Publication 550: Investment Income and Expenses

The U.S. tax code contains extensive rules for how individuals must account for their investment activities. The Internal Revenue Service (IRS) provides a detailed guide, Publication 550, to explain the tax treatment of income and expenses related to investments. This publication is designed to help individual investors, including those who own shares in mutual funds or money market funds, navigate these complex topics. This article serves as a simplified overview of the key information within Publication 550.

Understanding and Reporting Interest Income

Interest income is a common form of return for many investors and is generally taxable at the federal level. This includes earnings from bank accounts, certificates of deposit (CDs), and corporate bonds. Payers of this income, such as banks or brokerage firms, will send a Form 1099-INT if the total interest paid during the year is $10 or more. This form details the amount of taxable interest you received.

Some types of interest are exempt from federal income tax. The most common example is interest from municipal bonds, which are issued by states, cities, or counties. While this interest is federally tax-free, it may still be subject to state and local taxes and must be reported on your tax return. This information is provided on Form 1099-INT in a separate box for tax-exempt interest.

A more complex form of interest is Original Issue Discount (OID). OID occurs when a debt instrument is issued for a price less than its stated redemption price at maturity. This discount is considered a form of interest that accrues over the life of the bond, and a portion must be reported as income each year, even though you do not receive a cash payment. Financial institutions report OID to investors on Form 1099-OID.

The amounts shown on your Forms 1099-INT and 1099-OID are transferred to Schedule B (Interest and Ordinary Dividends) of your Form 1040. You are required to file Schedule B if your total taxable interest income exceeds $1,500 for the year. Even if you do not receive a Form 1099, you are still legally obligated to report all taxable interest income.

Understanding and Reporting Dividend Income

Dividends represent a distribution of a company’s earnings to its shareholders. For tax purposes, dividends are categorized as either ordinary or qualified. Ordinary dividends are taxed at your regular income tax rates, the same as your wages or interest income.

Qualified dividends benefit from lower tax rates, which are the same as the rates for long-term capital gains. For a dividend to be “qualified,” the dividend must have been paid by a U.S. corporation or a qualified foreign corporation. You also must have held the underlying stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date, which is the cutoff for entitlement to the dividend.

Many investors participate in dividend reinvestment plans (DRIPs), where cash dividends are automatically used to purchase additional shares of the same stock. These reinvested dividends are still taxable income in the year they are paid, just as if you had received the cash.

Dividend income is reported to you by the payer on Form 1099-DIV. This form separates total ordinary dividends from the portion that is considered qualified. You then report these amounts on your Form 1040. If your total ordinary dividend income is over $1,500, you must also complete and attach Schedule B.

Navigating Capital Gains and Losses

A capital asset includes most property you own for personal use or investment, such as stocks, bonds, and real estate. When you sell or exchange a capital asset, the difference between your selling price and your basis is a capital gain or a capital loss. Your basis is typically what you paid for the asset, including any commissions or fees. Adjustments to basis can occur, such as when dividends are reinvested.

The tax treatment of a capital gain or loss depends on how long you owned the asset, which is known as the holding period. If you hold an asset for one year or less, the gain or loss is short-term, and any gains are taxed at your ordinary income tax rates. If you hold an asset for more than one year, the gain or loss is long-term, and gains are taxed at lower, preferential rates.

Each transaction is first detailed on Form 8949, Sales and Other Dispositions of Capital Assets. This form requires the asset’s description, acquisition and sale dates, sales price, and cost basis. The totals from Form 8949 are then summarized on Schedule D, Capital Gains and Losses. Schedule D is where you net your short-term gains and losses, and your long-term gains and losses, to arrive at a net figure for each.

The wash sale rule prevents you from claiming a loss on the sale of a security if you buy a substantially identical security within 30 days before or after the sale. The disallowed loss is added to the cost basis of the new replacement security. If a security you own becomes completely worthless, you can treat it as if sold on the last day of the year for $0, resulting in a capital loss.

Identifying Deductible Investment Expenses

The Tax Cuts and Jobs Act of 2017 (TCJA) suspended most miscellaneous itemized deductions for investors through 2025, including advisory fees and safe deposit box rentals. The primary remaining deductible expense is investment interest expense. This is the interest paid on money you borrowed to purchase taxable investments, such as a margin loan from your broker.

The deduction for investment interest is limited to your net investment income for the year. Net investment income is the total of your taxable investment income, such as interest, ordinary dividends, and short-term capital gains, minus any other investment-related expenses. Any interest expense that is disallowed due to this limitation can be carried forward to future tax years and deducted when you have sufficient net investment income.

To claim this deduction, you must calculate the allowable amount using Form 4952, Investment Interest Expense Deduction. The result from this form is then reported as an itemized deduction on Schedule A of Form 1040. Interest on loans used to purchase tax-exempt investments, such as municipal bonds, is not deductible.

The Net Investment Income Tax

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

Whether you are subject to the NIIT depends on your Modified Adjusted Gross Income (MAGI). The MAGI thresholds are $200,000 for single or head of household filers, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. If your MAGI is below the applicable threshold, you are not subject to the NIIT.

The income subject to this tax includes interest, dividends, capital gains, rental and royalty income, and income from passive business activities. The tax is based on the lesser of two amounts: your total net investment income for the year, or the amount by which your MAGI exceeds the applicable threshold.

The NIIT is calculated and reported on Form 8960, Net Investment Income Tax. The total tax liability from Form 8960 is then added to the other taxes you owe on your Form 1040.