Unit 5: Investment Income

Question 1

What is interest income?

Answer 1

Interest is a form of income earned from deposits (such as bank and money market accounts), notes receivable, and investments in instruments such as bonds. Some interest income is taxable, and some is not.

Question 2

When must interest income be reported on Schedule B?

Answer 2

If taxable interest income exceeds $1,500, the taxpayer must report the interest on Schedule B, Interest and Ordinary Dividends.

Question 3

EXAMPLE: Reporting interest without a Form 1099-INT

Answer 3

Zebadiah loaned his friend Rufus $20,000 for one year at 3% interest. Rufus paid $600 in interest. Even though Zebadiah did not receive a Form 1099-INT (not required for personal loans), he must still report the $600 interest as taxable income on his Form 1040.

Question 4

How are gifts for opening bank accounts treated for tax purposes?

Answer 4

Noncash gifts for opening accounts in savings institutions may need to be reported as interest income. For deposits less than $5,000, gifts valued over $10 must be reported. For deposits of $5,000+, gifts valued over $20 must be reported as interest.

Question 5

EXAMPLE: Cash bonuses vs. rewards programs

Answer 5

Cash bonuses for opening new checking or credit card accounts are considered taxable interest. However, rewards earned from credit/debit card purchases (like airline miles or store discount cards) are typically considered “rebates” and not taxable income.

Question 6

EXAMPLE: Interest below reporting threshold

Answer 6

Kiana earned $9 and $8 in interest from two different savings accounts. Because both amounts are below the $10 reporting threshold, she doesn’t receive Form 1099-INT from either bank. However, the interest is still taxable and must be reported on her tax return.

Question 7

When is interest on a CD taxable?

Answer 7

Interest earned on a certificate of deposit (CD) is generally taxable when the taxpayer receives it or is entitled to receive it without incurring a penalty.

Question 8

How is borrowed money for a CD investment treated?

Answer 8

Interest a taxpayer pays on funds borrowed to meet the minimum deposit for a CD, and interest earned on the CD are two separate items. The total CD interest must be included in income, while the interest paid can potentially be deducted as investment interest (if itemizing).

Question 9

“ლ, “EXAMPLE: CD investment with borrowed funds”,”Tiffany invested $40

Answer 9

000 of her own money and borrowed $10

Question 10

What is tax-exempt interest?

Answer 10

Interest earned on debt obligations of state and local governments (municipal bonds) is generally exempt from federal income tax but may be subject to state and local income taxes.

Question 11

How is tax-exempt interest reported on tax returns?

Answer 11

Tax-exempt interest must be reported on Form 1040, even though it is not taxable at the federal level.

Question 12

EXAMPLE: Reporting municipal bond interest

Answer 12

Travis earns $109,000 in wages and receives $2,950 in municipal bond interest. He must report both his wages and the full municipal bond interest on his tax return, but the municipal bond interest is not federally taxable.

Question 13

Can interest be deducted on loans used to buy tax-exempt investments?

Answer 13

No. If a taxpayer borrows money to buy investments that generate tax-free income (like municipal bonds), the interest is not deductible as investment interest.

Question 14

How is interest on U.S. government obligations taxed?

Answer 14

Interest on U.S. obligations (Treasury bills, notes, bonds) is normally taxable for federal income tax purposes but exempt from state and local income taxes.

Question 15

How is Series EE bond interest treated?

Answer 15

Series EE bonds are issued at a discount. The difference between the purchase price and redemption amount is interest income, which can be reported either when the bond matures/is redeemed OR annually as the bond’s value increases.

Question 16

How is Series I bond interest treated?

Answer 16

Series I bonds are issued at face value with a 30-year maturity. Face value and accrued interest are payable at maturity. Interest can be reported either at redemption/maturity OR annually as the bond’s value increases.

Question 17

What reporting method must be used for savings bonds?

Answer 17

Taxpayers must use the same reporting method (either annual reporting or deferral until redemption/maturity) for all Series EE and Series I bonds they own.

Question 18

What is the Education Savings Bond Program?

Answer 18

A special rule that permits qualified taxpayers to exempt interest earned upon redemption of eligible savings bonds if used to pay higher education expenses in the same year for the taxpayer, spouse, or dependents.

Question 19

What bonds qualify for the Education Savings Bond Program?

Answer 19

Only Series EE and I bonds issued after 1989 qualify for the Education Savings Bond Program.

Question 20

What are the ownership requirements for education savings bonds?

Answer 20

The bonds must be registered in the taxpayer’s name or their spouse’s name. They cannot be registered in a child’s name under age 24, even if used for the dependent child’s education.

Question 21

What is the age requirement for education savings bonds?

Answer 21

The taxpayer and owner of the bonds must be at least 24 years old before the bond’s issue date to qualify for the education savings bond exemption.

Question 22

What expenses qualify for the education savings bond interest exclusion?

Answer 22

Only tuition and fees required for enrollment or attendance at an eligible educational institution. Room and board, textbooks, and other expenses do NOT qualify.

Question 23

What timing requirements apply to education savings bonds?

Answer 23

The bonds must be redeemed in the same year that the qualified education expenses are paid to qualify for the exclusion.

Question 24

What filing statuses can claim the education savings bond exclusion?

Answer 24

All filing statuses EXCEPT married filing separately (MFS). Taxpayers filing MFS are ineligible for the exclusion.

Question 25

What income limits apply to the education savings bond exclusion for 2024?

Answer 25

Single/HOH: Phases out between MAGI of $96,800-$111,800 Married Filing Jointly: Phases out between MAGI of $145,200-$175,200

Question 26

EXAMPLE: Partial exclusion of education savings bond interest

Answer 26

Sonya redeemed education savings bonds for $10,000 ($8,000 principal, $2,000 interest). Her qualified educational expenses were only $8,000, and she used the remaining $2,000 for a car payment. She can only exclude 80% of the interest ($1,600), and must pay tax on the remaining $400.

Question 27

EXAMPLE: Education savings bonds with MFS filing status

Answer 27

Gunther cashed qualified savings bonds for $7,520 ($5,000 principal, $2,520 interest) and paid $11,000 for college tuition. Normally, he could exclude all interest, but because he's filing married filing separately, all bond interest becomes taxable.

Question 28

What is a dividend?

Answer 28

A dividend is a distribution of cash, stock, or other property from a corporation or mutual fund. Dividend income is reported on Form 1099-DIV and must be reported on Schedule B if total dividend income exceeds $1,500.

Question 29

What is the tax rate for qualified dividends in 2024?

Answer 29

Qualified dividends are taxed at preferential capital gains rates: 0% rate: Income up to $47,025 (single), $94,050 (MFJ) 15% rate: Income $47,026-$518,900 (single), $94,051-$583,750 (MFJ) 20% rate: Income above $518,901 (single), $583,751 (MFJ)

Question 30

EXAMPLE: Qualified dividends tax advantage

Answer 30

Aiden is single with $790,000 in wages (37% tax bracket) and $120,000 in qualified dividends. His dividend income will be taxed at only 20% rather than his 37% ordinary income rate, though he will also be subject to the Net Investment Income Tax.

Question 31

What are ordinary dividends?

Answer 31

Ordinary dividends are corporate distributions in cash paid to shareholders out of earnings and profits. Unless they are qualified dividends, they are taxed at ordinary income tax rates and are reported in Box 1a of Form 1099-DIV.

Question 32

What are qualified dividends?

Answer 32

Qualified dividends are dividends that meet certain requirements and are taxed at lower capital gain rates. They are reported in Box 1b of Form 1099-DIV.

Question 33

What requirements must be met for qualified dividends?

Answer 33

1. The dividends must be paid by a U.S. corporation or qualified foreign corporation 2. The taxpayer generally must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date

Question 34

How is the holding period calculated for qualified dividends?

Answer 34

Count the number of days stock was held, starting with the day AFTER acquisition (acquisition date not included) and including the day of sale. The ex-dividend date is when a shareholder will no longer be entitled to receive the most recently declared dividend.

Question 35

What are nondividend distributions?

Answer 35

Distributions not paid out of a corporation's earnings and profits. They're considered a recovery/return of capital and generally not taxable. However, they reduce the taxpayer's basis in the stock, and once basis reaches zero, additional distributions are taxed as capital gains.

Question 36

How should money market fund earnings be reported?

Answer 36

Amounts received from money market funds should generally be reported as dividends, not as interest, even though they are often called "interest" in common language.

Question 37

What is a stock dividend?

Answer 37

A distribution of stock, rather than money, by a corporation to its own shareholders. Generally not a taxable event in the year of distribution since shareholders receive no money and all increase their shares proportionally.

Question 38

How does a stock dividend affect basis?

Answer 38

When a stock dividend is granted, the total basis of the shareholder's stock is not affected, but the basis of individual shares is adjusted by allocating the existing basis across all shares (original plus new).

Question 39

EXAMPLE: Stock dividend basis calculation

Answer 39

Sharon owns 100 shares with a $5,000 basis ($50/share). She receives a stock dividend of 100 additional shares. After the dividend, she owns 200 shares with the same $5,000 total basis, but now each share has a $25 basis ($5,000 ÷ 200). No taxable income results.

Question 40

When does a stock dividend become taxable?

Answer 40

If a shareholder has the option to receive cash instead of stock, the stock dividend is taxable in the year distributed. The recipient must include the fair market value of the stock in gross income, and that becomes the basis of the shares received.

Question 41

EXAMPLE: Taxable stock dividend

Answer 41

Danton owns 1,000 shares in Superjet Corp. with a $10,000 basis. The company declares a dividend with a cash option. Danton takes 100 additional shares worth $15 each. He must recognize $1,500 of income, which becomes his basis in the new shares.

Question 42

What is a dividend reinvestment plan (DRIP)?

Answer 42

A plan that allows taxpayers to use their dividends to purchase more shares of stock in a corporation instead of receiving cash dividends. The dividends must still be reported as income even when reinvested.

Question 43

EXAMPLE: DRIP with discounted shares

Answer 43

Francesco owns 100 shares of a company trading at $50/share. Through the DRIP, he buys 50 more shares at $40/share. He must report $500 as dividend income ($10 per share discount × 50 shares) because he received shares at below market value.

Question 44

What is a mutual fund?

Answer 44

An investment vehicle that allows investors to pool their money to invest in stocks, bonds, and other securities. The combined holdings are known as its "portfolio," and mutual funds are professionally managed by portfolio managers.

Question 45

How are mutual fund distributions reported?

Answer 45

Mutual fund distributions are reported based on the character of the income source and may include ordinary dividends, qualified dividends, capital gain distributions, exempt-interest dividends, and nondividend distributions.

Question 46

How are capital gain distributions from mutual funds treated?

Answer 46

Capital gain distributions from a mutual fund are always treated as long-term capital gains, regardless of how long the mutual fund investment was held by the taxpayer.

Question 47

EXAMPLE: Year-end mutual fund dividend timing

Answer 47

Alessandro's mutual fund declared a $230 dividend on December 27, 2024, but paid it on January 9, 2025. Alessandro must report the dividend in 2024 (when declared) not 2025, regardless of whether he withdraws or reinvests it.

Question 48

What are constructive distributions?

Answer 48

Transactions between a corporation and its shareholders that may be considered disguised dividends. They're typically assessed during audits and can have negative consequences—taxable to shareholders and non-deductible to the corporation.

Question 49

What are examples of constructive distributions?

Answer 49

1. Payment of personal expenses for shareholder 2. Unreasonably high compensation to shareholder-employees 3. Unreasonable rents (high or low) between corporation and shareholder 4. Cancellation of shareholder debt 5. Property transfers for less than fair market value 6. Below-market or interest-free loans to shareholders

Question 50

EXAMPLE: Constructive dividend through unreasonable compensation

Answer 50

Erika performs part-time administrative duties for her family's corporation but receives a $700,000 salary, and the company pays her personal car lease. The IRS would likely reclassify much of the salary and personal expenses as constructive distributions—taxable to Erika and not deductible by the corporation.