Benefit

If you cash in a certificate of deposit (CD) or savings account before its fixed maturity date for any reason (such as you need the money to pay personal expenses or you can obtain a higher interest rate if you move the money), you may be forced to pay a penalty. The penalty is subtracted from the funds you receive.

You can deduct this penalty, which may be a forfeiture of interest and/or principal (if the penalty exceeds the interest), even though you do not itemize your other deductions. In the case of savings certificates with fixed maturities of longer than one year, your deduction is based on the forfeiture of original issue discount (which is nothing more than a way of figuring interest). Regardless of the maturity involved, this deduction is called a penalty on early withdrawal of savings. There is no dollar limit on this deduction.

Conditions

There are no conditions or requirements to meet. As long as you take money out of a savings certificate before the specified maturity date and are subject to a penalty, you can deduct the penalty in full.

Planning Tip

When putting money into time‐savings vehicles, such as certificates of deposit, don't extend the investment period beyond the time you may need the funds so that you can avoid early withdrawal penalties if you do need the money then. Consider splitting your savings into multiple savings certificates with different maturity dates so that you can readily have access to some funds penalty free.

Pitfalls

You cannot net the penalty against the interest you receive and eliminate the need to separately deduct the penalty. You must report all of the interest on the savings certificate and then separately deduct the early withdrawal penalty.

The above‐the‐line deduction for the penalty on early withdrawals from savings accounts does not apply to the 10% early distribution penalty usually imposed on withdrawals from qualified retirement plans and IRAs before age 59½.

Where to Claim the Benefit

The forfeited amount is reported to you (and the IRS) on Form 1099‐INT if the certificate of deposit is for one year or less, or on Form 1099‐OID if the certificate of deposit is for longer than one year. You deduct this amount on Schedule 1 of Form 1040 or 1040‐SR.

Benefit

If your bank goes under and your account is not covered in whole or in part by FDIC insurance, you can deduct your loss.

Historically, there have been different ways to treat your loss (each of which is explained in the next section):

• Bad debt deduction
• Casualty loss, but this option doesn't apply for 2018 through 2025
• Ordinary loss, but this option is also barred for 2018 through 2025

For 2022, your only option is to claim a bad debt deduction.

Conditions

The conditions for deducting your loss on bank deposits are simple: The bank must be insolvent or bankrupt so that there is no reasonable prospect of recovering your money, and your deposits must not be covered by FDIC or state insurance. Additional conditions and limits, however, may apply to the deduction method you select.

Planning Tip

Why rely on tax write‐offs to make you whole? The best option is to make sure that your deposits are adequately covered by FDIC insurance. Understand your FDIC limits so you don't expose your savings to potential loss, especially when you have accounts in separate institutions that have merged or been taken over.

The rules on FDIC coverage and a listing of the banks with this insurance protection may be found at www.fdic.gov. You can also use the Electronic Deposit Insurance Estimator (EDIE) at www.fdic.gov/edie/ to see where you stand in terms of FDIC coverage for your checking and savings accounts, money market accounts, and certificates of deposit.

Pitfall

The biggest problem with bank losses is knowing exactly what your losses really are. You may recover something when the bank's finances are settled, even if it is only pennies on the dollar. Generally the trustees of a troubled bank will give you an estimate of your expected recovery and loss.

Where to Claim the Benefit

A bad debt is reported on Form 8949, Sales and Other Dispositions of Capital Assets. Be sure that your loss is entered in parentheses to indicate a loss amount. This is then entered on Schedule D, the amount of which is then reported on page 1 of Form 1040 or 1040‐SR.

Benefit

In today's volatile stock market, as well as trading in cryptocurrencies, it's not uncommon to have losses. Capital losses are deductible in full (there is no dollar limit) as an offset to your capital gains for the year. If your capital losses exceed your gains, up to $3,000 of capital losses can be used to offset ordinary income, such as salary and interest income. If your capital losses are more than this $3,000 limit, you can carry the excess forward indefinitely to be used in a future year. The $3,000 limit has not been increased since 1978.

Understand what capital losses are so that you can plan wisely to get the greatest tax benefit from your losses. Capital losses generally arise on the sale or other disposition of capital assets, such as stocks, collectibles, or real estate. Your loss is the difference between what you receive on the sale and your adjusted basis in the property (usually what you paid for it).

There are 2 classes of capital losses: short‐term losses resulting from assets held one year or less and long‐term losses resulting from assets held more than one year. As a practical matter, while complex rules govern the order in which capital losses are used to offset different categories of capital gains, in the end capital losses can be used to fully offset capital gains.

Conditions

You must sell or otherwise dispose of an asset to have a deductible loss. A mere decline in the value of an asset you continue to hold does not entitle you to claim a loss. There are exceptions to the disposition requirement (e.g., a bad debt is treated as a short‐term capital loss even though the debt is not sold or otherwise disposed of).

As mentioned earlier, the loss must be with respect to a capital asset. And this asset must be held for investment or business purposes. You cannot deduct a capital loss on an asset held primarily for personal purposes (such as your home, personal car, or boat).

Planning Tips

Don't overlook basis adjustments that may increase your loss (by increasing your basis). Take into account:

• Stock dividends you reinvested in the same company
• Brokers' commissions
• Acquisition costs (e.g., attorney's fees to handle the purchase of real estate)
• Selling costs (e.g., real estate broker's fees)

At year‐end, review your investment portfolio to see if there are capital losses you want to harvest for tax advantage. But always temper your tax planning with investment considerations. Don't sell only to generate losses; let your investment decisions be driven primarily by economics (e.g., you think the investment will never recover or there are better places to put your investment dollars).

Pitfalls

While you may have an economic loss on a transaction, do not automatically assume it qualifies for capital loss treatment for tax purposes. Certain pitfalls may trip you up.

Where to Claim the Loss

To claim capital losses, you must file Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D to figure the deductible amount. Short‐term transactions are entered in Part I of Form 8949; long‐term transactions are entered in Part II of Form 8949. The form has 3 different ways to determine basis: transactions listed on Form 1099‐B with basis included, transactions listed on Form 1099‐B without basis included, and transactions not reported on Form 1099‐B. You must use a separate Form 8949 for each type of basis determination. Gains and losses are netted in each of these parts and then short‐term gains or losses are carried over to Parts I and II of Schedule D and then netted against long‐term gains or losses in Part III of Schedule D. Make sure that the amount of any loss entered in column (f) of Schedule D is within parentheses to indicate a loss amount.

You enter the amount of your net capital loss from Part III of Schedule D onto Form 1040 or 1040‐SR.

Benefit

If you qualify, you pay no tax on net capital gains (net long‐term capital gains in excess of net short‐term capital losses), capital gain distributions from certain mutual funds, and qualified dividends.

Conditions

To qualify for the zero tax rate, your taxable income must be below a set amount. Table 8.1 shows the upper limit for taxable income that you can receive and still have zero tax on capital gains. In the past, this threshold was based on being in the bottom two tax brackets, but now it's a specific dollar amount. The potential zero‐tax income (e.g., qualified dividends) is taken into account in determining whether you fall within this threshold.

Taxable income is adjusted gross income reduced by the standard deduction or itemized deductions, limited cash contributions to charity by non‐itemizers if this rule is extended for 2022, net disaster losses if the rule is extended for 2022, and the 20% qualified business income (QBI) deduction for owners of pass‐through entities; it does not take tax credits into account.

The gains must be from property held long term (usually more than one year). Capital gains distributions and qualified dividends are identified as such on Form 1099‐DIV.

Planning Tip

Just because taxable income is above the threshold amount for your filing status does not mean you lose out entirely on the zero tax rate. Depending on your filing status, taxable income, and qualified dividends and capital gains, you may be able to use the zero rate for some of your dividends and capital gains.

Pitfalls

Receiving too much income in capital gains can push you into a higher tax bracket and void the use of the zero tax rate. For example, say you are single and you estimate that your taxable income for the year will be $35,000. You then sell property you've held for years at a profit of $10,000. This gain will put you over the $41,675 threshold for your filing status, preventing your gain from being fully tax free.

If your taxable income exceeds the threshold in Table 8.1, you pay a tax rate of 15% on your capital gains. But if your income exceeds the threshold in Table 8.2, the applicable tax rate is 20%.

Where to Claim the Benefit

Dividends and capital gains must be reported on the return, even though they may be tax free because of the zero tax rate. Dividends are reported directly on Form 1040 or 1040‐SR. Capital gains distributions and capital gains must be reported on Schedule D and then on Form 1040 or 1040‐SR.

Benefit

If you hold stocks or bonds issued with coupons or in registered form that become worthless, you can deduct your investment. Worthless securities are treated as becoming worthless on the last day of the year in which they actually become worthless. This date governs whether the loss is treated as a short‐term loss (if you held the security no more than one year prior to December 31) or a long‐term loss (if you held the security more than one year prior to December 31).

The loss is treated as a capital loss (discussed earlier in this chapter), even though there is no sale involved. However, if the loss relates to Section 1244 stock (discussed later in this chapter), the loss is treated as an ordinary loss up to $50,000 ($100,000 on a joint return).

Conditions

There are 2 conditions you must meet to write off your investment in worthless securities:

1. The security must have had some value at the end of the prior year.
2. The security must have become totally worthless.

Planning Tips

If you hold a security that is partially but not wholly worthless, sell it to nail down your loss. For example, if you think a company is on the brink of bankruptcy, try to sell the security so that you can fix the loss. Typically, your brokerage firm will buy it for a nominal amount, enabling you to claim a loss for the difference between your basis (usually what you paid for it) and what you received for it. Or you can abandon the security, which means that you permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security.

Bonds not issued with interest coupons or in registered form that become worthless result in a bad debt deduction (discussed earlier under “Loss on Bank Deposits”).

You can claim a loss only in the year in which the security becomes totally worthless, but you have 7 years to discover that a security has become worthless. This is because the statute of limitations on amending your return to claim the loss for a worthless security is 7 years rather than the usual 3 years from the due date of your return.

If you are unsure in which year to claim the loss, it is generally advisable to report it in the earliest year you suspect that the worthlessness occurred and then to renew your claim in each subsequent year when the earliest year proves to be incorrect. This requires that you file amended returns to eliminate the loss from the earliest return and report it on a subsequent return.

Pitfalls

Don't let time pass you by. Once the 7‐year period for filing an amended return has passed, your loss can never be claimed. Each year, make sure to check on the status of any questionable securities to make sure you don't overlook a loss write‐off you are entitled to claim.

The amount you can write off for worthless securities is limited to your basis in the stocks or bonds. Even though you may have witnessed soaring prices only to be followed by the wipeout, you cannot benefit in any way from those record highs; your tax loss is limited to your basis, which is usually what you paid for the securities.

Where to Claim the Loss

You report worthless securities on Form 8949, Sales and Other Distributions of Capital Assets (in Part I if the securities were held for no more than one year; Part II if they were held more than one year). In columns (c) and (d) write “Worthless.” Then, in column (f), be sure to enter the amount of your loss in parentheses. Amounts from Form 8949 are then carried over to Schedule D and then Form 1040 or 1040‐SR.

Benefit

If you own stock that qualifies as Section 1244 stock, you can claim an ordinary loss on the sale or worthlessness of the stock. The ordinary loss is limited to $50,000 ($100,000 on a joint return).

Conditions

To be able to treat your loss as an ordinary loss, you must meet the following 2 conditions:

1. The stock must qualify as Section 1244 stock.
2. The amount of your loss cannot exceed the dollar limit.

Planning Tip

You can claim a Section 1244 loss regardless of how you suffer the loss. Whether you sell your stock at a loss or the company goes under, ordinary loss treatment applies if you meet the conditions discussed earlier.

You (and the corporation) must keep certain records and make them available for IRS inspection, if requested. The records should show that the corporation met the qualifications for the stock to be classified as Section 1244 stock. The corporation should keep records on its gross receipts data for 5 years, and you should keep records on what you paid for the stock. If you don't keep these records, you risk losing your ordinary loss deduction.

Pitfall

If you own stock in an S corporation that holds small business stock, the portion of any loss on such stock passed through to you does not qualify as an ordinary loss on Section 1244 stock. Under the technical language of the tax law, only individuals and partnerships can claim Section 1244 losses. Even though S corporations are pass‐through entities like partnerships, they are not eligible to claim Section 1244 losses.

Where to Claim the Loss

An ordinary loss on Section 1244 stock is reported on Form 4797, Sales of Business Property, which you attach to Form 1040 or 1040‐SR. This form is used whether the loss arises from the sale of the stock or from its becoming worthless so that no sale takes place. The amount from Form 4797 is entered on Schedule 1 of Form 1040 or 1040‐SR.

If the amount of the loss exceeds your dollar limit, you treat the excess loss as a capital loss (discussed earlier).

Benefit

You can deduct interest on borrowing from a brokerage firm that uses your brokerage account as collateral if the money is used for investment purposes. This is called margin interest, and the brokerage firm sets the limits on borrowing, interest rate, and other terms of the loan. You can also deduct interest on other loans used to make investments as an itemized deduction to the extent of your net investment income. If your investment interest is more than your net investment income for the year, you can carry the excess interest forward indefinitely and use it in a future year.

Conditions

There are 2 important conditions:

1. The funds borrowed must be used for investment purposes.
2. For full deductibility of the interest, you must have net investment income to offset it.

Planning Tip

You can opt to treat capital gains and/or qualified dividends as investment income. If you make this election, your capital gains and/or dividends are not eligible for preferential tax rates and are instead included as ordinary income.

Generally it is not advisable to make this election because doing so effectively converts income that would otherwise be taxed at no more than 15% or 20% to income taxed at up to 37% (the taxable income thresholds for the 20% rate are listed in Table 8.2 earlier in this chapter). But the election can make sense in some situations; only running the numbers can determine when this is so.

Pitfall

You cannot deduct interest, regardless of the source of the loan, if you use the money to buy or carry municipal bonds (for example, you need to raise cash and you sell your taxable investments while holding on to your municipal bonds).

Where to Claim the Deduction

You figure your investment interest limitation on Form 4952, Investment Interest Expense Deduction. You then enter the deductible amount on Schedule A, which is filed with Form 1040 or 1040‐SR.

Benefit

If you buy a taxable bond, such as a corporate bond, you can elect in the year of the purchase to begin amortizing the bond premium. This means that each year you own the bond, you can offset the taxable interest received on the bond by the amortizable premium amount.

If you opt to amortize bond premium, reduce the bond's basis by the amount of amortization.

If you buy a tax‐exempt bond, such as a municipal bond, at a premium, you must amortize the bond premium. But you cannot deduct the amortized premium amount. Instead, you reduce the basis of the bond by the amortization for the year.

Conditions

To amortize the bond premium on a taxable bond, you must meet the following 2 conditions:

1. You elect amortization.
2. You figure amortization using the constant yield method for bonds issued after September 27, 1985 (other amortization methods apply for earlier bond issues). This is a 3‐step process under which you determine your yield, the accrual periods to use in figuring amortization, and the bond premium. The computation is rather complicated. For more details, see Chapter 3 of IRS Publication 550, Investment Income and Expenses.

Planning Tips

It is usually advisable to elect amortization so you can offset current interest income from the bond. If you do not make the election, you will probably realize a capital loss when the bond is redeemed at par or you sell it for less than you paid for it.

You do not have to elect amortization for taxable bonds held in IRAs or qualified retirement plans. Since the interest is not currently deductible, no offset is necessary.

Pitfall

If you want to amortize bond premiums on taxable bonds, you generally must elect to do so by attaching your own statement to the return indicating this choice. The election applies to all taxable bonds you own and to those you buy in later years.

Once you have made your choice, you can't change it unless you receive the written approval of the IRS. To request a change, you must file Form 3115, Application for Change in Accounting Method.

Where to Claim the Deduction

The amortizable amount of a premium is not a separate deduction. Instead, it is an adjustment to the interest reported on Schedule B of Form 1040 or 1040‐SR. Report the bond's interest and then subtract the amortization, noting “ABP Adjustment” next to it.

If the amortization exceeds the amount of interest reported, the excess can be deducted as a miscellaneous itemized deduction on Schedule A of Form 1040 or 1040‐SR. This deduction is not subject to the 2%‐of‐adjusted‐gross‐income floor, so it is deductible in 2022 even though deductions subject to the 2%‐of‐AGI floor are not.

Benefit

Interest on municipal bonds is not subject to federal income tax. You may fully exclude this interest from income. There is no dollar limit.

The exclusion applies to both interest on individual bonds and interest from mutual funds holding municipal bonds.

Conditions

Interest is classified as municipal bond interest only if the bond is issued by a state or local government or government agency.

Planning Tip

Interest on municipal bonds may also be exempt from state income taxes. Table 8.3 shows you how the states treat municipal bond interest. The U.S. Supreme Court has decided that it is permissible for a state to tax the interest earned on out‐of‐state bonds while exempting the interest from in‐state bonds.

Pitfalls

Municipal bond interest can affect the amount of taxes you pay on your Social Security benefits. Municipal bond interest, while exempt from federal income tax, is taken into account in determining your provisional income, the figure used to fix the taxable portion of Social Security benefits at 85%, 50%, or zero. For Medicare recipients, the tax‐free municipal bond interest may also impact whether you are subject to additional premiums for Parts B and D.

Interest on private activity bonds issued after August 6, 1986, while excluded from income for regular tax purposes, is subject to the alternative minimum tax (AMT) (the interest on such bonds issued in 2009 and 2010 continues to be exempt from AMT). These bonds generally pay a slightly higher interest rate than other municipal bonds. However, if you know you will be subject to AMT, it is advisable when making bond investments to forgo the additional interest in favor of municipal bonds not subject to AMT.

Even though interest on municipal bonds is tax free, gain on the sale of the bonds is taxable. For instance, you purchase a bond at par value and sell it 2 years later for $2,000 more than you paid. You have a $2,000 gain that is taxable.

Where to Claim the Exclusion

Even though the interest is fully excludable, you are required to report tax‐exempt interest on your return. You report this interest on line 2a of Form 1040 or 1040‐SR.

Benefit

Tax on the interest on series E, EE, and I bonds can be deferred until the bonds are cashed in or reach their final maturity dates.

Conditions

Deferral is automatic; you don't have to take any action to receive this tax treatment. You simply do not report the interest annually on your return.

Planning Tips

You can opt to report interest on these savings bonds annually instead of using deferral. This option may make sense when the bondholder has little or no other income so that the interest is taxed at a low rate, if at all.

The U.S. Treasury has changed the way in which interest on series EE bonds is computed. Rather than adjusting the interest semiannually, bonds sold on or after May 1, 2005, now pay a fixed rate until redemption or maturity (e.g., 0.10% for bonds purchased from May 1, 2022, to October 31, 2022). As a result, Series I bonds may be a better option because their interest rate still adjusts semiannually for inflation. For example, I bonds purchased from May 1, 2022, through October 31, 2022, pay a variable rate of 4.81% plus a fixed rate of 0.00%, for a total rate of 4.81%.

Interest may be tax free if  bonds are redeemed to pay certain higher education costs and other conditions are met (see Chapter 3).

Interest is never subject to state and local income taxes.

You can use a federal tax refund on an original return to purchase up to $5,000 in series I savings bonds. Purchases must be made in multiples of $50. You can request up to 3 different savings bond registrations (e.g., in your name, in your spouse's name, or for someone else). See the instructions to Form 8888, Allocation of Refund (Including Savings Bond Purchases), for details.

Pitfalls

Do not continue to hold a bond beyond its final maturity date. No interest is paid after this date. Bonds reach final maturity in 30 years for series EE and I bonds. E bonds used to have maturies of 30 years or 40 years; the last E bond reached its final maturity in June 2010.

In the past, you could have continued deferral beyond a bond's maturity date by rolling it over into a series HH bond. However, these bonds ceased being issued as of August 31, 2004 (previously issued series HH bonds continue to earn interest).

You cannot redeem an EE or I bond until 12 months after its purchase unless your county has been declared a disaster area. There is a 3‐month interest penalty for bonds redeemed before 5 years.

Where to Claim the Benefit

You do not have to report interest if you want to defer it; no special form or schedule needs to be filed.

Benefit

If you have a gain on the sale of small business stock, you can exclude a percentage of the gain from income (called a Section 1202 exclusion). The portion of the gain that is not excluded is subject to a 28% capital gain rate (unless your tax bracket is below this rate so that the tax rate is limited to your bracket, which is what you would pay on ordinary income). The amount of the exclusion depends on when the stock was acquired. The exclusion is 50% of the gain on stock acquired before February 18, 2009; 75% of the gain for stock acquired after February 17, 2009, and before September 28, 2010; and 100% for stock acquired after September 27, 2010.

Conditions

To qualify to exclude a percentage of the gain from income, the stock must qualify as small business stock and you must meet a holding period requirement.

Planning Tips

If you acquired qualified small business stock from a C corporation at different times, be sure to track your holding period for each as well as your cost basis in the stock. Then when selling qualified small business stock, you can identify which shares you are selling to optimize your tax position in the year of the sale.

If you don't qualify for the 100% exclusion, you can defer tax on the gain from the sale of Section 1202 stock that you've held for at least 6 months by reinvesting the proceeds in other Section 1202 stock within 60 days of the sale. You must make an election for this deferral.

Pitfall

If you deferred gain on the sale of small business stock, understand that eventually you may pay tax on the gain. You had to reduce the basis in the small business stock acquired during the 60‐day period by the amount of the deferred gain. When you sell this stock, the reduction will effectively increase your gain.

Where to Claim the Exclusion

To exclude a portion or all of your gain, report the entire gain on Form 8949, completing all the columns on that line. Then immediately below the line on which you reported gain in column (a) write “Section 1202 exclusion” and in column (g) enter the amount of the exclusion as a loss (in parentheses).

Benefit

If you have a gain on the sale of DC Zone assets, you can exclude all of the gain from the sale of assets held more than 5 years in the District of Columbia Enterprise Zone for assets if they were acquired after 1997 and before January 1, 2012. In effect, you are not taxed when you sell these qualified assets.

Conditions

There are 3 conditions for excluding gain on property acquired before January 1, 2012:

1. The property must be a District of Columbia Enterprise Zone (DC Zone) asset, which includes DC Zone business stock, DC Zone partnership interest, and DC Zone business property (including real or other property integral to a DC Zone business).
2. You must have acquired the DC Zone assets before January 1, 2012, and held them for more than 5 years before the sale. Obviously, any sale in 2021 meets this time condition.
3. The gain may not be otherwise treated as recapture income or gain from a sale to a related party.

Planning Tips

To determine whether you own property in a DC Zone, see IRS Publication 954, Tax Incentives for Distressed Communities.

If you own a business that employs people in a qualified empowerment zone, you may be eligible for a special employment tax credit (see Chapter 14).

Pitfall

The election to postpone gain from empowerment zone assets by making a rollover no longer applies; it expired at the end of 2020.

Where to Claim the Benefit

Report the sale of DC zone stock in Part II of Form 8949 as if you weren't electing the exclusion. Enter "X" in column (f), with the amount of the exclusion reported as a negative number in column (g). Report the sale of DC Zone business property on Form 4797, Sales of Business Property.

Benefit

You can postpone gain on the sale of any property as long as you reinvest it in a qualified opportunity zone through an investment fund. There is no dollar limit on how much gain your can defer; in effect it is limited only by your reinvestment. This deferral opportunity applies only through December 31, 2026.

Conditions

There are 2 conditions:

1. You usually must make the reinvestment within 180 days of the sale that produces your gain.
2. The sale must be to an unrelated party.

Planning Tip

There are now more than 200 qualified opportunity zone funds (called “O Funds”) for investors. As with any investment, check on fund managers, investment fees, and the location in which the funds are invested.

Pitfall

Investing in an investment fund in a qualified opportunity zone presents an investment risk and a tax risk. While you get to defer your gain, you must settle up with the government when selling your investment in a qualified opportunity zone fund, or December 31, 2026, whichever is earlier. Your basis in the investment in the fund is deemed to be zero, so all of your resulting gain is taxable. However, if you hold it for at least 5 years, your zero basis is increased by 10% of the gain originally deferred. If you hold it for another 2 years (at least 7 years in total), your basis is increased by another 5% of the gain originally deferred.

Even though you have to recognize gain no later than December 26, 2026, if you continue to hold the investment fund beyond this date there's a special election for a sale of your shares in the investment fund. You can elect to use a basis for an investment held at least 10 years equal to the fair market value of the property on the date of sale.

Where to Elect Deferral

The election to defer gain is reported on Form 8949, Sales and Other Dispositions of Capital Assets. Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, must be filed each year you hold any investment in a qualified opportunity fund.

Benefit

If you hold investments in foreign countries, including stocks or mutual funds, you may pay taxes abroad. You can write off foreign taxes you pay in one of 2 ways:

1. Deduct the taxes as an itemized deduction.
2. Claim a tax credit for the foreign taxes.

Either way, there is no dollar limit to the benefit you can claim.

Conditions

The foreign tax must be a tax on income similar to U.S. tax. However, you cannot write off any tax imposed by a country designated by the U.S. government as engaging in terrorist activities. These countries are listed in IRS Publication 514, Foreign Tax Credit for Individuals.

Planning Tips

Generally, claiming the credit is more valuable than deducting the foreign taxes. The credit reduces your tax liability dollar for dollar. You do not have to be an itemizer if you claim the credit.

If you opt to claim the credit and the amount of the credit you can use in the current year is limited because of your tax liability, you can carry the excess credit back to the 2 preceding years and then forward for up to 5 succeeding years until it is used up. You can only use a carryback or carryover in a year in which you have income from foreign sources.

You have 10 years in which to change your choice from deduction to credit or credit to deduction. You can file an amended return for a period of up to 10 years to change the treatment of the write‐off on your return.

Pitfalls

You cannot elect to treat some foreign taxes as a deduction while treating others as a credit within the same year. You must opt to use one write‐off method for all your foreign taxes. But you can change your choice from year to year.

You get no benefit for foreign taxes paid on investments held by an IRA. Since the IRA is not a taxpayer, it cannot claim a deduction or credit for the foreign taxes paid by it. This means the funds in your IRA are reduced by these taxes with no offsetting benefit. You may wish to reconsider investments subject to foreign taxes being held in an IRA.

If you are subject to the alternative minimum tax (a shadow tax system to ensure that taxpayers who successfully reduce their regular tax will at least pay some income tax), you lose the benefit of an itemized deduction for foreign taxes, which are not deductible for AMT purposes.

If you have an ownership interest in a foreign corporation with earnings from intangibles (patents, trademarks, copyrights), you may have global intangible low‐taxed income (GILTI), which is included in the corporation's income for the year. As an individual, if you make a special election (called a Section 250 election), you are treated as a corporation for purposes of the tax and can claim a foreign tax credit (subject to an 80% limitation). These rules are highly complex and should be discussed with a tax expert.

You may have to complete Form 8938, Statement of Specified Foreign Financial Assets, and file it with your personal tax return if the value of foreign accounts exceeds certain thresholds (e.g., more than $50,000 at the end of the year if you're single). This is referred to as FATCA because the reporting obligation was created by the Foreign Account Tax Compliance Act. Check the instructions to this form and IRS guidance at www.irs.gov/Businesses/Corporations/Basic-Questions-and-Answers-on-Form-8938 for more details about the foreign assets to which the form applies.

If you own or have authority over a foreign financial account, including a bank account, brokerage account, mutual fund, unit trust, or other type of financial account, with a value exceeding $10,000 at any time during the year, you may be required to file a Report of Foreign Bank and Financial Accounts (FBAR) annually. FinCEN Form 114 is used for this purpose and must be filed for 2022 by April 18, 2023 (the same deadline as the one for your federal income tax return) with a 6‐month filing extension (this extension is automatic). Filing Form 8938 does not relieve you of the obligation to file the FBAR form. Civil penalties for non‐willful FBAR violations are capped at $10,000, but courts are split on whether this applies per account or per form. The U.S. Supreme Court has agreed to decide this matter in the 2022–2023 term, but a decision may not be handed down before June 2023 (see the Supplement for any update). Penalties for willful FBAR violations are even greater.

Where to Claim the Deduction or Credit

Foreign taxes you pay on investments are reported to you (and the IRS) on Form 1099‐INT or Form 1099‐DIV. Use this figure for claiming your deduction or credit.

If you are claiming a deduction for foreign taxes, you must file Schedule A. Your deduction is part of your itemized deductions entered on Form 1040 or 1040‐SR.

If you are claiming the foreign tax credit related to your investments, you may qualify to report it on Schedule 3 on Form 1040 or 1040‐SR (without having to complete Form 1116). This simplified filing option applies if the amount of the foreign tax credit is not more than $300 ($600 on a joint return).

If your foreign tax credit is more than this limit, you must complete Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), and then follow the filing instructions given earlier.

Benefit

There is no regular tax on the exercise of incentive stock options.

Conditions

Incentive stock options (ISOs) are a type of compensation that must be granted in connection with employment. An ISO gives an employee the right to buy employer stock at a set price (called the strike price) within a set time period, after the ISO vests (i.e., cannot be taken from the employee unless he or she leaves employment). If the strike price is less than the market price, an employee exercising the option buys the stock at a bargain; the spread between the strike price and market price at the time the ISO is exercised is not subject to regular income tax if the following 2 conditions are met:

1. You must hold the stock acquired through the ISO for more than 2 years from the date the ISO was granted and more than one year after the ISO was exercised.
2. You must have been continuously employed by the employer granting the ISO from the date of the grant up to 3 months prior to the date on which you exercise the ISO.

If the stock acquired through the ISO is sold prior to the required holding period, then there is taxable compensation and immediate capital gain or loss recognition. The rules are complex; see IRS Publication 525, Taxable and Nontaxable Income.

Planning Tip

If you hold ISOs, determine how many to exercise this year, factoring in their expiration date and the impact on alternative minimum tax.

Pitfall

While there is no regular tax on the exercise of an ISO if certain conditions are met, the spread between the strike price and market price is treated as an adjustment for the alternative minimum tax (AMT). Thus, exercising ISOs can generate or increase AMT liability. In fact, exercising ISOs is the number one reason why individuals are impacted by the AMT.

Where to Claim the Benefit

The exercise of the ISO is not reported on Form 1040 or 1040‐SR, except to the extent it is included on Form 6251, Alternative Minimum Tax—Individuals.

Benefit

Income that builds up in the annuity over the years is not currently taxed; earnings are deferred until distributions are taken. Usually this occurs when you “annuitize” at a certain age to commence regular distributions for the remainder of the contract. This may be a set number of years or over your life (“single life annuity”) or joint life with a named beneficiary such as a spouse (“joint and survivor annuity”).

Conditions

To defer tax on the investment earnings in the contract, you must adhere to the terms of the contract imposed by the insurance company.

Planning Tips

If you need money before you want to start annuity payouts, you may be able to take a loan from your contract; this is tax free. Such borrowing is limited of course by the value of the annuity. You must pay interest on the loan and meet repayment terms to avoid taxation.

Once annuity payments commence, only the earnings portion is taxable. Amounts representing a return of your investment cost in the contract (your total investment as of the annuity starting date) are not taxed. The information needed to report the taxable amount of payments is provided to you on Form 1099‐R, Distributions from Pensions, Annuities, Retirement or Profit‐Sharing Plans, IRAs, Insurance Contracts, Etc.

Usually, there is automatic federal income tax withholding on annuity payments, but you may choose not to have withholding or to have additional withholding by completing Form W‐4P, Withholding Certificate for Pension or Annuity Payments, and submitting it to the insurance company.

Pitfalls

If you take distributions (not loans) from an annuity before age 59½ or surrender the contract, you may be subject to a 10% early distribution penalty. What's more, there may be surrender charges imposed by the insurance company for canceling the contract.

If the annuity guarantees a certain payout and you die before receiving it, your heirs must report the income portion of the payout as income in respect of decedent.

Where to Claim the Benefit

While you are deferring earnings, you do not have to report anything on your tax return. Once distributions commence, earnings are reported directly on Form 1040 or 1040‐SR.