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Free tax software 2011 download 3. Free tax software 2011 download   Investment Expenses Table of Contents Topics - This chapter discusses: Useful Items - You may want to see: Limits on DeductionsPassive activity. Free tax software 2011 download Other income (nonpassive income). Free tax software 2011 download Expenses. Free tax software 2011 download Additional information. Free tax software 2011 download Interest ExpensesInvestment Interest Limit on Deduction Bond Premium AmortizationSpecial rules to determine amounts payable on a bond. Free tax software 2011 download Basis. Free tax software 2011 download How To Figure Amortization Choosing To Amortize How To Report Amortization Expenses of Producing IncomeFees to buy or sell. Free tax software 2011 download Including mutual fund or REMIC expenses in income. Free tax software 2011 download Nondeductible ExpensesUsed as collateral. Free tax software 2011 download Short-sale expenses. Free tax software 2011 download Expenses for both tax-exempt and taxable income. Free tax software 2011 download State income taxes. Free tax software 2011 download Nondeductible amount. Free tax software 2011 download Basis adjustment. Free tax software 2011 download How To Report Investment Expenses When To Report Investment Expenses Topics - This chapter discusses: Limits on Deductions , Interest Expenses , Bond Premium Amortization , Expenses of Producing Income , Nondeductible Expenses , How To Report Investment Expenses , and When To Report Investment Expenses . Free tax software 2011 download Useful Items - You may want to see: Publication 535 Business Expenses 925 Passive Activity and At-Risk Rules 929 Tax Rules for Children and Dependents Form (and Instructions) Schedule A (Form 1040) Itemized Deductions 4952 Investment Interest Expense Deduction See chapter 5, How To Get Tax Help , for information about getting these publications and forms. Free tax software 2011 download Limits on Deductions Your deductions for investment expenses may be limited by: The at-risk rules, The passive activity loss limits, The limit on investment interest, or The 2% limit on certain miscellaneous itemized deductions. Free tax software 2011 download The at-risk rules and passive activity rules are explained briefly in this section. Free tax software 2011 download The limit on investment interest is explained later in this chapter under Interest Expenses . Free tax software 2011 download The 2% limit is explained later in this chapter under Expenses of Producing Income . Free tax software 2011 download At-risk rules. Free tax software 2011 download   Special at-risk rules apply to most income-producing activities. Free tax software 2011 download These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. Free tax software 2011 download Generally, this is the cash and the adjusted basis of property you contribute to the activity. Free tax software 2011 download It also includes money you borrow for use in the activity if you are personally liable for repayment or if you use property not used in the activity as security for the loan. Free tax software 2011 download For more information, see Publication 925. Free tax software 2011 download Passive activity losses and credits. Free tax software 2011 download   The amount of losses and tax credits you can claim from passive activities is limited. Free tax software 2011 download Generally, you are allowed to deduct passive activity losses only up to the amount of your passive activity income. Free tax software 2011 download Also, you can use credits from passive activities only against tax on the income from passive activities. Free tax software 2011 download There are exceptions for certain activities, such as rental real estate activities. Free tax software 2011 download Passive activity. Free tax software 2011 download   A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. Free tax software 2011 download However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true. Free tax software 2011 download More than one-half of the personal services you perform during the year in all trades or businesses are performed in real property trades or businesses in which you materially participate. Free tax software 2011 download You perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate. Free tax software 2011 download  The term “trade or business” generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. Free tax software 2011 download However, it does not include rental activities or certain activities treated as incidental to holding property for investment. Free tax software 2011 download   You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity. Free tax software 2011 download Other income (nonpassive income). Free tax software 2011 download    Generally, you can use losses from passive activities only to offset income from passive activities. Free tax software 2011 download You cannot use passive activity losses to offset your other income, such as your wages or your portfolio income. Free tax software 2011 download Portfolio income includes gross income from interest, dividends, annuities, or royalties that is not derived in the ordinary course of a trade or business. Free tax software 2011 download It also includes gains or losses (not derived in the ordinary course of a trade or business) from the sale or trade of property (other than an interest in a passive activity) producing portfolio income or held for investment. Free tax software 2011 download This includes capital gain distributions from mutual funds (and other regulated investment companies) and real estate investment trusts. Free tax software 2011 download   You cannot use passive activity losses to offset Alaska Permanent Fund dividends. Free tax software 2011 download Expenses. Free tax software 2011 download   Do not include in the computation of your passive activity income or loss: Expenses (other than interest) that are clearly and directly allocable to your portfolio income, or Interest expense properly allocable to portfolio income. Free tax software 2011 download However, this interest and other expenses may be subject to other limits. Free tax software 2011 download These limits are explained in the rest of this chapter. Free tax software 2011 download Additional information. Free tax software 2011 download   For more information about determining and reporting income and losses from passive activities, see Publication 925. Free tax software 2011 download Interest Expenses This section discusses interest expenses you may be able to deduct as an investor. Free tax software 2011 download For information on business interest, see chapter 4 of Publication 535. Free tax software 2011 download You cannot deduct personal interest expenses other than qualified home mortgage interest, as explained in Publication 936, Home Mortgage Interest Deduction, and interest on certain student loans, as explained in Publication 970. Free tax software 2011 download Investment Interest If you borrow money to buy property you hold for investment, the interest you pay is investment interest. Free tax software 2011 download You can deduct investment interest subject to the limit discussed later. Free tax software 2011 download However, you cannot deduct interest you incurred to produce tax-exempt income. Free tax software 2011 download See Tax-exempt income under Nondeductible Expenses, later. Free tax software 2011 download You also cannot deduct interest expenses on straddles discussed under Interest expense and carrying charges on straddles , later. Free tax software 2011 download Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity. Free tax software 2011 download Investment property. Free tax software 2011 download   Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. Free tax software 2011 download It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Free tax software 2011 download Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity). Free tax software 2011 download Partners, shareholders, and beneficiaries. Free tax software 2011 download   To determine your investment interest, combine your share of investment interest from a partnership, S corporation, estate, or trust with your other investment interest. Free tax software 2011 download Allocation of Interest Expense If you borrow money for business or personal purposes as well as for investment, you must allocate the debt among those purposes. Free tax software 2011 download Only the interest expense on the part of the debt used for investment purposes is treated as investment interest. Free tax software 2011 download The allocation is not affected by the use of property that secures the debt. Free tax software 2011 download Example 1. Free tax software 2011 download You borrow $10,000 and use $8,000 to buy stock. Free tax software 2011 download You use the other $2,000 to buy items for your home. Free tax software 2011 download Since 80% of the debt is used for, and allocated to, investment purposes, 80% of the interest on that debt is investment interest. Free tax software 2011 download The other 20% is nondeductible personal interest. Free tax software 2011 download Debt proceeds received in cash. Free tax software 2011 download   If you receive debt proceeds in cash, the proceeds are generally not treated as investment property. Free tax software 2011 download Debt proceeds deposited in account. Free tax software 2011 download   If you deposit debt proceeds in an account, that deposit is treated as investment property, regardless of whether the account bears interest. Free tax software 2011 download But, if you withdraw the funds and use them for another purpose, you must reallocate the debt to determine the amount considered to be for investment purposes. Free tax software 2011 download Example 2. Free tax software 2011 download Assume in Example 1 that you borrowed the money on March 1 and immediately bought the stock for $8,000. Free tax software 2011 download You did not buy the household items until June 1. Free tax software 2011 download You had deposited the $2,000 in the bank. Free tax software 2011 download You had no other transactions on the bank account until June. Free tax software 2011 download You did not sell the stock, and you made no principal payments on the debt. Free tax software 2011 download You paid interest from another account. Free tax software 2011 download The $8,000 is treated as being used for an investment purpose. Free tax software 2011 download The $2,000 is treated as being used for an investment purpose for the 3-month period. Free tax software 2011 download Your total interest expense for 3 months on this debt is investment interest. Free tax software 2011 download In June, when you spend the $2,000 for household items, you must begin to allocate 80% of the debt and the interest expense to investment purposes and 20% to personal purposes. Free tax software 2011 download Amounts paid within 30 days. Free tax software 2011 download   If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. Free tax software 2011 download This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account. Free tax software 2011 download   If you received the loan proceeds in cash, you can treat the payment as made on the date you received the cash instead of the date you actually made the payment. Free tax software 2011 download Payments on debt may require new allocation. Free tax software 2011 download   As you repay a debt used for more than one purpose, you must reallocate the balance. Free tax software 2011 download You must first reduce the amount allocated to personal purposes by the repayment. Free tax software 2011 download You then reallocate the rest of the debt to find what part is for investment purposes. Free tax software 2011 download Example 3. Free tax software 2011 download If, in Example 2 , you repay $500 on November 1, the entire repayment is applied against the amount allocated to personal purposes. Free tax software 2011 download The debt balance is now allocated as $8,000 for investment purposes and $1,500 for personal purposes. Free tax software 2011 download Until the next reallocation is necessary, 84% ($8,000 ÷ $9,500) of the debt and the interest expense is allocated to investment. Free tax software 2011 download Pass-through entities. Free tax software 2011 download   If you use borrowed funds to buy an interest in a partnership or S corporation, then the interest on those funds must be allocated based on the assets of the entity. Free tax software 2011 download If you contribute to the capital of the entity, you can make the allocation using any reasonable method. Free tax software 2011 download Additional allocation rules. Free tax software 2011 download   For more information about allocating interest expense, see chapter 4 of Publication 535. Free tax software 2011 download When To Deduct Investment Interest If you use the cash method of accounting, you must pay the interest before you can deduct it. Free tax software 2011 download If you use an accrual method of accounting, you can deduct interest over the period it accrues, regardless of when you pay it. Free tax software 2011 download For an exception, see Unpaid expenses owed to related party under When To Report Investment Expenses, later in this chapter. Free tax software 2011 download Example. Free tax software 2011 download You borrowed $1,000 on August 26, 2013, payable in 90 days at 12% interest. Free tax software 2011 download On November 26, 2013, you paid this with a new note for $1,030, due on February 26, 2014. Free tax software 2011 download If you use the cash method of accounting, you cannot deduct any part of the $30 interest on your return for 2013 because you did not actually pay it. Free tax software 2011 download If you use an accrual method, you may be able to deduct a portion of the interest on the loans through December 31, 2013, on your return for 2013. Free tax software 2011 download Interest paid in advance. Free tax software 2011 download   Generally, if you pay interest in advance for a period that goes beyond the end of the tax year, you must spread the interest over the tax years to which it belongs under the OID rules discussed in chapter 1. Free tax software 2011 download You can deduct in each year only the interest for that year. Free tax software 2011 download Interest on margin accounts. Free tax software 2011 download   If you are a cash method taxpayer, you can deduct interest on margin accounts to buy taxable securities as investment interest in the year you paid it. Free tax software 2011 download You are considered to have paid interest on these accounts only when you actually pay the broker or when payment becomes available to the broker through your account. Free tax software 2011 download Payment may become available to the broker through your account when the broker collects dividends or interest for your account, or sells securities held for you or received from you. Free tax software 2011 download   You cannot deduct any interest on money borrowed for personal reasons. Free tax software 2011 download Limit on interest deduction for market discount bonds. Free tax software 2011 download   The amount you can deduct for interest expense you paid or accrued during the year to buy or carry a market discount bond may be limited. Free tax software 2011 download This limit does not apply if you accrue the market discount and include it in your income currently. Free tax software 2011 download   Under this limit, the interest is deductible only to the extent it is more than: The total interest and OID includible in gross income for the bond for the year, plus The market discount for the number of days you held the bond during the year. Free tax software 2011 download Figure the amount in (2) above using the rules for figuring accrued market discount in chapter 1 under Market Discount Bonds . Free tax software 2011 download Interest not deducted due to limit. Free tax software 2011 download   In the year you dispose of the bond, you can deduct any interest expense you were not allowed to deduct in earlier years because of the limit. Free tax software 2011 download Choosing to deduct disallowed interest expense before the year of disposition. Free tax software 2011 download   You can choose to deduct disallowed interest expense in any year before the year you dispose of the bond, up to your net interest income from the bond during the year. Free tax software 2011 download The rest of the disallowed interest expense remains deductible in the year you dispose of the bond. Free tax software 2011 download Net interest income. Free tax software 2011 download   This is the interest income (including OID) from the bond that you include in income for the year, minus the interest expense paid or accrued during the year to purchase or carry the bond. Free tax software 2011 download Limit on interest deduction for short-term obligations. Free tax software 2011 download   If the current income inclusion rules discussed in chapter 1 under Discount on Short-Term Obligations do not apply to you, the amount you can deduct for interest expense you paid or accrued during the year to buy or carry a short-term obligation is limited. Free tax software 2011 download   The interest is deductible only to the extent it is more than: The amount of acquisition discount or OID on the obligation for the tax year, plus The amount of any interest payable on the obligation for the year that is not included in income because of your accounting method (other than interest taken into account in determining the amount of acquisition discount or OID). Free tax software 2011 download The method of determining acquisition discount and OID for short-term obligations is discussed in chapter 1 under Discount on Short-Term Obligations . Free tax software 2011 download Interest not deducted due to limit. Free tax software 2011 download   In the year you dispose of the obligation, or, if you choose, in another year in which you have net interest income from the obligation, you can deduct any interest expense you were not allowed to deduct for an earlier year because of the limit. Free tax software 2011 download Follow the same rules provided in the earlier discussion under Limit on interest deduction for market discount bonds , earlier. Free tax software 2011 download Limit on Deduction Generally, your deduction for investment interest expense is limited to your net investment income. Free tax software 2011 download You can carry over the amount of investment interest you could not deduct because of this limit to the next tax year. Free tax software 2011 download The interest carried over is treated as investment interest paid or accrued in that next year. Free tax software 2011 download You can carry over disallowed investment interest to the next tax year even if it is more than your taxable income in the year the interest was paid or accrued. Free tax software 2011 download Net Investment Income Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income. Free tax software 2011 download Investment income. Free tax software 2011 download   This generally includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties). Free tax software 2011 download Investment income does not include Alaska Permanent Fund dividends. Free tax software 2011 download It also does not include qualified dividends or net capital gain unless you choose to include them. Free tax software 2011 download Choosing to include qualified dividends. Free tax software 2011 download   Investment income generally does not include qualified dividends, discussed in chapter 1. Free tax software 2011 download However, you can choose to include all or part of your qualified dividends in investment income. Free tax software 2011 download   You make this choice by completing Form 4952, line 4g, according to its instructions. Free tax software 2011 download   If you choose to include any of your qualified dividends in investment income, you must reduce your qualified dividends that are eligible for the lower capital gains tax rates by the same amount. Free tax software 2011 download Choosing to include net capital gain. Free tax software 2011 download    Investment income generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds). Free tax software 2011 download However, you can choose to include all or part of your net capital gain in investment income. Free tax software 2011 download   You make this choice by completing Form 4952, line 4g, according to its instructions. Free tax software 2011 download   If you choose to include any of your net capital gain in investment income, you must reduce your net capital gain that is eligible for the lower capital gains tax rates by the same amount. Free tax software 2011 download   For more information about the capital gains rates, see Capital Gain Tax Rates in chapter 4. Free tax software 2011 download    Before making either choice, consider the overall effect on your tax liability. Free tax software 2011 download Compare your tax if you make one or both of these choices with your tax if you do not. Free tax software 2011 download Investment income of child reported on parent's return. Free tax software 2011 download   Investment income includes the part of your child's interest and dividend income you choose to report on your return. Free tax software 2011 download If the child does not have qualified dividends, Alaska Permanent Fund dividends, or capital gain distributions, this is the amount on line 6 of Form 8814. Free tax software 2011 download Include it on line 4a of Form 4952. Free tax software 2011 download Example. Free tax software 2011 download Your 8-year-old son has interest income of $2,200, which you choose to report on your own return. Free tax software 2011 download You enter $2,200 on Form 8814, lines 1a and 4, and $200 on lines 6 and 12 and complete Part II. Free tax software 2011 download Also enter $200 on Form 1040, line 21. Free tax software 2011 download Your investment income includes this $200. Free tax software 2011 download Child's qualified dividends. Free tax software 2011 download   If part of the amount you report is your child's qualified dividends, that part (which is reported on Form 1040, line 9b) generally does not count as investment income. Free tax software 2011 download However, you can choose to include all or part of it in investment income, as explained under Choosing to include qualified dividends , earlier. Free tax software 2011 download   Your investment income also includes the amount on Form 8814, line 12 (or, if applicable, the reduced amount figured next under Child's Alaska Permanent Fund dividends). Free tax software 2011 download Child's Alaska Permanent Fund dividends. Free tax software 2011 download   If part of the amount you report is your child's Alaska Permanent Fund dividends, that part does not count as investment income. Free tax software 2011 download To figure the amount of your child's income that you can consider your investment income, start with the amount on Form 8814, line 6. Free tax software 2011 download Multiply that amount by a percentage that is equal to the Alaska Permanent Fund dividends divided by the total amount on Form 8814, line 4. Free tax software 2011 download Subtract the result from the amount on Form 8814, line 12. Free tax software 2011 download Example. Free tax software 2011 download Your 10-year-old child has taxable interest income of $4,000 and Alaska Permanent Fund dividends of $2,000. Free tax software 2011 download You choose to report this on your return. Free tax software 2011 download You enter $4,000 on Form 8814, line 1a, $2,000 on line 2a, and $6,000 on line 4. Free tax software 2011 download You then enter $4,000 on Form 8814, lines 6 and 12, and Form 1040, line 21. Free tax software 2011 download You figure the amount of your child's income that you can consider your investment income as follows: $4,000 − ($4,000 × ($2,000 ÷ $6,000)) = $2,667 You include the result, $2,667, on Form 4952, line 4a. Free tax software 2011 download Child's capital gain distributions. Free tax software 2011 download   If part of the amount you report is your child's capital gain distributions, that part (which is reported on Schedule D (Form 1040), line 13, or Form 1040, line 13) generally does not count as investment income. Free tax software 2011 download However, you can choose to include all or part of it in investment income, as explained in Choosing to include net capital gain , earlier. Free tax software 2011 download   Your investment income also includes the amount on Form 8814, line 12 (or, if applicable, the reduced amount figured under Child's Alaska Permanent Fund dividends , earlier). Free tax software 2011 download Investment expenses. Free tax software 2011 download   Investment expenses are your allowed deductions (other than interest expense) directly connected with the production of investment income. Free tax software 2011 download Investment expenses that are included as a miscellaneous itemized deduction on Schedule A (Form 1040) are allowable deductions after applying the 2% limit that applies to miscellaneous itemized deductions. Free tax software 2011 download Use the smaller of: The investment expenses included on Schedule A (Form 1040), line 23, or The amount on Schedule A (Form 1040), line 27. Free tax software 2011 download See Expenses of Producing Income , later, for a discussion of the 2% limit. Free tax software 2011 download Losses from passive activities. Free tax software 2011 download   Income or expenses that you used in computing income or loss from a passive activity are not included in determining your investment income or investment expenses (including investment interest expense). Free tax software 2011 download See Publication 925 for information about passive activities. Free tax software 2011 download Example. Free tax software 2011 download Ted is a partner in a partnership that operates a business. Free tax software 2011 download However, he does not materially participate in the partnership's business. Free tax software 2011 download Ted's interest in the partnership is considered a passive activity. Free tax software 2011 download Ted's investment income from interest and dividends (other than qualified dividends) is $10,000. Free tax software 2011 download His investment expenses (other than interest) are $3,200 after taking into account the 2% limit on miscellaneous itemized deductions. Free tax software 2011 download His investment interest expense is $8,000. Free tax software 2011 download Ted also has income from the partnership of $2,000. Free tax software 2011 download Ted figures his net investment income and the limit on his investment interest expense deduction in the following way: Total investment income $10,000 Minus: Investment expenses (other than interest) 3,200 Net investment income $6,800 Deductible investment interest expense for the year $6,800 The $2,000 of income from the passive activity is not used in determining Ted's net investment income. Free tax software 2011 download His investment interest deduction for the year is limited to $6,800, the amount of his net investment income. Free tax software 2011 download Form 4952 Use Form 4952 to figure your deduction for investment interest. Free tax software 2011 download See Form 4952 for more information. Free tax software 2011 download Exception to use of Form 4952. Free tax software 2011 download   You do not have to complete Form 4952 or attach it to your return if you meet all of the following tests. Free tax software 2011 download Your investment interest expense is not more than your investment income from interest and ordinary dividends minus any qualified dividends. Free tax software 2011 download You do not have any other deductible investment expenses. Free tax software 2011 download You have no carryover of investment interest expense from 2012. Free tax software 2011 download   If you meet all of these tests, you can deduct all of your investment interest. Free tax software 2011 download    Bond Premium Amortization If you pay a premium to buy a bond, the premium is part of your basis in the bond. Free tax software 2011 download If the bond yields taxable interest, you can choose to amortize the premium. Free tax software 2011 download This generally means that each year, over the life of the bond, you use a part of the premium to reduce the amount of interest includible in your income. Free tax software 2011 download If you make this choice, you must reduce your basis in the bond by the amortization for the year. Free tax software 2011 download If the bond yields tax-exempt interest, you must amortize the premium. Free tax software 2011 download This amortized amount is not deductible in determining taxable income. Free tax software 2011 download However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year. Free tax software 2011 download Bond premium. Free tax software 2011 download   Bond premium is the amount by which your basis in the bond right after you get it is more than the total of all amounts payable on the bond after you get it (other than payments of qualified stated interest). Free tax software 2011 download For example, a bond with a maturity value of $1,000 generally would have a $50 premium if you buy it for $1,050. Free tax software 2011 download Special rules to determine amounts payable on a bond. Free tax software 2011 download   For special rules that apply to determine the amounts payable on a variable rate bond, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules (for example, a bond callable prior to the stated maturity date of the bond), or a bond that provides for remote or incidental contingencies, see Regulations section 1. Free tax software 2011 download 171-3. Free tax software 2011 download Basis. Free tax software 2011 download   In general, your basis for figuring bond premium amortization is the same as your basis for figuring any loss on the sale of the bond. Free tax software 2011 download However, you may need to use a different basis for: Convertible bonds, Bonds you got in a trade, and Bonds whose basis has to be determined using the basis of the person who transferred the bond to you. Free tax software 2011 download See Regulations section 1. Free tax software 2011 download 171-1(e). Free tax software 2011 download Dealers. Free tax software 2011 download   A dealer in taxable bonds (or anyone who holds them mainly for sale to customers in the ordinary course of a trade or business or who would properly include bonds in inventory at the close of the tax year) cannot claim a deduction for amortizable bond premium. Free tax software 2011 download   See section 75 of the Internal Revenue Code for the treatment of bond premium by a dealer in tax-exempt bonds. Free tax software 2011 download How To Figure Amortization For bonds issued after September 27, 1985, you must amortize bond premium using a constant yield method on the basis of the bond's yield to maturity, determined by using the bond's basis and compounding at the close of each accrual period. Free tax software 2011 download Constant yield method. Free tax software 2011 download   Figure the bond premium amortization for each accrual period as follows. Free tax software 2011 download Step 1: Determine your yield. Free tax software 2011 download   Your yield is the discount rate that, when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Free tax software 2011 download Figure the yield as of the date you got the bond. Free tax software 2011 download It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage. Free tax software 2011 download   If you do not know the yield, consult your broker or tax advisor. Free tax software 2011 download Databases available to them are likely to show the yield at the date of purchase. Free tax software 2011 download Step 2: Determine the accrual periods. Free tax software 2011 download   You can choose the accrual periods to use. Free tax software 2011 download They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. Free tax software 2011 download The computation is simplest if accrual periods are the same as the intervals between interest payment dates. Free tax software 2011 download Step 3: Determine the bond premium for the accrual period. Free tax software 2011 download   To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Free tax software 2011 download Then subtract the result from the qualified stated interest for the period. Free tax software 2011 download   Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. Free tax software 2011 download After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest. Free tax software 2011 download Example. Free tax software 2011 download On February 1, 2012, you bought a taxable bond for $110,000. Free tax software 2011 download The bond has a stated principal amount of $100,000, payable at maturity on February 1, 2019, making your premium $10,000 ($110,000 − $100,000). Free tax software 2011 download The bond pays qualified stated interest of $10,000 on February 1 of each year. Free tax software 2011 download Your yield is 8. Free tax software 2011 download 07439% compounded annually. Free tax software 2011 download You choose to use annual accrual periods ending on February 1 of each year. Free tax software 2011 download To find your bond premium amortization for the accrual period ending on February 1, 2013, you multiply the adjusted acquisition price at the beginning of the period ($110,000) by your yield. Free tax software 2011 download When you subtract the result ($8,881. Free tax software 2011 download 83) from the qualified stated interest for the period ($10,000), you find that your bond premium amortization for the period is $1,118. Free tax software 2011 download 17. Free tax software 2011 download Special rules to figure amortization. Free tax software 2011 download   For special rules to figure the bond premium amortization on a variable rate bond, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules (for example, a bond callable prior to the stated maturity date of the bond), or a bond that provides for remote or incidental contingencies, see Regulations section 1. Free tax software 2011 download 171-3. Free tax software 2011 download Bonds Issued Before September 28, 1985 For these bonds, you can amortize bond premium using any reasonable method. Free tax software 2011 download Reasonable methods include: The straight-line method, and The Revenue Ruling 82-10 method. Free tax software 2011 download Straight-line method. Free tax software 2011 download   Under this method, the amount of your bond premium amortization is the same each month. Free tax software 2011 download Divide the number of months you held the bond during the year by the number of months from the beginning of the tax year (or, if later, the date of acquisition) to the date of maturity or earlier call date. Free tax software 2011 download Then multiply the result by the bond premium (reduced by any bond premium amortization claimed in earlier years). Free tax software 2011 download This gives you your bond premium amortization for the year. Free tax software 2011 download Revenue Ruling 82-10 method. Free tax software 2011 download   Under this method, the amount of your bond premium amortization increases each month over the life of the bond. Free tax software 2011 download This method is explained in Revenue Ruling 82-10, 1982-1 C. Free tax software 2011 download B. Free tax software 2011 download 46. Free tax software 2011 download Choosing To Amortize You choose to amortize the premium on taxable bonds by reporting the amortization for the year on your income tax return for the first tax year you want the choice to apply. Free tax software 2011 download You should attach a statement to your return that you are making this choice under section 171. Free tax software 2011 download See How To Report Amortization, next. Free tax software 2011 download This choice is binding for the year you make it and for later tax years. Free tax software 2011 download It applies to all taxable bonds you own in the year you make the choice and also to those you acquire in later years. Free tax software 2011 download You can change your decision to amortize bond premium only with the written approval of the IRS. Free tax software 2011 download To request approval, use Form 3115. Free tax software 2011 download For more information on requesting approval, see section 5 of the Appendix to Revenue Procedure 2011-14 in Internal Revenue Bulletin 2011-4. Free tax software 2011 download You can find Revenue Procedure 2011-14 at www. Free tax software 2011 download irs. Free tax software 2011 download gov/irb/2011-04_IRB/ar08. Free tax software 2011 download html. Free tax software 2011 download How To Report Amortization Subtract the bond premium amortization from your interest income from these bonds. Free tax software 2011 download Report the bond's interest on Schedule B (Form 1040A or 1040), line 1. Free tax software 2011 download Under your last entry on line 1, put a subtotal of all interest listed on line 1. Free tax software 2011 download Below this subtotal, print “ABP Adjustment,” and the total interest you received. Free tax software 2011 download Subtract this amount from the subtotal, and enter the result on line 2. Free tax software 2011 download Bond premium amortization more than interest. Free tax software 2011 download   If the amount of your bond premium amortization for an accrual period is more than the qualified stated interest for the period, you can deduct the difference as a miscellaneous itemized deduction on Schedule A (Form 1040), line 28. Free tax software 2011 download    But your deduction is limited to the amount by which your total interest inclusions on the bond in prior accrual periods is more than your total bond premium deductions on the bond in prior periods. Free tax software 2011 download Any amount you cannot deduct because of this limit can be carried forward to the next accrual period. Free tax software 2011 download Pre-1998 election to amortize bond premium. Free tax software 2011 download   Generally, if you first elected to amortize bond premium before 1998, the above treatment of the premium does not apply to bonds you acquired before 1988. Free tax software 2011 download Bonds acquired before October 23, 1986. Free tax software 2011 download   The amortization of the premium on these bonds is a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit. Free tax software 2011 download Bonds acquired after October 22, 1986, but before 1988. Free tax software 2011 download    The amortization of the premium on these bonds is investment interest expense subject to the investment interest limit, unless you choose to treat it as an offset to interest income on the bond. Free tax software 2011 download Expenses of Producing Income You deduct investment expenses (other than interest expenses) as miscellaneous itemized deductions on Schedule A (Form 1040). Free tax software 2011 download To be deductible, these expenses must be ordinary and necessary expenses paid or incurred: To produce or collect income, or To manage property held for producing income. Free tax software 2011 download The expenses must be directly related to the income or income-producing property, and the income must be taxable to you. Free tax software 2011 download The deduction for most income-producing expenses is subject to a 2% limit that also applies to certain other miscellaneous itemized deductions. Free tax software 2011 download The amount deductible is limited to the total of these miscellaneous deductions that is more than 2% of your adjusted gross income. Free tax software 2011 download For information on how to report expenses of producing income, see How To Report Investment Expenses , later. Free tax software 2011 download Attorney or accounting fees. Free tax software 2011 download   You can deduct attorney or accounting fees that are necessary to produce or collect taxable income. Free tax software 2011 download However, in some cases, attorney or accounting fees are part of the basis of property. Free tax software 2011 download See Basis of Investment Property in chapter 4. Free tax software 2011 download Automatic investment service and dividend reinvestment plans. Free tax software 2011 download   A bank may offer its checking account customers an automatic investment service so that, for a charge, each customer can choose to invest a part of the checking account each month in common stock. Free tax software 2011 download Or a bank that is a dividend disbursing agent for a number of publicly-owned corporations may set up an automatic dividend reinvestment service. Free tax software 2011 download Through that service, cash dividends are reinvested in more shares of stock after the bank deducts a service charge. Free tax software 2011 download   A corporation in which you own stock also may have a dividend reinvestment plan. Free tax software 2011 download This plan lets you choose to use your dividends to buy more shares of stock in the corporation instead of receiving the dividends in cash. Free tax software 2011 download   You can deduct the monthly service charge you pay to a bank to participate in an automatic investment service. Free tax software 2011 download If you participate in a dividend reinvestment plan, you can deduct any service charge subtracted from your cash dividends before the dividends are used to buy more shares of stock. Free tax software 2011 download Deduct the charges in the year you pay them. Free tax software 2011 download Clerical help and office rent. Free tax software 2011 download   You can deduct office expenses, such as rent and clerical help, you incurred in connection with your investments and collecting the taxable income on your investments. Free tax software 2011 download Cost of replacing missing securities. Free tax software 2011 download   To replace your taxable securities that are mislaid, lost, stolen, or destroyed, you may have to post an indemnity bond. Free tax software 2011 download You can deduct the premium you pay to buy the indemnity bond and the related incidental expenses. Free tax software 2011 download   You may, however, get a refund of part of the bond premium if the missing securities are recovered within a specified time. Free tax software 2011 download Under certain types of insurance policies, you can recover some of the expenses. Free tax software 2011 download   If you receive the refund in the tax year you pay the amounts, you can deduct only the difference between the expenses paid and the amount refunded. Free tax software 2011 download If the refund is made in a later tax year, you must include the refund in income in the year you received it, but only to the extent that the expenses decreased your tax in the year you deducted them. Free tax software 2011 download Fees to collect income. Free tax software 2011 download   You can deduct fees you pay to a broker, bank, trustee, or similar agent to collect investment income, such as your taxable bond or mortgage interest, or your dividends on shares of stock. Free tax software 2011 download Fees to buy or sell. Free tax software 2011 download   You cannot deduct a fee you pay to a broker to acquire investment property, such as stocks or bonds. Free tax software 2011 download You must add the fee to the cost of the property. Free tax software 2011 download See Basis of Investment Property in chapter 4. Free tax software 2011 download    You cannot deduct any broker's fees, commissions, or option premiums you pay (or that were netted out) in connection with the sale of investment property. Free tax software 2011 download They can be used only to figure gain or loss from the sale. Free tax software 2011 download See Reporting Capital Gains and Losses , in chapter 4, for more information about the treatment of these sale expenses. Free tax software 2011 download Investment counsel and advice. Free tax software 2011 download   You can deduct fees you pay for counsel and advice about investments that produce taxable income. Free tax software 2011 download This includes amounts you pay for investment advisory services. Free tax software 2011 download Safe deposit box rent. Free tax software 2011 download   You can deduct rent you pay for a safe deposit box if you use the box to store taxable income-producing stocks, bonds, or other investment-related papers and documents. Free tax software 2011 download If you also use the box to store tax-exempt securities or personal items, you can deduct only part of the rent. Free tax software 2011 download See Tax-exempt income under Nondeductible Expenses, later, to figure what part you can deduct. Free tax software 2011 download State and local transfer taxes. Free tax software 2011 download   You cannot deduct the state and local transfer taxes you pay when you buy or sell securities. Free tax software 2011 download If you pay these transfer taxes when you buy securities, you must treat them as part of the cost of the property. Free tax software 2011 download If you pay these transfer taxes when you sell securities, you must treat them as a reduction in the amount realized. Free tax software 2011 download Trustee's commissions for revocable trust. Free tax software 2011 download   If you set up a revocable trust and have its income distributed to you, you can deduct the commission you pay the trustee for managing the trust to the extent it is to produce or collect taxable income or to manage property. Free tax software 2011 download However, you cannot deduct any part of the commission used for producing or collecting tax-exempt income or for managing property that produces tax-exempt income. Free tax software 2011 download   If you are a cash-basis taxpayer and pay the commissions for several years in advance, you must deduct a part of the commission each year. Free tax software 2011 download You cannot deduct the entire amount in the year you pay it. Free tax software 2011 download Investment expenses from pass-through entities. Free tax software 2011 download   If you hold an interest in a partnership, S corporation, real estate mortgage investment conduit (REMIC), or a nonpublicly offered mutual fund, you can deduct your share of that entity's investment expenses. Free tax software 2011 download A partnership or S corporation will show your share of these expenses on your Schedule K-1 (Form 1065) or Schedule K-1 (Form 1120S). Free tax software 2011 download A nonpublicly offered mutual fund will indicate your share of these expenses in box 5 of Form 1099-DIV (or substitute statement). Free tax software 2011 download Publicly-offered mutual funds are discussed later. Free tax software 2011 download   If you hold an interest in a REMIC, any expenses relating to your residual interest investment will be shown on Schedule Q (Form 1066), line 3b. Free tax software 2011 download Any expenses relating to your regular interest investment will appear in box 5 of Form 1099-INT (or substitute statement) or box 9 of Form 1099-OID (or substitute statement). Free tax software 2011 download   Report your share of these investment expenses on Schedule A (Form 1040), subject to the 2% limit, in the same manner as your other investment expenses. Free tax software 2011 download Including mutual fund or REMIC expenses in income. Free tax software 2011 download   Your share of the investment expenses of a REMIC or a nonpublicly offered mutual fund, as described above, are considered to be indirect deductions through that pass-through entity. Free tax software 2011 download You must include in your gross income an amount equal to the expenses allocated to you, whether or not you are able to claim a deduction for those expenses. Free tax software 2011 download If you are a shareholder in a nonpublicly offered mutual fund, you must include on your return the full amount of ordinary dividends or other distributions of stock, as shown in box 1a of Form 1099-DIV (or substitute statement). Free tax software 2011 download If you are a residual interest holder in a REMIC, you must report as ordinary income on Schedule E (Form 1040) the total amounts shown on Schedule Q (Form 1066), lines 1b and 3b. Free tax software 2011 download If you are a REMIC regular interest holder, you must include the amount of any expense allocation you received on Form 1040, line 8a. Free tax software 2011 download Publicly-offered mutual funds. Free tax software 2011 download   Most mutual funds are publicly offered. Free tax software 2011 download These mutual funds, generally, are traded on an established securities exchange. Free tax software 2011 download These funds do not pass investment expenses through to you. Free tax software 2011 download Instead, the dividend income they report to you in box 1a of Form 1099-DIV (or substitute statement) is already reduced by your share of investment expenses. Free tax software 2011 download As a result, you cannot deduct the expenses on your return. Free tax software 2011 download   Include the amount from box 1a of Form 1099-DIV (or substitute statement) in your income. Free tax software 2011 download    A publicly offered mutual fund is one that: Is continuously offered pursuant to a public offering, Is regularly traded on an established securities market, and Is held by or for no fewer than 500 persons at any time during the year. Free tax software 2011 download Contact your mutual fund if you are not sure whether it is publicly offered. Free tax software 2011 download Nondeductible Expenses Some expenses that you incur as an investor are not deductible. Free tax software 2011 download Stockholders' meetings. Free tax software 2011 download   You cannot deduct transportation and other expenses you pay to attend stockholders' meetings of companies in which you have no interest other than owning stock. Free tax software 2011 download This is true even if your purpose in attending is to get information that would be useful in making further investments. Free tax software 2011 download Investment-related seminar. Free tax software 2011 download   You cannot deduct expenses for attending a convention, seminar, or similar meeting for investment purposes. Free tax software 2011 download Single-premium life insurance, endowment, and annuity contracts. Free tax software 2011 download   You cannot deduct interest on money you borrow to buy or carry a single-premium life insurance, endowment, or annuity contract. Free tax software 2011 download Used as collateral. Free tax software 2011 download   If you use a single premium annuity contract as collateral to obtain or continue a mortgage loan, you cannot deduct any interest on the loan that is collateralized by the annuity contract. Free tax software 2011 download Figure the amount of interest expense disallowed by multiplying the current interest rate on the mortgage loan by the lesser of the amount of the annuity contract used as collateral or the amount of the loan. Free tax software 2011 download Borrowing on insurance. Free tax software 2011 download   Generally, you cannot deduct interest on money you borrow to buy or carry a life insurance, endowment, or annuity contract if you plan to systematically borrow part or all of the increases in the cash value of the contract. Free tax software 2011 download This rule applies to the interest on the total amount borrowed to buy or carry the contract, not just the interest on the borrowed increases in the cash value. Free tax software 2011 download Tax-exempt income. Free tax software 2011 download   You cannot deduct expenses you incur to produce tax-exempt income. Free tax software 2011 download Nor can you deduct interest on money you borrow to buy tax-exempt securities or shares in a mutual fund or other regulated investment company that distributes only exempt-interest dividends. Free tax software 2011 download Short-sale expenses. Free tax software 2011 download   The rule disallowing a deduction for interest expenses on tax-exempt securities applies to amounts you pay in connection with personal property used in a short sale or amounts paid by others for the use of any collateral in connection with the short sale. Free tax software 2011 download However, it does not apply to the expenses you incur if you deposit cash as collateral for the property used in the short sale and the cash does not earn a material return during the period of the sale. Free tax software 2011 download Short sales are discussed in Short Sales in chapter 4. Free tax software 2011 download Expenses for both tax-exempt and taxable income. Free tax software 2011 download   You may have expenses that are for both tax-exempt and taxable income. Free tax software 2011 download If you cannot specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. Free tax software 2011 download You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income. Free tax software 2011 download   One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. Free tax software 2011 download If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. Free tax software 2011 download To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result. Free tax software 2011 download Example. Free tax software 2011 download You received $6,000 interest; $4,800 was tax-exempt and $1,200 was taxable. Free tax software 2011 download In earning this income, you had $500 of expenses. Free tax software 2011 download You cannot specifically identify the amount of each expense item that is for each income item, so you must divide your expenses. Free tax software 2011 download 80% ($4,800 tax-exempt interest divided by $6,000 total interest) of your expenses is for the tax-exempt income. Free tax software 2011 download You cannot deduct $400 (80% of $500) of the expenses. Free tax software 2011 download You can deduct $100 (the rest of the expenses) because they are for the taxable interest. Free tax software 2011 download State income taxes. Free tax software 2011 download   If you itemize your deductions, you can deduct, as taxes, state income taxes on interest income that is exempt from federal income tax. Free tax software 2011 download But you cannot deduct, as either taxes or investment expenses, state income taxes on other exempt income. Free tax software 2011 download Interest expense and carrying charges on straddles. Free tax software 2011 download   You cannot deduct interest and carrying charges allocable to personal property that is part of a straddle. Free tax software 2011 download The nondeductible interest and carrying charges are added to the basis of the straddle property. Free tax software 2011 download However, this treatment does not apply if: All the offsetting positions making up the straddle either consist of one or more qualified covered call options and the optioned stock, or consist of section 1256 contracts (and the straddle is not part of a larger straddle); or The straddle is a hedging transaction. Free tax software 2011 download  For information about straddles, including definitions of the terms used in this discussion, see Straddles in chapter 4. Free tax software 2011 download   Interest includes any amount you pay or incur in connection with personal property used in a short sale. Free tax software 2011 download However, you must first apply the rules discussed in Payments in lieu of dividends under Short Sales in chapter 4. Free tax software 2011 download   To determine the interest on market discount bonds and short-term obligations that are part of a straddle, you must first apply the rules discussed under Limit on interest deduction for market discount bonds and Limit on interest deduction for short-term obligations (both under Interest Expenses, earlier). Free tax software 2011 download Nondeductible amount. Free tax software 2011 download   Figure the nondeductible interest and carrying charges on straddle property as follows. Free tax software 2011 download Add: Interest on indebtedness incurred or continued to buy or carry the personal property, and All other amounts (including charges to insure, store, or transport the personal property) paid or incurred to carry the personal property. Free tax software 2011 download Subtract from the amount in (1): Interest (including OID) includible in gross income for the year on the personal property, Any income from the personal property treated as ordinary income on the disposition of short-term government obligations or as ordinary income under the market discount and short-term bond provisions — see Discount on Debt Instruments in chapter 1, The dividends includible in gross income for the year from the personal property, and Any payment on a loan of the personal property for use in a short sale that is includible in gross income. Free tax software 2011 download Basis adjustment. Free tax software 2011 download   Add the nondeductible amount to the basis of your straddle property. Free tax software 2011 download How To Report Investment Expenses To deduct your investment expenses, you must itemize deductions on Schedule A (Form 1040). Free tax software 2011 download Enter your deductible investment interest expense on Schedule A (Form1040), line 14. Free tax software 2011 download Include any deductible short sale expenses. Free tax software 2011 download (See Short Sales in chapter 4 for information on these expenses. Free tax software 2011 download ) Also attach a completed Form 4952 if you used that form to figure your investment interest expense. Free tax software 2011 download Enter the total amount of your other investment expenses (other than interest expenses) on Schedule A (Form 1040), line 23. Free tax software 2011 download List the type and amount of each expense on the dotted lines next to line 23. Free tax software 2011 download (If necessary, you can show the required information on an attached statement. Free tax software 2011 download ) For information on how to report amortizable bond premium, see Bond Premium Amortization , earlier in this chapter. Free tax software 2011 download When To Report Investment Expenses If you use the cash method to report income and expenses, you generally deduct your expenses, except for certain prepaid interest, in the year you pay them. Free tax software 2011 download If you use an accrual method, you generally deduct your expenses when you incur a liability for them, rather than when you pay them. Free tax software 2011 download Also see When To Deduct Investment Interest , earlier in this chapter. Free tax software 2011 download Unpaid expenses owed to related party. Free tax software 2011 download   If you use an accrual method, you cannot deduct interest and other expenses owed to a related cash-basis person until payment is made and the amount is includible in the gross income of that person. Free tax software 2011 download The relationship, for purposes of this rule, is determined as of the end of the tax year for which the interest or expense would otherwise be deductible. Free tax software 2011 download If a deduction is denied under this rule, this rule will continue to apply even if your relationship with the person ceases to exist before the amount is includible in the gross income of that person. Free tax software 2011 download   This rule generally applies to those relationships listed in chapter 4 under Related Party Transactions . Free tax software 2011 download It also applies to accruals by partnerships to partners, partners to partnerships, shareholders to S corporations, and S corporations to shareholders. Free tax software 2011 download   The postponement of deductions for unpaid expenses and interest under the related party rule does not apply to OID, regardless of when payment is made. Free tax software 2011 download This rule also does not apply to loans with below-market interest rates or to certain payments for the use of property and services when the lender or recipient has to include payments periodically in income, even if a payment has not been made. Free tax software 2011 download Prev  Up  Next   Home   More Online Publications
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Sale of Assets Financed with Tax-Exempt Bonds by State and Local Governments and 501(c)(3) Organizations

Tax Exempt Bonds (“TEB”) focuses on providing participants in the municipal bond industry with quality service to assist issuers and conduit borrowers in understanding their tax responsibilities. TEB has initiated an outreach and educational services program to increase understanding and compliance with tax law applicable to tax-exempt bonds. As part of this service TEB is providing the following information with respect to the sale of property financed by tax-exempt bonds. Governmental issuers and 501(c)(3) organizations may use this information to establish practices to monitor tax compliance throughout the period that their bonds are outstanding. This information is not intended to be cited as an authoritative source. TEB recommends that issuers and 501(c)(3) organizations review this basic information concerning remedial actions in consultation with their counsel.

For remedial action with respect to exempt facility bonds, see section 1.142-2 of the Income Tax Regulations (the “Regulations”), and for build America bonds, see IRM 7.2.3.1.2.3.

Generally

To raise needed funds, state and local governments and 501(c)(3) organizations may plan to sell property financed with tax-exempt bonds. The sale of such property could cause the bond issue to become taxable. A timely remedial action, if necessary, will help ensure that the interest on the bond issue remains tax-exempt.

There are three basic remedial action options as generally described below:

  • Redemption or defeasance of nonqualified bonds
  • Alternative use of disposition proceeds
  • Alternative use of facility

Governmental Bonds Example

A governmental bond is one that is not a private activity bond. A bond is a private activity bond if both: (i) more than 10% of the proceeds of a bond issue are used for a private business use (the private business use test); and (ii) more than 10% of the debt service on the bonds is directly or indirectly secured by an interest in property or payments with respect to property used for a private business use or derived from payments in respect of property used for a private business use (the private security or payment test). The sale of bond-financed property, a “deliberate action,” may cause the bond issue to meet both of these tests.

Private business use, generally, is use directly or indirectly in a trade or business carried on by any person other than a governmental unit. The result of meeting both the private business use test and the private security or payment test (together, the private business tests) is that the tax-exempt bond issue becomes a taxable private activity bond.

An example of when governmental bonds are likely to meet the private business tests is the sale of a tax-exempt bond financed facility to a corporation. The sale is a deliberate action because the sale was within the issuer’s control. Depending on how much of the proceeds of the bond issue that the issuer used to construct or acquire the facility and how long after the bonds are issued that the sale occurs, the private business use test may be met since the purchaser is not a governmental entity. If the present value of the sales price is greater than 10% of the present value of the debt service on the bonds, the private security or payment test is met. If the revenues from the facility were pledged as security for the payment of debt service on the bonds and are expected to be more than 10% of the present value of the debt service, the private security or payment test is met (regardless of the sales price to the new purchaser). If the bond issue meets both the private business use test and the private security or payment test, the bonds are taxable unless remedial action is taken as described below.

Qualified 501(c)(3) Bonds Example

If the bonds financing the property are qualified 501(c)(3) bonds, the private business use test threshold of 10% is reduced to 5%. The 5% is further reduced by the percentage of proceeds of the bonds used to pay costs of issuance. (Up to 2% of the proceeds may be used for costs of issuance.) Additionally, use of tax-exempt bond financed property in an unrelated trade or business of any 501(c)(3) organization, as described in section 513 of the Internal Revenue Code (the “Code”), is considered private business use and counts toward the 5% limit.

An example of qualified 501(c)(3) bonds likely to meet the private business tests is the sale of tax-exempt bond financed land to a taxable corporation. The sale is a deliberate action because the sale was within the issuer’s (or 501(c)(3) borrower’s) control. Depending on how much of the proceeds of the bond issue that the issuer or 501(c)(3) borrower used to construct or acquire the facility and how long after the bonds are issued that the sale occurs, the private business use test may be met since the purchaser is not a governmental entity or a 501(c)(3) organization. If the parcel of land sold was pledged as security for the payment of debt service on the bonds, the private security or payment test is met if the sales price is more than 5% of the present value of the debt service on the bonds. If the revenues from the facility were pledged as security for the payment of debt service on the bonds and are expected to be more than 5% of the present value of the debt service, the private security or payment test is met (regardless of the sales price to the new purchaser). If the bond issue meets both the private business use test and the private security or payment test, the bonds are taxable unless remedial action is taken as described below.

A qualified 501(c)(3) bond is one where, among other requirements, the tax-exempt bond financed property is owned by a 501(c)(3) organization or a governmental unit. An example of qualified 501(c)(3) bonds failing to meet this requirement is the sale of the tax-exempt bond financed land to a taxable corporation. Accordingly, the bonds are taxable unless remedial action is taken as described below.

Remedial Action under the Treasury Regulations

The Regulations permit an issuer to take remedial action to preclude the sale of tax-exempt bond financed assets from causing the bonds to become taxable bonds. There are five basic conditions that an issuer must meet to qualify to take a remedial action. The conditions are:

  • The issuer must have reasonably expected on the issue date that the bonds would not meet either the applicable private business tests (including the ownership test for qualified 501(c)(3) bonds) or the private loan financing test for the entire term of the bonds.
  • The term of the bonds must not be longer than reasonably necessary for the qualified purposes of the issue (as a guideline, the term is not greater than 120% of the average reasonably expected economic life of the financed property).
  • Generally, the terms of a sale must be a bona fide and arm’s-length arrangement for fair market value.
  • Disposition proceeds must be treated as gross proceeds for arbitrage and rebate purposes. Disposition proceeds are any amounts, including property, derived from the sale, exchange or other disposition of the tax-exempt bond financed property.
  • Except for a remedial action involving the redemption or defeasance of nonqualified bonds, the proceeds must have been spent on a qualified purpose before the date of the deliberate action, that is, the sale of the bond-financed assets.

Redemption or Defeasance of Nonqualified Bonds

Generally, in the case of a sale of bond-financed property, the nonqualified bonds are the portion of the outstanding bonds equal to the percentage of the proceeds of the bond issue that financed that property. For example, if 50% of the proceeds of a bond issue financed the sold property, the nonqualified bonds equal 50% of the outstanding bonds of the issue at the time of the sale.

The first type of remedial action available is the redemption or defeasance of all of the nonqualified bonds within 90 days of the deliberate action. (Generally, proceeds of another issue of tax-exempt bonds may not be used for this redemption.) If the disposition proceeds are all cash, the issuer need not redeem or defease all of the nonqualified bonds, but must use all of the disposition proceeds to redeem a pro rata portion of nonqualified bonds. The redemption must be on the earliest call date after the deliberate action, or if the earliest call date is more than 90 days after the deliberate action, the issuer must establish a defeasance escrow within 90 days of the deliberate action. Defeasance is only permitted as a remedial action if the first call date is no more than 10 ½ years from the issue date of the bonds. The issuer must provide written notice to the Commissioner of the escrow within 90 days of its establishment.

Alternative Use of Disposition Proceeds

The second type of remedial action, available when the seller receives only cash, allows the issuer to spend the disposition proceeds within two years of the date of the sale for an alternative qualifying use. The issuer must treat the disposition proceeds as proceeds of the bonds, and must not take any action after the date of the sale to cause either the applicable private business use tests or the private loan financing test to be met. (If the bonds are qualified 501(c)(3) bonds, the disposition proceeds must be used for a qualified purpose under section 145 of the Code.) If the issuer does not expect the full amount of the disposition proceeds to be spent for a qualifying purpose within the two year period, it must use the balance of disposition proceeds to redeem (or defease) nonqualified bonds as allowed for the first type of remedial action described above.

Note: If the proceeds of a governmental bond issue are to be subsequently used by a 501(c)(3) organization, remediation by spending the disposition proceeds for an alternate use requires that the nonqualified bonds satisfy all the requirements for qualified 501(c)(3) bonds beginning on the date of the sale.

Alternative Use of Facility

The third type of remedial action available to the issuer is when the tax-exempt financed facility will be used after the sale for a purpose that is a qualifying purpose for another type of tax-exempt bonds (provided that the purchaser of the facility does not use tax-exempt bond proceeds for its purchase). The nonqualified bonds must satisfy all the requirements for the alternate type of tax-exempt bonds beginning on the date of the sale. The issuer must either apply any disposition proceeds resulting from the sale to pay the debt service on the bonds on the next available payment date or deposit the proceeds into an escrow within 90 days of their receipt. If the issuer must establish an escrow, the investment yield on the disposition proceeds must be restricted to the yield on the bonds and the escrow used to pay debt service on the next available payment date.

Allocation of Disposition Proceeds

For all three remedial actions, if the property was financed by different sources, the issuer must first allocate disposition proceeds to the outstanding bonds in proportion to the principal amounts of the outstanding bonds. If the disposition proceeds are not greater than the principal amount of outstanding bonds allocated to the sold property, the proceeds must first be allocated to the outstanding bonds before allocating to bonds no longer outstanding or to sources not derived from borrowing (such as revenues of the issuer).

Remedial Actions-Examples

The following examples assume that the above-described five conditions for remedial action are satisfied. Also, in these examples, no bond proceeds were used for costs of issuance or to fund a reserve fund.


Example 1. - Disposition proceeds are less than the principal amount of the outstanding bonds allocated to the sold property.

Issuer issues $10 million of bonds to finance the construction of a community center. Issuer later sells the center for $5 million, its fair market value. At this time, all $10 million of the bonds are still outstanding. The issuer may choose to remediate by using all $5 million of disposition proceeds to redeem within 90 days or establish a defeasance escrow for a pro rata portion of the $10 million of nonqualified bonds. The remaining outstanding $5 million of bonds would not be private activity bonds because the issuer has remediated as required by the Regulations.

Or, the issuer could remediate by using the alternative use of disposition proceeds option. Under this option, the issuer must apply the total amount of disposition proceeds, $5 million, to a qualifying alternative use within two years (or use a combination of the alternative use of disposition proceeds and redemption or defeasance options).

The disposition proceeds are considered gross proceeds of the bonds and as such are subject to the applicable yield restriction and arbitrage rebate rules pending their use as described above.

Example 2.- Disposition proceeds are greater than the principal amount of the outstanding bonds allocated to the sold property.

Issuer issues $10 million of bonds to finance a school and land. Issuer subsequently sells a portion of the land for $3 million. At this time, all $10 million of the bonds are still outstanding. The principal amount of outstanding bonds allocated to the sold property is $2 million. If the issuer chooses to remediate by redeeming bonds, it must redeem $2 million of outstanding bonds leaving the issuer with $1 million of gross proceeds.

Or, the issuer could remediate by using the alternative use of disposition proceeds option. If so, the Issuer must apply the total amount of the disposition proceeds, $3 million, to a qualifying use within two years (or use a combination of the alternative use of disposition proceeds and redemption or defeasance options).

The disposition proceeds are considered gross proceeds of the bonds and as such are subject to the applicable yield restriction and arbitrage rebate rules pending their use as described above.

Example 3. - Disposition proceeds are greater than the principal amount of the outstanding bonds allocated to the sold property and the conduit borrower finances the project in part with tax-exempt bond proceeds and in part with an equity contribution.

A 501(c)(3) conduit borrower contributed $4 million of cash from its revenues and used $6 million of tax-exempt bonds to finance a $10 million acquisition of a continuing care facility. Subsequently, the conduit borrower sells the facility for $12 million. At this time, all $6 million of the bonds are still outstanding. Thus the issuer has $6 million of nonqualified bonds. The issuer may remediate by either redeeming all of the $6 million nonqualified bonds or by requiring the conduit borrower to use $12 million of disposition proceeds for an alternative use within two years (provided all requirements of qualified 501(c)(3) bonds are met).

Of the $12 million of disposition proceeds, $6 million are considered gross proceeds of the bonds and as such are subject to the applicable yield restriction and arbitrage rebate rules pending their use as described above.

Gross Proceeds - Example 2 versus Example 3

When the tax-exempt bond financed property is sold for an amount in excess of the principal amount of the outstanding bonds allocated to that property, a different result occurs with respect to that excess amount depending on whether all the bonds of the issue have been redeemed. In Example 3, where the issuer redeemed all of the outstanding bonds, the remaining disposition proceeds are not gross proceeds of the bonds and, therefore, are no longer subject to the federal tax restrictions. This is because the amount of gross proceeds cannot exceed the amount of the outstanding bonds of the issue. Whereas in Example 2, although the issuer has redeemed the nonqualified bonds, the issuer still has bonds of the issue outstanding and thus the additional disposition proceeds are gross proceeds of the bonds and subject to the applicable yield restriction and arbitrage rebate rules pending their use.

Correction of Violations Using TEB Voluntary Closing Agreement Program (VCAP)

If an issuer or conduit borrower discovers that it has sold bond financed assets causing the applicable private business tests to be met but is ineligible to self-correct through a remedial action provision, TEB encourages the issuer to take advantage of its Voluntary Closing Agreement Program (TEB VCAP) to resolve federal tax violations relating to bonds as described in Notice 2008-31 and IRM section 7.2.3.

Page Last Reviewed or Updated: 04-Sep-2013

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