Income and Assets · Income

Interest income

Interest is listed in the definition of gross income (IRC § 61(a)(4)), so the interesting questions are never whether a payment is interest but whether a section takes it back out, and when it has to be counted. Both answers are narrower than clients expect. “Tax-free” usually turns out to mean “tax-exempt for regular tax purposes, still reported, and possibly a preference item”; and interest is frequently taxable in a year when nothing was received.

The rule

The exclusion and its three exceptions. Gross income does not include interest on any State or local bond (IRC § 103(a)). Subsection (b) withdraws that for a private activity bond which is not a qualified bond within § 141, an arbitrage bond within § 148, and any bond not in registered form as required by § 149. So municipal interest is excluded by default and includible by exception, and the exception is common enough that a bond fund’s own statement is the only reliable place to settle it.

Excluded is not invisible, and not always free. Interest on specified private activity bonds, reduced by deductions that would have been allowable had it been includible, is an item of tax preference for alternative minimum tax purposes (IRC § 57(a)(5)(A)), and an exempt-interest dividend from a regulated investment company is treated as such interest to the extent of its proportionate share (IRC § 57(a)(5)(B)). Separately, no deduction is allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt (IRC § 265(a)(2)).

United States savings bonds have two rules, one on timing and one on exclusion. A cash-basis holder of a non-interest-bearing obligation issued at a discount and redeemable for increasing fixed amounts may elect to treat the annual increase in redemption price as income received in that year (IRC § 454(a)); the election, once made, binds for that obligation and for all others of the same kind the taxpayer holds or later acquires. Separately, no amount is includible by reason of redeeming a qualified United States savings bond in a year in which the individual pays qualified higher education expenses (IRC § 135(a)) — subject to a proportionate limit where the proceeds exceed those expenses (IRC § 135(b)(1)), an income phase-out (IRC § 135(b)(2)), a reduction for scholarships, veterans benefits and qualified tuition program payments (IRC § 135(d)(1)), and an absolute bar where a married individual does not file jointly (IRC § 135(d)(3)).

Original issue discount accrues whether or not anything is paid. The holder of a debt instrument having original issue discount includes the sum of the daily portions for each day held (IRC § 1272(a)(1)), with exceptions including tax-exempt obligations (IRC § 1272(a)(2)(A)). This is the clearest case of interest income arising in a year with no cash.

Below-market loans generate imputed interest. Where individuals lend to each other below the applicable federal rate, § 7872 recharacterises the foregone interest — but two thresholds soften it. The section does not apply to any day on which aggregate gift loans directly between individuals do not exceed a de minimis figure (IRC § 7872(c)(2)(A)), unless the loan is directly attributable to purchasing or carrying income-producing assets (IRC § 7872(c)(2)(B)); and for gift loans not exceeding a larger figure, the amount treated as retransferred to the lender cannot exceed the borrower’s net investment income (IRC § 7872(d)(1)(A)). Neither relief applies where a principal purpose of the interest arrangement is the avoidance of federal tax (IRC §§ 7872(c)(3)(B), (d)(1)(B)).

Reporting starts low. A person paying interest aggregating a small figure or more to any other person in a calendar year must file an information return, and so must a nominee who receives interest and passes it on (IRC § 6049(a)(1), (2)).

Current figures

How it works in practice

Take the statements as a starting point and then ask two questions of each line: is any of this excluded, and is any of it in the wrong year.

On exclusion, the recurring work is with municipal bond funds. The year-end statement breaks the distribution into a tax-exempt portion, a portion attributable to specified private activity bonds, and sometimes a taxable portion — and all three matter, because the exempt part still has to be reported, the private activity part is an alternative minimum tax preference, and the taxable part is ordinary income. A client who says “it’s all municipal” has usually read only the first line.

On timing, three situations produce income with no cash. Original issue discount accrues daily. Accrued interest paid to a seller when a bond is bought between coupon dates is not the buyer’s income even though the next coupon reports in full, so it has to be subtracted. And a § 454 election, once made, keeps reporting savings bond increases every year thereafter — worth knowing when a client inherits the consequences of an election someone made decades ago.

Two intake questions find things that never generate a statement. “Did you lend money to a family member, and on what terms” reaches § 7872, where a genuinely interest-free family loan can still produce imputed interest to the lender. And “did anything arrive in your name that belongs to someone else” reaches nominee interest, where the payee of record must both report the gross and back out the part belonging to the true owner.

How this has changed

The architecture of this topic is old and stable; the movement is in the figures, and they move unevenly. The § 135 phase-out is adjusted annually under § 135(b)(2)(B) and now stands at roughly two and a half times the unindexed figures still printed in § 135(b)(2)(A) — a taxpayer or a question working from the statutory text alone would deny the exclusion to almost everyone who now qualifies. The § 7872 thresholds, by contrast, are statutory and unindexed: the de minimis and gift loan figures have stood since the section was enacted and are the same today, so their real value has eroded steadily.

Two consequences of that unevenness are worth carrying. First, the § 7872 rules now catch loans that would have been unremarkable when the thresholds were set, so ordinary family lending reaches them more often than it used to. Second, any source that gives the § 135 income limits without a year attached is wrong for every year but one, while a source giving the § 7872 figures without a year is right.

The one structural point that has changed in living memory is the alternative minimum tax’s reach. Because the exemption amounts and their phase-out thresholds have moved substantially, the practical significance of § 57(a)(5) rises and falls with them even though the preference itself is untouched — so whether private activity bond interest matters for a given client is an annual question, not a settled one.

Exam focus

Know § 103(a) with its three exceptions in § 103(b), and be ready to say that the exclusion is the default and the taxability the exception. Expect the private activity bond to appear as either an inclusion or a preference item.

Know that original issue discount accrues to a cash-basis holder, and that the § 454 election is available, elective, and binding once made.

For § 135, the reliably examinable points are the age test at issuance, the separate-return bar, and that expenses are reduced by scholarships and § 529 payments before the proportionate and income limits are applied.

For § 7872, know the two thresholds and what each does — one disapplies the section, the other caps the imputed amount at net investment income — and know that both fall away for tax avoidance and that the de minimis exception fails for loans used to acquire income-producing assets.

Check yourself

1. A client’s municipal bond fund statement shows $8,000 of exempt-interest dividends, of which $1,200 is attributable to specified private activity bonds. What is reported?

Answer: the whole $8,000 as tax-exempt interest, none of it in gross income under IRC § 103(a), and $1,200 as an item of tax preference for alternative minimum tax purposes. IRC § 57(a)(5)(B) treats an exempt-interest dividend as interest on a specified private activity bond to the extent of its proportionate share of such interest received by the company paying it.

2. Grandparents bought Series EE bonds in their granddaughter’s name when she was born. She redeems them at 22 to pay tuition. Does IRC § 135 exclude the interest?

Answer: no. IRC § 135(c)(1)(B) requires the bond to have been issued to an individual who had attained age 24 before the date of issuance. A bond issued in a newborn’s name can never satisfy that, whatever the proceeds are later spent on. Bonds registered to a parent aged over 24 at issue could have qualified.

3. A cash-basis taxpayer holds a corporate bond with original issue discount and received no cash from it this year. Is anything includible?

Answer: yes. IRC § 1272(a)(1) includes in the holder’s gross income the sum of the daily portions of the original issue discount for each day held during the taxable year, regardless of the method of accounting and regardless of whether anything was paid. The exceptions in § 1272(a)(2) — tax-exempt obligations among them — do not reach an ordinary corporate bond.

4. A parent makes an $8,000 interest-free loan to a child, who uses it to buy a car. Does IRC § 7872 apply?

Answer: no. IRC § 7872(c)(2)(A) provides that the section does not apply to any day on which the aggregate outstanding amount of gift loans directly between the individuals does not exceed the de minimis figure, and $8,000 is below it. Had the child used the loan to buy income-producing assets, IRC § 7872(c)(2)(B) would disapply the exception and the section would operate.