 1099–S ................................. 59 1116 ..................................... 16 1120 ..................................... 24 1120-A .................................. 24 2439 ..................................... 19 3115 ....................................... 7 4684 ..................................... 47 4797 ..................................... 43 4952 ............................... 31, 34 6198 ..................................... 59 6781 ............................... 38, 55 8271 ..................................... 27 8275 ..................................... 27 8275–R ................................. 27 8582 ............................... 24, 59 8615 ....................................... 3 8814 ................................. 3, 31 8815 ................................. 9, 17 8818 ..................................... 10 8824 ..................................... 43 8832 ..................................... 24 SS–4 ..................................... 24 W–8BEN ................................. 4 W–9 ........................................ 3

Fractional shares ................. 20, 41Free tax services ....................... 65

Frozen deposits ..................... 5, 18Futures contract, regulated ....... 37

GGains and losses:

Deposits ............................... 47Gains on sales or trades ..... 42, 44Gifts ............................... 40, 49, 50

Glossary .................................... 66

H Hedging transactions ........... 39, 48

Help (See Tax help) Holding period:

Investment property ............. 49 Straddles .............................. 56

How to report:Bond premium amortization . 32Capital gains and losses ...... 59

Dividend income ................... 21 Interest income ..................... 16 Investment expenses ........... 34

Nonbusiness bad debts ....... 51 Positions ............................... 55

Rollover of gain .................... 58S corporation income, etc. ... 24Sales of SBIC stock ............. 49Section 1256 contracts and

straddles .......................... 38 Wash sales ........................... 53

IIncome from sources outside the

U.S. ........................................ 2Indian tribal government ............ 11

Inherited property: Basis of ................................ 40 Holding period ...................... 49

Installment sales .................... 5, 59 Insurance:

Borrowing on ........................ 33 Dividends on ........................ 20

Dividends, interest on ............ 5Interest option on ................. 11Life, interest on loan to buy . 33Life, paid to beneficiary ........ 11

Prepaid premiums .................. 5 Single-premium life .............. 33

Trades .................................. 44 Interest expenses:

Allocation .............................. 29 Carry forward ....................... 30 Investment ............................ 29

Limit on investment interest . 30 Margin accounts ................... 30

Mixed straddle account posi-tions ................................. 57

Paid in advance ................... 30Passive activity losses ......... 31

Straddles .............................. 34 Unstated ............................... 39

Interest income: Frozen deposits ................ 5, 18

How to report ....................... 16 In general ............................... 4

On condemnation award ........ 5On insurance dividends ......... 5On seller-financed mortgage 18On tax refund ......................... 5

Tax-exempt .......................... 11 Taxable ................................... 4 Usurious ................................. 5

When to report ..................... 15 Investment clubs ....................... 24 Investment expenses:

Deductible ............................ 32From pass-through entities .. 33How to report ....................... 34

Interest ................................. 29Limits on deductions ............ 29

Nondeductible ...................... 33 Investment income ...................... 3

Investment income, children ....... 3 Investment property:

Basis ..................................... 39 Defined ................................. 29

Gain or loss treatment ......... 46Sales and trades .................. 36 IRAs ............................................. 4

J Joint accounts ............................. 4

L Like-kind exchanges ............ 43, 44

Liquidating distributions . 19, 21, 42 Loans:

Below-market ......................... 6Gift and demand .................... 6

Guarantees ........................... 50Nonbusiness bad debt ......... 50

Term ....................................... 6Long-term capital gains and

losses ............................. 59, 60Loss on deposits ....................... 47Losses on sales or trades:

How to figure ........................ 42Passive activities ...... 26, 29, 31

Related parties ..................... 44Small business investment

company stock ................ 49Small business stock ........... 48

Wash sales ........................... 52

M Mark-to-market election ............. 64

Marked to market ................ 37, 38 Market discountbonds ............ 12, 14, 42, 46, 59

Maximum tax rate, net capitalgain ....................................... 60

Meetings, expenses of attending 33Money market certificates ........... 5Money market funds .................. 19More information (See Tax help)

Mortgage: Revenue bonds .................... 11

Secondary liability on home . 51 Seller-financed ..................... 18

Municipal bonds ........................ 11Mutual funds ...... 18, 19, 33, 41, 50

N Nominee distributions:

Dividends ........................ 18, 21 Interest ............................. 4, 18

Original issue discount ......... 12Nonbusiness bad debts ............. 50

Noncapital assets ...................... 45Nondeductible investment ex-

penses .................................. 33Nonqualified preferred stock ..... 43Nontaxable corporate distribu-

tions ................................ 19, 21 Nontaxable trades ............... 43, 49 Notes:Of individuals, bought at dis-

count ............................... 47Redemption or retirement of 36U.S. Treasury ........... 10, 44, 49

O Office expenses ......................... 32 Options:Calls and puts ...................... 53

Cash settlement ................... 53 Dealer equity ........................ 38 Deep-in-the-money ............... 55 Equity ................................... 38

Gain or loss .......................... 53 Holding period ...................... 50 Nonequity ............................. 38

Qualified covered call ........... 55Section 1256 contracts ........ 53

Wash sales ........................... 52Ordinary gains and losses ........ 45

Original issue discount(OID) ................... 11, 12, 18, 42

PPassive activity .. 24, 26, 29, 31, 59

Penalty: Accuracy-related .............. 4, 27 Backup withholding ................ 4

Failure to pay tax ................. 28Failure to supply SSN ............ 3On early withdrawals ........ 5, 18

Substantial understatement . 28 Valuation misstatement ........ 28

Portfolio income ......................... 29 Position:

Appreciated financial ............ 37 Defined ................................. 54 Holding period ...................... 56

Offsetting .............................. 54 Successor ............................. 56

Preferred stock: Nonqualified ......................... 43 Redemption premium ........... 20 Stripped ................................ 22

Premiums on bonds ............ 31, 42Public utility stock reinvestment 41Publications (See Tax help) Puts and calls ............................ 53

RReal estate invest-

ment trust (REIT) 18, 19, 41, 50Real estate mortgage invest-

ment conduits (REMICs): Regular interest .................... 22 Residual interest ............ 23, 53

Recordkeeping .......... 3, 10, 40, 49Registration of bonds .......... 11, 47Regulated futures contract ........ 37Related parties .............. 34, 44, 54Repossession of real property .. 50Rollover of gain from sale of se-

curities .................................. 57

S S corporations ........................... 23

Safe deposit box ....................... 33Sales and trades of investment

property ................................ 36 Savings bonds ....................... 7, 16 Scrip dividends .......................... 20

Section 1202 gain ..................... 61Section 1244 stock .................... 48Section 1256 con-

tracts ................... 37, 50, 54, 59 Securities:

Holding period ...................... 49 Installment sale .................... 59

Lost, stolen, etc., cost of re-placing ............................. 32

Rollover of gain from sale .... 57Worthless ................. 36, 48, 51 Self-employment .................. 24, 39 Seller-financed mortgage .......... 18 Short sales:

Adjusted basis ...................... 42 Defined ................................. 51 Expenses of ................... 33, 52 Extraordinary dividends ........ 52 Puts ...................................... 53 SBIC stock ........................... 49

Substitute payments ............. 51 Wash sales ........................... 52

Short-term capital gains andlosses ............................. 59, 60 Short-term obligations ............... 15 Sixty/forty rule ............................ 38

Small business investmentcompany stock ............... 49, 57

Small business stock ..... 48, 50, 58 Social security:Investment club earnings ..... 24

Number ................................... 3Specialized small business in-

vestment company ............... 57 Spouses:

Related parties ..................... 44 Transfers between ......... 40, 44

State or local government obli-gations .................................. 11 Stock:

Basis ............................... 19, 40 Capital asset ........................ 46 Constructive ownership ........ 45 Convertible ........................... 43 Dividends ........................ 19, 41 Fractional shares ............ 20, 41 Identification ......................... 41 Installment sale .................... 59 Nonqualified preferred .......... 43

Public utility, reinvestment ... 41Qualified small business ...... 58

Redemption of ...................... 36Rights ................. 19, 41, 46, 50Rollover of gain from sale .... 57

S corporation ........................ 42 Section 1202 ........................ 58

Small business (section1244) ............................... 48

Small Business InvestmentCompany ................... 49, 57

Sold or traded ...................... 40 Splits ..................................... 41 Straddle rules ....................... 54 Stripped preferred ................ 22 Surrender of ......................... 36 Trades .................................. 43

Straddles:Deferral of loss from ............ 54

Identified ............................... 55Interest expense and carrying

charges ........................... 34 Mixed .............................. 51, 56 Reporting .............................. 59

Stripped bonds and coupons 11, 13Stripped preferred stock ............ 22

Suggestions ................................. 2

T Tax help ..................................... 65

Tax refund, interest on ................ 5 Tax shelters ............................... 26

Tax-exempt income, expensesof .......................................... 33 Tax-exempt interest:Reporting .................... 4, 16, 20State or local government obli-

gations ............................. 11Stripped bonds and cou-

pons .......................... 11, 14 Taxes:State and local transfer ........ 33

State income ........................ 33 Taxpayer Advocate ................... 65

Traders in securities .................. 64 Trades:

Insurance .............................. 44Investment property for

annuity ............................. 36 Like-kind ......................... 43, 44

Nontaxable ............... 39, 43, 49 Stock .................................... 43 Taxable ................................. 39

U.S. Treasury notes or bonds 44Treasury bills, notes, and bonds 10Trust income received by benefi-

ciary ........................................ 3Trustee's commission, revocable

trust ...................................... 33 TTY/TDD information ................ 65

UU.S. savings bonds ............... 7, 16U.S. Treasury bills, notes,

and bonds ................ 10, 44, 49 Usurious interest ......................... 5

W Wash sales:

Holding period ...................... 50Loss deferral rules, straddles 55

Loss disallowed .................... 52When to report interest income . 15Worthless securities ...... 36, 48, 51

�

Tax Publications for Individual Taxpayers

General GuidesYour Rights as a TaxpayerYour Federal Income Tax (ForIndividuals)

Farmer’s Tax Guide

Tax Guide for Small Business (ForIndividuals Who Use Schedule C orC-EZ)Tax Calendars for 2001Highlights of 2000 Tax ChangesGuide to Free Tax Services

Specialized PublicationsArmed Forces’ Tax Guide

Fuel Tax Credits and RefundsTravel, Entertainment, Gift, and CarExpensesExemptions, Standard Deduction,and Filing InformationMedical and Dental ExpensesChild and Dependent Care ExpensesDivorced or Separated IndividualsTax Withholding and Estimated TaxTax Benefits for Work-RelatedEducationForeign Tax Credit for IndividualsU.S. Government Civilian EmployeesStationed AbroadSocial Security and OtherInformation for Members of theClergy and Religious WorkersU.S. Tax Guide for AliensScholarships and FellowshipsMoving ExpensesSelling Your HomeCredit for the Elderly or the DisabledTaxable and Nontaxable IncomeCharitable ContributionsResidential Rental Property

Commonly Used Tax Forms

Miscellaneous DeductionsTax Information for First-TimeHomeowners

Reporting Tip IncomeSelf-Employment TaxDepreciating Property Placed inService Before 1987Installment SalesPartnershipsSales and Other Dispositions ofAssetsCasualties, Disasters, and Thefts(Business and Nonbusiness)Investment Income and ExpensesBasis of AssetsRecordkeeping for IndividualsOlder Americans’ Tax GuideCommunity PropertyExamination of Returns, AppealRights, and Claims for RefundSurvivors, Executors, andAdministratorsDetermining the Value of DonatedPropertyMutual Fund DistributionsTax Guide for Individuals WithIncome From U.S. PossessionsPension and Annuity IncomeCasualty, Disaster, and Theft LossWorkbook (Personal-Use Property)Business Use of Your Home(Including Use by Day-CareProviders)Individual Retirement Arrangements(IRAs) (Including Roth IRAs andEducation IRAs)Tax Highlights for U.S. Citizens andResidents Going AbroadThe IRS Collection Process

Earned Income Credit (EIC)Tax Guide to U.S. Civil ServiceRetirement Benefits

Tax Highlights for Persons withDisabilitiesBankruptcy Tax GuideDirect SellersSocial Security and EquivalentRailroad Retirement BenefitsHow Do I Adjust My Tax Withholding?Passive Activity and At-Risk RulesHousehold Employer’s Tax GuideTax Rules for Children andDependentsHome Mortgage Interest DeductionHow To Depreciate PropertyPractice Before the IRS and Powerof AttorneyIntroduction to Estate and Gift TaxesIRS Will Figure Your Tax

Per Diem RatesReporting Cash Payments of Over$10,000The Taxpayer Advocate Service ofthe IRS

Derechos del ContribuyenteCómo Preparar la Declaración deImpuesto Federal

Crédito por Ingreso del TrabajoEnglish-Spanish Glossary of Wordsand Phrases Used in PublicationsIssued by the Internal RevenueService

U.S. Tax Treaties

Spanish Language Publications

Tax Highlights for CommercialFishermen

910

595

553509

334

225

171

3

378463

501

502503504505508

514516

517

519520521523524525526527529530

531533534

537

544

547

550551552554

541

555556

559

561

564570

575584

587

590

593

594

596721

901907

908

915

919925926929

946

911

936

950

1542

967

1544

1546

596SP

1SP

850

579SP

Comprendiendo el Proceso de Cobro594SP

947

Tax Benefits for Adoption968

Informe de Pagos en Efectivo enExceso de $10,000 (Recibidos enuna Ocupación o Negocio)

1544SP

See How To Get Tax Help for a variety of ways to get forms, including by computer, fax,phone, and mail. For fax orders only, use the catalog number when ordering.

U.S. Individual Income Tax ReturnItemized Deductions & Interest andOrdinary Dividends

Profit or Loss From BusinessNet Profit From Business

Capital Gains and Losses

Supplemental Income and LossEarned Income Credit

Profit or Loss From Farming

Credit for the Elderly or the Disabled

Income Tax Return for Single and Joint Filers With No Dependents

Self-Employment TaxU.S. Individual Income Tax Return

Interest and Ordinary Dividends forForm 1040A FilersChild and Dependent CareExpenses for Form 1040A FilersCredit for the Elderly or the Disabled for Form 1040A Filers

Estimated Tax for IndividualsAmended U.S. Individual Income Tax Return

Unreimbursed Employee BusinessExpenses

Underpayment of Estimated Tax byIndividuals, Estates, and Trusts

Power of Attorney and Declarationof Representative

Child and Dependent Care Expenses

Moving ExpensesDepreciation and AmortizationApplication for Automatic Extension of TimeTo File U.S. Individual Income Tax ReturnInvestment Interest Expense DeductionAdditional Taxes Attributable to IRAs, OtherQualified Retirement Plans, Annuities,Modified Endowment Contracts, and MSAsAlternative Minimum Tax–IndividualsNoncash Charitable Contributions

Change of AddressExpenses for Business Use of Your Home

Nondeductible IRAsPassive Activity Loss Limitations

1040Sch A & B

Sch CSch C-EZSch D

Sch ESch EICSch FSch H Household Employment Taxes

Sch RSch SE

1040EZ

1040ASch 1

Sch 2

Sch 3

1040-ES1040X

2106 Employee Business Expenses2106-EZ

2210

24412848

390345624868

49525329

6251828385828606

88228829

Form Number and TitleCatalogNumber

Sch J Farm Income Averaging

Additional Child Tax Credit8812

Education Credits8863

CatalogNumber

1170020604

11744

1186211980

124901290613141

1317713329

1360062299637046396610644120811323225379

11320

Form Number and Title

11330

113341437411338

113441333911346121872551311359113581132712075

10749

12064

11329

1134011360

See How To Get Tax Help for a variety of ways to get publications, includingby computer, phone, and mail.

970 Tax Benefits for Higher Education971 Innocent Spouse Relief

Sch D-1 Continuation Sheet for Schedule D 10424

972 Child Tax Credit

2000 Publication 550

Documents

Transcript of 2000 Publication 550