7916 / How is interest taxed earned on a time or savings deposit? In what year should the interest be reported?

“Dividends” received from a mutual savings bank that received a deduction under IRC Section 591 are not eligible for the 20/15/0 percent rates applicable to “qualified dividend income” (see Q 702).⁴

Generally, interest must be included in gross income for the year in which (1) it is actually received by the taxpayer or, if earlier, (2) it is constructively received by the taxpayer.⁵ Interest is constructively received by a taxpayer in the year during which it is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer might draw upon it at any time, or so that he or she could have drawn upon it during the year if notice of intention to withdraw had been given.⁶ Interest may be constructively received even though the taxpayer was never notified that the interest was available.⁷ On the other hand, interest is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions (see Q 662).⁸

If certificates of deposit (and certain other time deposits) with a term in excess of one year are issued at a price less than the “stated redemption price” that will be paid on maturity (i.e., the certificate is issued at a discount), the depositor must treat the “original issue discount” as interest received over the term of the certificate. Thus, the amount of original issue discount deemed to have been received during the calendar year must be included in the depositor’s ordinary income on his or her tax return for that year (see Q 7650).⁹ Addressing the proper year for reporting interest on an 18 certificate, the Service stated that the OID rules in IRC Section 1272 may require taxpayers to include interest as it accrues on certificates that have a stated maturity date of more than one year.¹⁰

Original issue discount on certificates of deposit with a term of one year or less does not have to be reported until the year of disposition.¹¹ However, for short-term obligations a taxpayer may elect to include original issue discount (or “acquisition discount” under an alternative election) as it accrues.¹² Such an election applies to all short-term taxable corporate obligations (and Treasury bills with respect to acquisition discount) acquired on or after the first day of the first taxable year for which the election is made, and it continues to apply until the Service consents to revocation of the election. Thus, an election with respect to a certificate of deposit will apply to such other taxable short-term obligations (including Treasury bills), and vice versa. See Q 7627 regarding these elections.

If the certificate has a stated interest feature, any interest actually or constructively received during the calendar year under that feature must also be included in ordinary income for that year.

It is unclear how “indexed” certificates of deposit will be treated for income tax purposes. A certificate of deposit is considered “indexed” if the payment of principal at maturity corresponds to increases or decreases in a market standard, such as the S&P 500 or the NASDA Q 101. In many cases, no stated interest is paid on the investment. Instead, the payment of principal at maturity is determined in proportion to any increase in the underlying index. It is possible that the owner of an indexed certificate of deposit may be required to report all or a portion of any accrued interest annually, even though no payments are received prior to maturity. Whether the interest expense on amounts borrowed to purchase an indexed certificate of deposit will be deductible only in the year of maturity is even more unclear (see Q 7919).

Banks and other financial institutions must supply their depositors who earn original issue discount with a statement (Form 1099-OID) setting forth the amount of original issue discount deemed to have been received during the year.¹³