Reporting Interest Income on Your 2020 Federal Income Tax Return

Any individual who received more than $10 of interest income during 2020 from a bank, credit union or a brokerage should receive a 2020 1099-INT from the issuing institution. This column discusses the different types of interest income that need to be reported on the 2020 federal income tax return.

Interest income is reported on an individual’s IRS Form 1040, line 2a (showing tax-exempt interest income including municipal interest and exempt interest dividends from mutual funds) and Form 1040, line 2b (that includes amounts reported to the individual on Form 1099-INT, Box 1).

IRS Schedule B is required to also be filed when any of the following apply:

(1) there is more than $1,500 of taxable interest income reported,

(2) the individual is excluding interest from Series EE savings bonds issued after 1989 and Series I savings bonds that were sold and proceeds were used to pay qualified higher education expenses;

(3) the individual has interest income related to any of the following special situations: (a) seller-financed mortgage; (b) nominee distribution; (c) bond purchased between interest payment dates; (d) original issue discount (OID) adjustments; or (e) amortizable bond premiums.

Nominee Interest

If an individual receives a Form 1099-INT with interest income in his or her name but the interest actually belongs to another person, the full amount of interest should be reported on the individual’s Schedule B. On a separate line below the total of interest reported, the individual should report on a line the nominee interest received as “nominee distribution” and subtract it from the total interest. The individual also needs to give the actual recipient of the interest a Form 1099-INT showing the interest as income to the recipient. A copy of the Form 1099-INT and Form 1096 also must be filed with the IRS.

Accrued Interest on Bonds

If bonds are sold between interest payment dates, part of the sale represents interest income accrued to the date of the sale. Both the seller and the purchaser of the bond have reporting responsibilities with respect to the accrued interest income earned between interest paying dates. These reporting responsibilities are explained below.

· Seller. The seller must report accrued income from the last interest pay date to the date of sale. The accrued interest also increases the bond’s cost basis. The following example illustrates:

Example 1. A bond costing $10,000 was sold for $10,600 on May 31, 2020. The sale price included $500 of accrued interest income from January 1 to May 31, 2020. The bond seller must report on his or her 2020 federal income tax return interest income of $500 and capital gain income of $100.

· Purchaser. The purchaser deducts the accrued interest from the next interest payment. On Schedule B, report the total interest payment, and on a separate line list “accrued Interest” and subtract it from the total interest. The cost basis of the bond does not include the amount of the accrued interest. The following example illustrates:

Example 2. The purchaser of the $10,600 bond in Example 1 receives interest income of $900 on his or her 2020 federal income tax return. On Schedule B, the purchaser reports $900 less $500 or $400 of taxable interest income. The cost basis of the bond is $10,100 ($10,600 purchase price does not include $500 of accrued interest).

Certificates of Deposit

Interest earned on certificates of deposits (CDs) is taxable each year as it is earned, even though cash is not withdrawn until a later year. The following example illustrates:

Example 3. On March 1, 2020, Julie purchases an 18-month, 1 percent CD, investing $12,000. The CD matures on August 31, 2021 at which time Julie will receive interest of $180 (1 percent/year times $12,000 x 1.5 year). But Julie receives a 2020 1099-INT in January 2021 showing interest income of $100 (10 months times $10 interest per month) that Julie must report on her 2020 income tax return, even though Julie does not actually receive the interest income until September 2021.

Exception. Interest income from a CD maturing in one year or less is recognized when the CD matures, which allows CD investors to defer income recognition until the year the interest income is actually received. The same rules apply to U.S. Treasury bills which also have maturities of one year or less.

Money Market Funds

Amounts received from money market funds should be reported as dividend income and not as interest income.

Other Taxable Interest Income

Insurance dividends – interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable in the year it is credited to the account. This is the case unless the interest can be withdrawn only on the anniversary date of the policy, or other specified date. In which case the interest is taxable in the year that date occurs.

Tax refunds – interest paid on federal income tax refunds is taxable but only for federal (and not state) income tax purposes.

Gift for opening bank account – for deposits of less than $5,000, gifts or services of more than $10 must be reported as interest income. For deposits of $5,000 or more, gifts or services valued at more than $20 must be reported as interest income. The value is determined by the cost to the financial institution.

Series EE and U.S. Savings Bond Interest

Interest is normally taxable when a U.S. Savings Bond is cashed, with the taxable interest income equal to the difference between the redemption value and Savings Bond original cost. Interest income is subject to federal income tax only (not subject to state and local taxes). U.S. Savings Bonds and other US Treasury obligation interest income is reported in Box 3 of Form 1099-INT.

Tax-exempt Interest

Interest on a bond used to finance government operations generally is not taxable if the bond is issued by a state, the District of Columbia, a possession of the U.S., or any of their political subdivisions.

Tax-exempt interest, reported on Box 8 of Form 1099-INT, includes municipal bond interest and exempt-interest dividends from a mutual fund or other regulated investment company.

The IRS requires reporting of tax-exempt interest on line 2a of Form 1040, because:

(1) tax-exempt income is a factor to determine the amount, if any, of Social Security benefits that are includable in gross income; and

(2) any investment interest expense incurred to purchase or carry tax-exempt obligations is not deductible.