Pub 550: Investment Income and Expenses

IRS Publication 550, Investment Income and Expenses, provides instructions on accounting for income from investments like stocks, bonds, or mutual funds. The publication also details which expenses can be deducted against that income. It establishes the framework for identifying taxable and non-taxable events, calculating correct amounts, and reporting them on the appropriate tax forms for any taxpayer with these assets.

Reporting Interest and Dividend Income

Reporting investment income begins when you receive tax forms from financial institutions. Banks and brokerage firms issue Form 1099-INT, Interest Income, to report interest paid to you during the year, generally when the amount is $10 or more. Similarly, companies in which you own stock or mutual funds will send Form 1099-DIV, Dividends and Distributions, to report dividends and other distributions paid to you.

A distinction must be made between taxable and tax-exempt interest. Most interest, such as that from bank accounts and corporate bonds, is taxable at your ordinary income tax rate and is found on Form 1099-INT. Some interest, such as that from municipal bonds, is often exempt from federal income tax. Original Issue Discount (OID), a form of interest on bonds issued below their redemption value, is also taxable and reported on Form 1099-OID.

You must also differentiate between ordinary and qualified dividends, as they are taxed differently. Ordinary dividends are taxed at your regular income tax rates. Qualified dividends are a portion of the ordinary dividends eligible for lower long-term capital gains tax rates. For a dividend to be qualified, you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

The income from these forms is reported on Schedule B (Form 1040), Interest and Ordinary Dividends. You are generally required to complete Schedule B if your total taxable interest or ordinary dividend income exceeds $1,500. On this schedule, you list each payer’s name and the income received, and the totals are then transferred to your Form 1040.

Understanding Capital Gains and Losses

Calculating your capital gain or loss begins with determining the asset’s basis. Basis is what you paid for an asset, including commissions or fees. For example, if you bought 100 shares of stock for $50 per share and paid a $10 commission, your basis is $5,010.

The method for determining basis depends on how you acquired the asset. For a purchased asset, the basis is its cost. If you inherited an asset, the basis is generally its fair market value on the date of the original owner’s death. For an asset received as a gift, you will generally take on the donor’s original basis.

Your initial basis can be adjusted over time. For instance, reinvesting dividends or capital gain distributions from a mutual fund to buy more shares increases your basis. Conversely, certain events can decrease your basis.

The holding period, or the length of time you own an asset, determines the tax treatment of the gain or loss. If you hold an asset for one year or less, the gain or loss is short-term and taxed as ordinary income. If you hold it for more than one year, the gain or loss is long-term and taxed at more favorable rates.

After calculating individual gains and losses, you must net them. This involves combining all short-term gains and losses to find a net short-term amount. You do the same for long-term gains and losses, and then combine the net results to find your overall capital gain or loss for the year.

Reporting Sales and Exchanges of Property

You report capital gains and losses on Form 8949, Sales and Other Dispositions of Capital Assets. You will use the information provided by your broker on Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, to complete this form. Form 1099-B details your sales proceeds and often reports your cost basis to the IRS.

On Form 8949, you must separate short-term from long-term transactions. Within those categories, you further sort transactions based on whether the basis was reported to the IRS on your Form 1099-B.

The totals from Form 8949 are transferred to Schedule D, Capital Gains and Losses. Schedule D consolidates these figures to determine your overall capital gain or loss for the year. This final amount is then carried over to your main Form 1040.

The wash sale rule prevents you from deducting a loss on a security if you buy a substantially identical security within 30 days before or after the sale. Any loss disallowed by this rule is added to the basis of the new shares.

Other rules cover situations like worthless securities and nonbusiness bad debts. A security that becomes completely worthless can be treated as a capital loss. A nonbusiness bad debt is treated as a short-term capital loss in the year it becomes completely worthless.

Deducting Investment Interest Expense

You may be able to deduct the interest paid on money borrowed to purchase investments, such as margin interest from a brokerage account. This is known as investment interest expense. To be deductible, the interest must be from a loan used to buy property held for investment.

The deduction for investment interest expense cannot exceed your net investment income for the year. Net investment income is your total investment income minus any deductible investment expenses, other than the interest itself. Investment income for this purpose includes taxable interest, ordinary dividends, and royalties but not qualified dividends or long-term capital gains.

You can elect to include qualified dividends and long-term capital gains as part of your investment income to increase your deduction limit. The trade-off is that any amount you include for this calculation will no longer be eligible for the lower preferential tax rates.

To calculate and claim this deduction, you must file Form 4952, Investment Interest Expense Deduction. If your investment interest expense for the year is more than your net investment income, the disallowed portion is not lost. You can carry forward the disallowed interest and deduct it in a future year when you have sufficient net investment income.

The Net Investment Income Tax

Certain taxpayers are subject to an additional 3.8% tax on their investment income, known as the Net Investment Income Tax (NIIT). This tax applies to individuals, estates, and trusts that have investment income and total income above certain thresholds.

The income thresholds that trigger the NIIT depend on your filing status and are based on modified adjusted gross income (MAGI). For individuals, the thresholds are $250,000 for married filing jointly, $125,000 for married filing separately, and $200,000 for single and head of household filers. For estates and trusts, the NIIT applies if their adjusted gross income exceeds the dollar amount at which the highest tax bracket begins for the tax year ($15,650 for 2025).

If your income exceeds the applicable threshold, you must calculate the tax. You are not subject to the NIIT if your income is at or below the threshold.

For the NIIT, net investment income includes interest, dividends, capital gains, rental and royalty income, and income from passive business activities. This definition is different from the one used for the investment interest expense deduction. From this gross investment income, you can subtract certain related expenses to arrive at your net investment income.

The NIIT is calculated on the lesser of your total net investment income or the amount by which your MAGI exceeds the filing status threshold. You multiply this smaller amount by 3.8% to determine your NIIT liability. This calculation is performed on Form 8960, Net Investment Income Tax, which you file with your Form 1040.