IRS Publication 550: Investment Income and Expenses

IRS Publication 550 explains the tax treatment of income and expenses from investments. It provides guidance on how to report earnings from various investments and what associated costs can be deducted. The publication covers the tax rules for many types of investment activities.

Understanding Investment Income

Interest and dividends are two of the most common types of investment income. Taxable interest can come from sources like bank accounts, money market funds, and corporate bonds. However, interest from bonds issued by states or municipalities is exempt from federal income tax, though it must still be reported.

Original Issue Discount (OID) is another form of interest income. OID occurs when a debt instrument, like a bond, is purchased for less than its face value. This discount is treated as interest that accrues over the bond’s life, and a portion must be reported as income each year, even if no cash payment is received.

Dividend income is a distribution of a company’s earnings to shareholders and is categorized as either ordinary or qualified. Ordinary dividends are taxed at an individual’s regular income tax rates. Qualified dividends are taxed at lower long-term capital gains rates but must meet certain criteria, including being paid by a U.S. corporation or qualifying foreign entity and the investor meeting a minimum holding period for the stock.

Investors in mutual funds or Real Estate Investment Trusts (REITs) can receive capital gain distributions. These are payouts from the net gains a fund realized by selling its assets. These distributions are taxed as long-term capital gains, regardless of how long the investor has owned shares in the fund.

Calculating Capital Gains and Losses

Selling a capital asset like stocks or bonds results in a capital gain or loss. The calculation starts with the asset’s basis, which is its original cost, including any commissions or fees. The basis can be adjusted over time, such as when dividends are reinvested to purchase more shares.

The holding period, or the length of time an asset is held, determines how a gain or loss is taxed. A holding period of one year or less is short-term, and gains are taxed at ordinary income rates. A holding period of more than one year is long-term, and gains are taxed at lower, more favorable rates.

To determine the final taxable amount, investors must net their capital gains and losses. First, all short-term gains and losses are netted against each other to find a net short-term result. Concurrently, all long-term gains and losses are netted to find a net long-term result.

The process concludes by netting the short-term and long-term results. For example, a net short-term loss is subtracted from a net long-term gain. The character of the final net amount depends on which type of gain or loss was larger.

If the netting process results in a net capital loss, an individual can deduct up to $3,000 of that loss ($1,500 if married filing separately) against other income. Any capital loss exceeding this annual limit is not lost. It can be carried forward to future tax years to offset capital gains or be deducted.

Deductible Investment Expenses

The primary deductible cost for many investors is investment interest expense. This is interest paid on money borrowed to purchase taxable investments, like buying stocks on margin. The deduction for this interest is limited to the amount of net investment income earned during the year.

To claim this deduction, taxpayers must file Form 4952, Investment Interest Expense Deduction. Net investment income includes taxable interest, ordinary dividends, and short-term capital gains, less other investment expenses. The final deduction is reported as an itemized deduction on Schedule A of Form 1040.

Investment interest expense that exceeds the net investment income limit for the year is not lost. It can be carried forward and deducted in future years, subject to that year’s income limitation.

Other investment-related costs, such as advisory fees and financial publication subscriptions, are not currently deductible. The suspension of these miscellaneous itemized deductions is in effect through tax year 2025. They are scheduled to be reinstated in 2026, at which point they will be deductible only to the extent they exceed 2% of adjusted gross income.

Reporting Investment Transactions on Tax Forms

Reporting investment activity requires gathering several informational documents sent by financial institutions. These include Form 1099-INT for interest, Form 1099-OID for original issue discount, Form 1099-DIV for dividends and capital gain distributions, and Form 1099-B for proceeds from broker transactions.

Interest and ordinary dividend income are reported on Schedule B, Interest and Ordinary Dividends. Taxpayers must complete this schedule if their total interest or dividend income exceeds $1,500 for the year. The totals from Schedule B are then transferred to Form 1040.

The sale of capital assets is reported first on Form 8949, Sales and Other Dispositions of Capital Assets. Using information from Form 1099-B, taxpayers list the details of each sale to calculate the gain or loss. The totals from Form 8949 are then carried over to Schedule D, Capital Gains and Losses.

On Schedule D, gains and losses are separated into short-term and long-term categories for the netting process. This consolidation determines the final net capital gain or loss for the year. The result from Schedule D is then reported on Form 1040.

Special Investment Situations

One common special circumstance is the wash sale rule. A wash sale occurs when an investor sells a security at a loss and acquires a substantially identical one within a 61-day period, spanning 30 days before to 30 days after the sale. This rule prevents claiming a tax loss while maintaining the same investment position.

If a wash sale occurs, the loss is disallowed for the current tax year. The disallowed loss is instead added to the cost basis of the new security. This adjustment postpones the tax benefit of the loss until the replacement security is sold.

Higher-income taxpayers may be subject to the Net Investment Income Tax (NIIT). This is a 3.8% tax on the lesser of an individual’s net investment income or the amount their modified adjusted gross income (MAGI) exceeds certain thresholds. The MAGI thresholds are $200,000 for single filers and $250,000 for married couples filing jointly, and the tax is calculated on Form 8960.

If a security becomes completely worthless during the tax year, it is treated as if it were sold for $0 on the last day of that year. This timing on December 31st is used to determine the holding period. This establishes whether the resulting capital loss is short-term or long-term.