Interest is compensation for the use of money over time, which can include interest on bank deposits, corporate bonds, mortgages, life insurance policies, tax refunds, and government debt, both domestic and foreign. Interest is income earned from deposits or investments in cash at a rate, specified by contract, on the principal and where the principal is subject only to credit risk, not investment risk. Interest may be taxable or tax-exempt, which will be reported on Form 1099-INT, Interest Income as such. Some tax-exempt interest, however, may be subject to the alternative minimum tax (AMT).
While there is no constitutional requirement to exempt interest from obligations of states and municipalities, interest on debt instruments from states, territories, and US possessions and their political subdivisions have been tax-exempt since the inception of the federal income tax in 1913. Bonds issued by municipalities have also been tax-exempt under the federal tax code. Additionally, tax-exempt organizations — universities, churches, hospitals, and similar nonprofits — may issue up to $225 million of tax-exempt bonds. Note, however, that interest on tax refunds paid by the state or municipalities is not tax-exempt nor is any gains from the sale of state or municipal bonds. However, interest earned from private activity bonds, federally insured loans, and arbitrage bonds are taxable by the federal government. Arbitrage bonds are issued so that states or municipalities can use the proceeds to buy higher yielding investments.
If the total interest earned during the year exceeds $1500, then the payers of that interest, including payers of tax-exempt interest, must be listed on Part I of Schedule B, Interest and Ordinary Dividends. Schedule B may also have to be filed if some interest was received that is not taxable such as tax-exempt interest, accrued interest, nominee distributions, frozen deposit interest, amortized bond premium, or interest on savings bonds used to pay tuition.
Some interest may be reported to a taxpayer who has no tax liability for the interest. Interest received as a nominee for another taxpayer, such as with a joint account, is not taxable to the nominee. When a taxpayer buys a bond, there may have been accrued interest included in the purchase, which is taxable to the seller but not the buyer. Interest from frozen accounts is also not taxable. These types of interest will be reported to the IRS even though they may not be taxable to the taxpayer receiving the Form 1099-INT, so they should be subtracted on Schedule B from the total interest listed, and each line should be labeled with the appropriate designation, such as "nominee distribution", "accrued interest", or "frozen deposits".
If the taxpayer serves as a nominee for a interest distribution, i.e., receiving the interest that belongs to someone else, such as for bonds held in a joint account, and the other person is not the nominee's spouse, then the nominee recipient must send a separate Form 1099-INT to the beneficial owner of the interest no later than January 31, so that the owner can report the interest on his own tax return. The nominee must file Form 1096, Annual Summary and Transmittal of U.S. Information Returns with the IRS by the end of February, or by the end of March, if filing electronically. On the nominee's tax return, the nominee portion of the interest is subtracted from the total interest on Schedule B, Interest and Ordinary Dividends, yielding the taxable portion to be reported on Form 1040.
Additionally, Schedule B may also have to be filed if the taxpayer had a financial interest or signature authority over a foreign financial account, in which case, Part III must be filled out to determine if a FinCEN Form 114, Report of Foreign Bank and Financial Accounts or Form 8938, Statement of Specified Foreign Financial Assets must be filed to report these accounts. More: Reporting Foreign Financial Assets
The interest earned by certificates of deposit and other such plans with terms exceeding one year are treated as deferred interest original issue discount (OID) and is taxed annually. The taxable OID is reported on Form 1099-OID. If the money is withdrawn before the maturity date, then a penalty may have to be paid. The full interest must still be reported, but any losses due to the penalty and forfeited interest, which should be listed on Form 1099-INT, may be deducted on Form 1040.
Taxes can be deferred with some savings certificates with terms not exceeding one year, if the certificate specifies that the interest is payable at maturity, and the maturity date is in the year after the purchase date. Interest is deemed to be earned at the earlier of the maturity date or when there is no substantial penalty for early withdrawal, so if that date is in the year after the purchase, then the interest will be taxable in that year. So, for instance, if you purchase a six-month savings certificate of deposit after June 30 and the interest is payable at maturity, then the interest is taxable in the year of maturity.
Interest earned by a custodian account of a minor is taxable to the child if her name and Social Security number are listed on the Form W-9, Request for Taxpayer Identification Number and Certification provided by the payer. However, if the net investment income exceeds $2100, then the excess may be subject to the kiddie tax, which will be taxed at the highest tax rate of both parents.
Interest earned on a loan by the taxpayer to another person is taxable when it is constructively received. If the taxpayer is on an accrual basis, then the interest is taxable when the interest is earned rather than received. If a market interest is not charged, then there may be imputed interest based on IRS rates, which the lender must report as a minimum. If the debt is only partially paid for the year, and if the interest portion is not identified, then the payment is 1st applied against the interest due, then the remaining portion of the principal. Interest income is not realized if the loan or note is exchanged for a new note that includes the interest due. If the lender gives away the note as a gift, then the lender must report any interest due as of the date of the gift; any interest earned afterwards is taxable to the donee.
The interest earned by bonds, like other interest, is taxable to the bondholder as ordinary income. However, bonds and other like securities, such as Treasuries, have special features that, in some cases, complicate the calculation of interest, which is covered in Taxation of Bond Income.
Federal tax law requires a minimum interest rate be charged on loans and on installment sales of property; otherwise, imputed interest rules apply, covered in Imputed Interest On Below-Market Loans.