Publication 550: Investment Income and Expenses

The Internal Revenue Service’s Publication 550, “Investment Income and Expenses,” serves as the official guide for taxpayers. It covers the rules for reporting income generated by investments and the expenses incurred to manage them. This article distills the guidance from Publication 550, focusing on the most common situations investors encounter when preparing their tax returns.

Understanding Interest Income

Interest income is payment for the use of your money. Most interest you receive is taxable, including from bank accounts, money market accounts, certificates of deposit (CDs), and corporate bonds. Financial institutions report this income to you and the IRS on Form 1099-INT.

A frequent source of tax-exempt interest is from municipal bonds issued by states, cities, or counties. While this interest is exempt from federal income tax, it must be reported on your tax return because it can affect the calculation of taxes on other income, like Social Security benefits.

Original Issue Discount (OID) occurs on long-term debt instruments purchased for less than face value. For tax purposes, a portion of this discount accrues each year and must be reported as taxable interest income annually, even though it is not paid until maturity. Payers report this on Form 1099-OID.

Decoding Dividend Income

Dividends are distributions of a company’s earnings to its shareholders. Most dividends are ordinary dividends, taxed at your regular income tax rates. Your broker or the paying corporation will report these payments to you on Form 1099-DIV, with the total amount listed in box 1a.

A portion of your ordinary dividends may be classified as qualified dividends, which are taxed at the lower long-term capital gains rates. For a dividend to be qualified, it must be paid by a U.S. or qualified foreign corporation. You must also meet a holding period requirement by owning the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The amount of your qualified dividends is shown in box 1b of your Form 1099-DIV.

Navigating Capital Gains and Losses

Calculating Gain or Loss

When you sell a capital asset like stocks or bonds, the result is a capital gain or loss. To calculate a gain or loss, subtract the asset’s basis from the sale proceeds. Proceeds are the gross amount from the sale, less commissions, while the basis is generally what you paid for the asset, including commissions.

For example, if you bought shares for $5,000 plus a $10 commission, your basis is $5,010. If you sold them for $8,000 minus a $10 commission, your proceeds are $7,990, resulting in a $2,980 capital gain.

An asset’s basis is not always its original cost. If you inherit an asset, your basis is its fair market value on the date of the previous owner’s death. For a gifted asset, you generally assume the donor’s basis.

Holding Periods

The tax rate on a capital gain depends on the holding period. A short-term capital gain or loss results from the sale of an asset you held for one year or less, and these gains are taxed at your ordinary income tax rates. An asset held for more than one year at the time of sale generates a long-term capital gain or loss.

Long-term gains are taxed at preferential rates, which for most taxpayers are 0%, 15%, or 20%. The holding period starts the day after you acquire the property and includes the day you sell it.

Netting and Loss Limitations

At the end of the tax year, you must combine all your capital gains and losses. First, you net all short-term gains and losses against each other to arrive at a net short-term result. You perform the same calculation for your long-term gains and losses.

These two net amounts are then combined. If one is a gain and the other is a loss, they are netted against each other. If the final result is a net capital loss, you can deduct up to $3,000 ($1,500 if married filing separately) against other income. Any net capital loss exceeding this limit can be carried forward to subsequent tax years.

The Wash Sale Rule

The wash sale rule prevents you from claiming a loss on a security if you buy a “substantially identical” one within 30 days before or 30 days after the sale. This 61-day window also applies if your spouse or a corporation you control makes the purchase. If a wash sale occurs, the loss is disallowed for the current tax year.

For example, if you sell 100 shares of XYZ Corp. for a $1,000 loss and buy 100 shares of the same stock 15 days later, you cannot deduct the loss. The disallowed loss is added to the cost basis of the new shares, postponing the tax benefit until the new shares are sold.

Accounting for Investment-Related Items

Investment Expenses

Following the Tax Cuts and Jobs Act of 2017, most investment expenses are no longer deductible for individuals. This suspended the deduction for costs like investment advisory fees, safe deposit box rentals, and financial publication subscriptions.

One primary deduction that remains is for investment interest expense, which is interest paid on money borrowed to purchase taxable investments. The deduction for this interest is limited to your net investment income for the year and is calculated on Form 4952.

Net Investment Income Tax (NIIT)

Higher-income taxpayers may be subject to the Net Investment Income Tax (NIIT). This is a 3.8% tax on either your net investment income or the amount your modified adjusted gross income (MAGI) exceeds certain thresholds, whichever is less. For 2024, the MAGI thresholds are $250,000 for married couples filing jointly, $125,000 for married filing separately, and $200,000 for single filers.

Net investment income includes:

• Interest
• Dividends
• Capital gains
• Rental and royalty income
• Income from passive business activities

The NIIT is calculated on Form 8960.

Reporting Investment Activity on Tax Forms

Schedule B, Interest and Ordinary Dividends

Schedule B is required if your total taxable interest or ordinary dividend income exceeds $1,500 for the year. On this form, you must list each payer and the amount of income received. Even if your income is below the threshold, you must still report all taxable interest and dividend income on your Form 1040. The totals from Schedule B are carried over to Form 1040.

Form 8949, Sales and Other Dispositions of Capital Assets

Form 8949 is used to report the details of each capital asset sale. For every transaction, you must list the property description, acquisition and sale dates, sales price, and cost basis. This form is where you reconcile amounts from Form 1099-B with what you report on your return. Part I of the form is for short-term transactions, while Part II is for long-term transactions, which is necessary to apply the correct tax rates.

Schedule D, Capital Gains and Losses

Schedule D summarizes your capital gain and loss activity from Form 8949. This form consolidates the information, allowing you to perform the final netting of your short-term and long-term gains and losses. The final result from Schedule D determines your overall net capital gain or loss for the year and is then transferred to your Form 1040.