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Miscellaneous Taxable Income This section discusses various types of taxable income. You may have to include income from certain transactions even if no money changes hands. For example, if you lend at a below-market interest rate or have had a debt cancelled, you may have to include an amount in income. See Recoveries for a discussion of when to include in your income amounts you receive that you deducted in an earlier year, such as a state income tax refund. The following brief discussions of income items are arranged in alphabetical order. Those that are discussed in greater detail in another publication include a reference to that publication. These discussions are followed by in-depth discussions of other taxable income items as shown in the Table of Contents. When you report miscellaneous taxable income on line 21 of Form 1040, write a brief description of the income on the dotted line next to line 21. Activity not for profit. You must include on your return income from an activity from which you do not expect to make a profit. An example of this type of activity would be a hobby or a farm you operate mostly for recreation and pleasure. Enter this income on line 21 of Form 1040. Deductions for expenses related to the activity are limited. They cannot total more than the income you report, and can be taken only if you itemize deductions on Schedule A (Form 1040). See Not-for-Profit Activities in chapter 1 of Publication 535, Business Expenses, for information on whether an activity is considered carried on for a profit. Alaska Permanent Fund dividend income. If you received a payment from Alaska's mineral income fund (Alaska Permanent Fund dividend), you should report this amount on line 21 of Form 1040. The state of Alaska sends each recipient a document that shows this amount with the check. The amount is also reported to IRS. If you otherwise qualify to use Form 1040A or 1040EZ, you can report the Alaska Permanent Fund dividend on line 12 of Form 1040A or line 3 of Form 1040EZ. See your form instructions. Alimony. Include in your income on line 11 of Form 1040 any alimony payments you receive. Amounts you receive for child support are not income to you. For complete information, get Publication 504, Divorced or Separated Individuals. Allowances and reimbursements. If you receive travel, transportation, or other business expense allowances or reimbursements from your employer, get Publication 463, Travel, Entertainment, Gift, and Car Expenses. If you are reimbursed for moving expenses, get Publication 521, Moving Expenses. Below-market loans. A below-market loan is a loan on which no interest is charged or, if it is charged, it is at a rate below the applicable federal rate. If you make a below-market loan, you must include the forgone interest (at the federal rate) from the loan as interest income on your return. These loans are considered a transaction in which you, the lender, are treated as having made. A loan to the borrower in exchange for a note which requires the payment of interest at the applicable federal rate, and An additional payment to the borrower, which the borrower transfers back to you as interest. Depending on the transaction, the additional payment to the borrower is treated as a: Gift, Dividend, Contribution to capital, Payment of compensation, or Another type of payment. The borrower may have to report this payment as income, depending on its classification. For more information on below-market loans, see chapter 1 of Publication 550. Canceled sales contract. If you sell property (such as land or a residence) under a contract, but the contract is canceled and you return the buyer's money in the same tax year as the original sale, you have no income from the sale. If the contract is canceled and you return the buyer's money in a later tax year, you must include your gain in your income for the year of the sale. When you return the money and take back the property in the later year, you treat the transaction as a purchase that gives you a new basis in the property equal to the funds you return to the buyer. See chapter 1 of Publication 544, Sales and Other Dispositions of Assets, for more information. Special rules apply to the reacquisition of real property where a secured indebtedness (mortgage) to the original seller is involved. For further information, see Repossession in Publication 537, Installment Sales. Charitable gift annuities. If you are the beneficiary of a charitable gift annuity, you are required to report the yearly annuity or fixed percentage payment in gross income. The types of income received are reported on Form 1099-R. Report the gross distribution from box 1 on Form 1040, line 16a; the portion taxed as ordinary income (box 2a minus box 3) on Form 1040, line 16b; the portion taxed as capital gain on Schedule D, line 8, column (f), and identified in column (a). Constructively received income. If a third party is paid income from property you own, you have constructively received the income. It is the same as if you had received the income and paid it to the third party. Income received by an agent for you is income you constructively received in the year the agent received it. If you agree by contract that a third party is to receive income for you, you must include the amount in gross income when the third party receives it. Example 1. You and your employer agree that part of your salary is to be paid directly to your former spouse. You must include that amount in gross income when your former spouse receives it. Example 2. You assign your "lifetime services" to a trust. By agreement, your employer pays the trust a monthly fee for your services equal to what otherwise would be your gross monthly salary. You continue to do the same work for your employer. You must include in your income as wages the amounts your employer pays to the trust. Valid check. A valid check that you received or that was made available to you before the end of the tax year is considered income constructively received in that year, even if you do not cash the check or deposit it to your account until the next year. For example, if the postal service tries to deliver a check to you on the last day of the tax year but you are not at home to receive it, you must include the amount in your income for that tax year. If the check was mailed so that it could not possibly reach you until after the end of the tax year, and you could not otherwise get the funds before the end of the year, you include the amount in your income for the next tax year. No constructive receipt. There may be facts to show that you did not constructively receive income. Example. Alice Johnson, a teacher, agreed to the school board's condition that, in her absence, she would be entitled to receive only the difference between her regular salary and the salary of a substitute teacher hired by the school board. Alice did not constructively receive the amount by which her salary was reduced to pay the substitute teacher. Court awards and damages. To determine if settlement amounts you receive by compromise or judgment must be included in your income, you must consider the item that the settlement replaces. Include the following as ordinary income. Interest on any award. Compensation for lost wages or lost profits in most cases. Punitive damages. See Punitive damages, later. Amounts received in settlement of pension rights (if you did not contribute to the plan). Damages for: Patent or copyright infringement, Breach of contract, or Interference with business operations. Back pay and damages for emotional distress received to satisfy a claim under Title VII of the Civil Rights Act of 1964. Do not include in your income compensatory damages for personal physical injury or physical sickness (whether received in a lump sum or installments). Emotional distress. If emotional distress is due to physical injuries or physical sickness, the damages you receive for medical care due to that emotional distress are not taxable. Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders. Punitive damages. Punitive damages generally are taxable. It does not matter if they relate to a physical injury or physical sickness. This rule does not create any inference about punitive damages under prior law. You can exclude from income punitive damages awarded in a civil action if the following conditions are met: It is a wrongful death action, and Applicable state law provided, or has been determined by a court of competent jurisdiction to provide, that only punitive damages can be awarded in such an action. The state law must have been in effect on September 13, 1995, and the court decision must have been issued on or before that date. Pre-existing agreement. If you receive damages under a written binding agreement, court decree, or mediation award that was in effect (or issued on or before) September 13, 1995, you do not have to include in income any of those damages received on account of personal injuries or sickness. Credit card insurance. Generally, if you receive benefits under a credit card disability or unemployment insurance plan, the benefits are taxable to you. These plans make the minimum monthly payment on your credit card account if you cannot make the payment due to injury, illness, disability, or unemployment. Report on line 21 of Form 1040 the amount of benefits you receive during the year that is more than the amount of the premiums you paid during the year. Estate and trust income. An estate or trust, unlike a partnership, may have to pay federal income tax. If you are a beneficiary of an estate or trust, you may be taxed on your share of its income distributed or required to be distributed to you. However, there is never a double tax. Estates and trusts file their returns on Form 1041, U.S. Income Tax Return for Estates and Trusts, and your share of the income is reported to you on Schedule K-1 of Form 1041. Current income required to be distributed. If you are the beneficiary of a trust that must distribute all of its current income, you must report your share of the distributable net income whether or not you actually received it. Current income not required to be distributed. If you are the beneficiary of an estate or trust and the fiduciary has the choice of whether to distribute all or part of the current income, you must report: All income that is required to be distributed to you, whether or not it is actually distributed, plus All other amounts actually paid or credited to you, up to the amount of your share of distributable net income. How to report. Each item of income is treated the same for you as for the estate or trust. For example, if dividend income is distributed to you from a trust, you report the distribution as dividend income on your return. The same rule applies to distributions of tax-exempt interest and capital gains. The fiduciary of the estate or trust must tell you the type of items making up your share of the estate or trust income and any credits you are allowed on your individual income tax return. Losses. Losses of estates and trusts generally are not deductible by the beneficiaries. Grantor trust. Income earned by a grantor trust is taxable to the grantor, not the beneficiary, if the grantor keeps certain control over the trust. This rule applies if the property (or income from the property) put into the trust will or may revert (be returned) to the grantor or the grantor's spouse. The grantor is the one who transferred property to the trust. Generally, a trust is a grantor trust if the grantor has a reversionary interest valued (at the date of transfer) at more than 5% of the value of the transferred property. Fees for services. Include all fees for your services in your gross income. Examples of these fees are amounts you receive for services you perform as: A corporate director, An executor or administrator of an estate, A notary public, or An election precinct official. Corporate director. If you received (or should have received) a Form W-2 showing corporate director fees, report these fees on line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ. Otherwise, report these payments on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) as self-employment income. Executor or administrator of an estate. If these payments total $600 or more for the year, you may receive a Form 1099-MISC. Report these payments on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) as self-employment income. Exception: If you are not in the trade or business of being an executor (for instance, you are the executor of a friend's or relative's estate), do not include these amounts on Schedule C or Schedule C-EZ. Report them on line 21 of Form 1040. Notary public. Report payments for these services on Schedule C (Form 1040) or Schedule C-EZ (Form 1040). These payments are not subject to self-employment tax. Election precinct official. You should receive a Form W-2 showing payments for services performed as an election official or election worker. Report these payments on line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ. Free tour. If you received a free tour from a travel agency for organizing a group of tourists, you must include its value in your income. Report the fair market value of the tour on line 21 of Form 1040 or on Schedule C or Schedule C-EZ (Form 1040). You cannot deduct your expenses in serving as the voluntary leader of the group at the group's request. Gambling winnings. You must include your gambling winnings in your income on line 21 of Form 1040. If you itemize your deductions on Schedule A (Form 1040), you can deduct gambling losses you had during the year, but only up to the amount of your winnings. Lotteries and raffles. Winnings from lotteries and raffles are gambling winnings. In addition to cash winnings, you must include in your income the fair market value of bonds, cars, houses, and other noncash prizes. If you win a state lottery prize payable in installments, you must include in your gross income the annual payments and any amount you receive designated as "interest" on the unpaid installments. Form W-2G. You may have received a Form W-2G showing the amount of your gambling winnings and any tax taken out of them. Include the amount from box 1 on line 21 of Form 1040. Be sure to include any amount from box 2 on line 57 of Form 1040. Hobby losses. Losses from a hobby are not deductible from other income. A hobby is an activity from which you do not expect to make a profit. See Activity not for profit, earlier. If you collect stamps, coins, or other items as a hobby for recreation and pleasure, and you sell any of the items, your gain is taxable as a capital gain. However, if you sell items from your collection at a loss, you cannot deduct a net loss. Illegal income. Illegal income, such as stolen or embezzled funds, must be included in your gross income on line 21 of Form 1040, or on Schedule C or Schedule C-EZ (Form 1040) if from your self-employment activity. Indian fishing rights. If you are a member of a qualified Indian tribe that has fishing rights secured by treaty, executive order, or an Act of Congress as of March 17, 1988, do not include in your income amounts you receive from activities related to those fishing rights. The income is not subject to income tax, self-employment tax, or employment taxes. Jury duty. Jury duty pay you receive must be included in your income on line 21 of Form 1040. If you must give the pay to your employer because your employer continues to pay your salary while you serve on the jury, you can deduct the amount turned over to your employer as an adjustment to income. Include the amount you repay your employer on line 32 of Form 1040. Write "Jury pay" and the amount on the dotted line next to line 32. Kickbacks. You must include in your income on line 21 of Form 1040, or on Schedule C or Schedule C-EZ (Form 1040), kickbacks, side commissions, push money, or similar payments you receive. Example. You sell cars and help arrange car insurance for buyers. Insurance brokers pay back part of their commissions to you for referring customers to them. You must include the kickbacks in your income. Note received for services. If your employer gives you a secured note as payment for your services, you must include the fair market value (usually the discount value) of the note in your income for the year you receive it. When you later receive payments on the note, the proportionate part of each payment is a recovery of the fair market value that you previously included in your income. Do not include that part again in your income. Include the rest of the payment in your income in the year of payment. If your employer gives you an unsecured note as payment for your services, payments on the note that are credited toward the principal amount of the note are compensation income when you receive them. Prepaid income. Prepaid income is generally included in your gross income in the year you receive it. Prepaid income includes amounts such as rents or interest received in advance and compensation for future services. However, if you use an accrual method of accounting, you can defer prepaid income you receive for services to be performed before the end of the next tax year. In this case, you can include the payment in your gross income as you earn it by performing the services. Prizes and awards. If you win a prize in a lucky number drawing, television or radio quiz program, beauty contest, or other event, you must include it in your income. For example, if you win a $50 prize in a photography contest, you must report this income on line 21 of Form 1040. If you refuse to accept a prize, do not include its value in your income. Employee cash awards or bonuses. Cash awards or bonuses given to you by your employer for good work or suggestions generally must be included in your income as wages. However, certain employee awards can be excluded from income. See Employee achievement awards under Income Not Taxed, later. Goods or services. Prizes and awards in goods or services must be included in your income at their fair market value. If you are a salesperson and receive "prize points" redeemable for merchandise, which are awarded by a distributor to employees of dealers, you must include their fair market value in your income. The "prize points" are taxable in the year they are paid or made available to you, rather than in the year you redeem them for merchandise. Pulitzer, Nobel, and other prizes. If you were awarded a Pulitzer, Nobel, or other prize in recognition of past accomplishments (in religious, charitable, scientific, artistic, educational, literary, or civic fields), you generally must include the value of the prize in your income. However, you do not include this prize in your income if you meet all of the following requirements. You were selected without any action on your part to enter the contest or proceeding. You are not required to perform substantial future services as a condition for receiving the prize or award. The prize or award is transferred by the payer directly to a governmental unit or tax-exempt charitable organization as designated by you. The following conditions apply to the transfer: You cannot use the prize or award before it is transferred, You should provide the designation before the prize or award is presented to prevent a disqualifying use. The designation should contain: The purpose of the designation by making a reference to section 74(b)(3) of the Internal Revenue Code, A description of the prize or award, The name and address of the organization to receive the prize or award, Your name, address, and taxpayer identification number, and Your signature and the date signed. In the case of an unexpected presentation, you must return the prize or award before using it (or spending, depositing, investing it, etc., in the case of money) and then prepare the statement as described in (b). After the transfer, you should receive from the payer a written response stating when and to whom the designated amounts were transferred. These rules do not apply to scholarships and fellowship awards. For information, see Publication 520. Railroad retirement annuities. The following types of payments are treated as pension or annuity income and are taxable under the rules explained in Publication 575. Tier 1 railroad retirement benefits that are more than the "social security equivalent benefit." Tier 2 benefits. Vested dual benefits. Sale of personal items. If you sold an item you owned for personal use, such as a car, refrigerator, furniture, stereo, jewelry, or silverware, your gain is taxable as a capital gain that you report on Schedule D (Form 1040). You cannot deduct a loss. However, if you sold an item you held for investment, such as gold or silver bullion, coins, or gems, any gain is taxable as a capital gain and any loss is deductible as a capital loss. Social security and equivalent railroad retirement benefits. Social security or equivalent railroad retirement benefits, if taxable, must be included in the income of the person who has the legal right to receive the benefits. Social security benefits include any monthly benefit under Title II of the Social Security Act and any part of a tier I railroad retirement benefit treated as a social security benefit. Social security benefits do not include any supplemental security income (SSI) payments. Joint return. If you are married and file a joint return, you and your spouse must combine your incomes and your social security and equivalent railroad retirement benefits when figuring if any of your combined benefits are taxable. Even if your spouse did not receive any benefits, you must add your spouse's income to yours when figuring if any of your benefits are taxable. Form SSA-1099. If you received social security benefits during the year, you will receive Form SSA-1099, Social Security Benefit Statement. An IRS Notice 703 will be enclosed with your Form SSA-1099. This notice includes a worksheet you can use to figure whether any of your benefits are taxable. For an explanation of the information found on your Form SSA-1099, get Publication 915. Form RRB-1099. If you received equivalent railroad retirement or special guaranty benefits during the year, you will receive Form RRB-1099, Payments by the Railroad Retirement Board. For an explanation of the information found on your Form RRB-1099, get Publication 915. If you received other railroad retirement benefits, get Publication 575 for information on how these benefits are taxed. Lump-sum payment. If you received a lump-sum benefit payment during the year that is for one or more earlier years, use the worksheets in Publication 915 to determine the amount, if any, that is taxable. Taxable amount. Use the worksheet in the Form 1040 or Form 1040A instruction package to determine the amount of your benefits to include in your income. Publication 915 also has worksheets you can use. However, you must use the worksheets in Publication 915 if you exclude qualified adoption expenses, interest from U.S. savings bonds issued after 1989, interest paid on a student loan, or if you take the foreign earned income exclusion, the foreign housing exclusion or deduction, the exclusion of income from U.S. possessions, or the exclusion of income from Puerto Rico by bona fide residents of Puerto Rico. Benefits may affect your IRA deduction. You must use the special worksheets in Appendix B of Publication 590 to figure your taxable benefits and your IRA deduction if all of the following conditions apply. You receive social security or equivalent railroad retirement benefits. You have taxable compensation. You contribute to your IRA. You or your spouse is covered by a retirement plan at work. How to report. If any of your benefits are taxable, you must use either Form 1040 or Form 1040A to report the taxable part. You cannot use Form 1040EZ. Report your net benefits (the amount in box 5 of your Forms SSA-1099 and RRB-1099) on line 20a of Form 1040, or line 13a of Form 1040A. Report the taxable part (from the last line of the worksheet) on line 20b of Form 1040, or on line 13b of Form 1040A. State tuition programs. Only distributions from a qualified state tuition program that are more than the amount contributed to the program are taxable. A qualified state tuition program is one that is established and maintained by a state or agency and that: Allows a person to: Buy tuition credits or certificates for a designated beneficiary who would then be entitled to a waiver or payment of qualified higher educational expenses, or Make contributions to an account that is set up to meet the qualified higher educational expenses of a designated beneficiary of the account, Requires all purchases or contributions to be made only in cash, Prohibits the contributor and the beneficiary from directing the amount invested, Allows a change of beneficiary to be made only between members of the same family, and Imposes a penalty on any refund of earnings that does not meet at least one of the following conditions. The amount is used for qualified higher educational expenses of the beneficiary. The refund is made because of the death or disability of the beneficiary. The refund is made because the beneficiary received (and the refund is not more than) a scholarship, a veteran's educational assistance allowance, or another nontaxable payment (other than a gift, bequest, or inheritance) received for educational expenses. For more information on a specific program, contact the state or agency that established and maintains it. Unemployment compensation. You must include in your income all unemployment compensation you receive. You should receive a Form 1099-G showing the amount paid to you. Generally, you enter unemployment compensation on line 19 of Form 1040, line 12 of Form 1040A, or line 3 of Form 1040EZ. Types of unemployment compensation. Unemployment compensation generally includes any amount received under an unemployment compensation law of the United States or of a state. It includes: Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund, State unemployment insurance benefits, Railroad unemployment compensation benefits, Disability payments from a government program paid as a substitute for unemployment compensation. Amounts received as workers' compensation for injuries or illness are not unemployment compensation, Trade readjustment allowances under the Trade Act of 1974, Benefits under the Airline Deregulation Act of 1978, and Unemployment assistance under the Disaster Relief Act Amendments of 1974. Governmental program. If you contribute to a governmental unemployment compensation program and your contributions are not deductible, amounts you receive under the program are not included as unemployment compensation until you recover your contributions. Supplemental unemployment benefits. Benefits received from a company-financed fund (to which the employees did not contribute) are not unemployment compensation. They are taxable as wages subject to income tax withholding but not subject to social security, Medicare, or federal unemployment taxes. Report these payments on line 7 of Form 1040 or Form 1040A. You may have to repay some of your supplemental unemployment benefits to qualify for trade readjustment allowances under the Trade Act of 1974. If you repay supplemental unemployment benefits in the same year you receive them, reduce the total benefits by the amount you repay. If you repay the benefits in a later year, you must include the full amount of the benefits in your income for the year you received them. Deduct the repayment in the later year as an adjustment to gross income. Include the repayment on line 32 of Form 1040, and put "Sub-pay TRA" and the amount on the dotted line next to line 32. If the amount you repay in a later year is more than $3,000, you may be able to take a credit against your tax for the later year instead of deducting the amount repaid. For information on this, see the discussion on Repayments, later. Private unemployment fund. Unemployment benefit payments from a private fund to which you voluntarily contribute are taxable only if the amounts you receive are more than your total payments into the fund. Report the taxable amount on line 21 of Form 1040. Payments by a union. Benefits paid to you as an unemployed member of a union from regular union dues are included in your gross income on line 21 of Form 1040. Guaranteed annual wage. Payments you receive from your employer during periods of unemployment, under a union agreement that guarantees you full pay during the year, are taxable as wages. State employees. Payments can be made by a state to its employees who are not covered by the state's unemployment compensation law. If the payments are similar to benefits under that state law, they are fully taxable. Report these payments on line 21 of Form 1040. Repayment of unemployment compensation benefits. If you repaid in 1998 unemployment compensation benefits you received in 1998, subtract the amount you repaid from the total amount you received and enter the difference on line 19 of Form 1040, line 12 of Form 1040A, or line 3 of Form 1040EZ. Also, enter "Repaid" and the amount you repaid on the dotted line next to line 19, line 12, or line 3. If, in 1998, you repaid unemployment compensation that you included in your gross income in an earlier year, you may deduct the amount repaid on Schedule A (Form 1040) if you itemize deductions. See Repayments, later. Tax withholding and estimated tax. You can choose to have federal income tax withheld from your unemployment compensation. To make this choice, complete Form W-4V, Voluntary Withholding Request, and give it to the paying office. Tax will be withheld at 15% of your payment. If you do not choose to have tax withheld from your unemployment compensation, you may be liable for estimated tax. For more information on estimated tax, get Publication 505. Union benefits and dues. Amounts deducted from your pay for union dues, assessments, contributions, or other payments to a union cannot be excluded from your gross income. You may be able to deduct some of these payments as a miscellaneous deduction subject to the 2% limit if they are related to your job and if you itemize deductions on Schedule A (Form 1040). For more information, get Publication 529, Miscellaneous Deductions. Strike and lockout benefits. Benefits paid to you by a union as strike or lockout benefits, including both cash and the fair market value of other property, are usually included in your income as compensation. You can exclude these benefits from your income only when the facts clearly show that the union intended them as gifts to you. Reimbursed union convention expenses. If you are a delegate of your local union chapter and you attend the annual convention of the international union, do not include in your income amounts you receive from the international union to reimburse you for expenses of traveling away from home to attend the convention. You cannot deduct the reimbursed expenses, even if you are reimbursed in a later year. If you are reimbursed for lost salary, you must include that reimbursement in your income. Bartering Bartering is an exchange of property or services. You must include in your income, at the time received, the fair market value of property or services you receive in bartering. If you exchange services with another person and you both have agreed ahead of time as to the value of the services, that value will be accepted as fair market value unless the value can be shown to be otherwise. Generally, you report this income on Schedule C or Schedule C-EZ (Form 1040). But if the barter involves exchange of something other than services, such as in Example 4 below, you may have to use another form or schedule instead. Example 1. You are a self-employed attorney who performs legal services for a client, a small corporation. The corporation gives you shares of its stock as payment for your services. You must include the fair market value of the shares in your income on Schedule C or Schedule C-EZ (Form 1040) in the year you receive them. Example 2. You are a self-employed accountant. You and a house painter are members of a barter club. Members get in touch with each other directly and bargain for the value of the services to be performed. In return for accounting services you provided, the house painter painted your home. You must report as your income on Schedule C or Schedule C-EZ (Form 1040) the fair market value of the house painting services you received. The house painter must include in income the fair market value of the accounting services you provided. Example 3. You are self-employed and a member of a barter club. The club uses "credit units" as a means of exchange. It adds credit units to your account for goods or services you provide to members, which you can use to purchase goods or services offered by other members of the barter club. The club subtracts credit units from your account when you receive goods or services from other members. You must include in your income the value of the credit units that are added to your account, even though you may not actually receive goods or services from other members until a later tax year. Example 4. You own a small apartment building. In return for 6 months' rent-free use of an apartment, an artist gives you a work of art she created. You must report as rental income on Schedule E (Form 1040) the fair market value of the artwork, and the artist must report as income on Schedule C or Schedule C-EZ (Form 1040) the fair rental value of the apartment. Form 1099-B from barter exchange. If you exchanged property or services through a barter exchange, you should receive Form 1099-B or a similar statement from the barter exchange. You should receive the statement by February 1, 1999, and it should show the value of cash, property, services, credits, or scrip you received from exchanges during the year. The IRS will also receive a copy of Form 1099-B. Backup withholding. The income you receive from bartering is generally not subject to regular income tax withholding. However, backup withholding will apply in certain circumstances to ensure that income tax is collected on this income. Under backup withholding, the barter exchange must withhold, as income tax, 31% of the income if: You do not give the barter exchange your taxpayer identification number (generally a social security number or an employer identification number), or The IRS notifies the barter exchange that you gave it an incorrect identification number. If you join a barter exchange, you must certify under penalties of perjury that your taxpayer identification number is correct and that you are not subject to backup withholding. If you do not make this certification, backup withholding may begin immediately. The barter exchange will give you a Form W-9, Request for Taxpayer Identification Number and Certification, or a similar form, for you to make this certification. If tax is withheld from your barter income, the barter exchange will report the amount of tax withheld on Form 1099-B, or similar statement. Canceled Debts Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your gross income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold. If you are not self-employed, report the amount on line 21 of Form 1040. If you are self-employed, report the amount on Schedule C or C-EZ (Form 1040) if you are a sole proprietor or on Schedule F (Form 1040) if you are a farmer. Form 1099-C. If a federal government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2. Interest included in canceled debt. If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest will also be shown in box 3. Whether or not you must include the interest portion of the canceled debt in your gross income depends on whether the interest would be deductible if you paid it. If the interest would not be deductible (such as interest on a personal loan), include in your income the amount from box 2 of Form 1099-C. If the interest would be deductible (such as on a business loan), include in your income the net amount of the canceled debt (shown in box 2) less the interest amount (shown in box 3). Mortgage loan. If your financial institution offers a discount for the early payment of your mortgage loan, the amount of the discount is canceled debt. You must include the canceled amount in your gross income. Stockholder debt. If you are a stockholder in a corporation and the corporation cancels or forgives your debt to it, the canceled debt is dividend income to you. If you are a stockholder in a corporation and you cancel a debt owed to you by the corporation, you generally do not realize income. This is because the canceled debt is considered as a contribution to the capital of the corporation equal to the amount of debt principal that you canceled. Exceptions and Exclusions There are several exceptions and exclusions to the inclusion of canceled debt in income. These are explained next. Nonrecourse debt. If you are not personally liable for the debt (nonrecourse debt), different rules apply. You may have a gain or loss if nonrecourse debt is canceled or forgiven in conjunction with the sale or foreclosure of property to which the debt attaches. See Publication 544 for more information. Student loans. Certain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers. You do not have income if your student loan is canceled after you agreed to this provision and then performed the services required. To qualify, the loan must have been made by: The government -- federal, state, or local, or an instrumentality, agency, or subdivision thereof, A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or An educational institution: Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or As part of a program of the institution to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization. A loan will also qualify if it was made by an educational institution or a tax-exempt 501(c)(3) organization to refinance any loan to assist the individual in attending the institution that meets the requirements above. An educational institution is an organization with a regular faculty and curriculum and a regularly enrolled body of students in attendance at the place where the educational activities are carried on. A section 501(c)(3) organization is any corporation, community chest, fund, or foundation organized and operated exclusively for one or more of the following purposes: Charitable, Religious, Educational, Scientific, Literary, Testing for public safety, Fostering national or international amateur sports competition (but only if none of its activities involve providing athletic facilities or equipment), or The prevention of cruelty to children or animals. Exception. You do have income if your student loan is canceled because of services performed for an educational institution. Deductible debt. If a debt that qualified for a tax deduction is canceled, you do not realize income from the canceled debt. However, whether or not you must include the canceled debt in your gross income depends on whether you use the cash or an accrual method of accounting. If you use the cash method, you do not include it in income. If you use an accrual method, you do include it in income. For more information, see chapter 5 of Publication 334, Tax Guide for Small Business. Price reduced after purchase. Generally, if the seller reduces the amount you owe for property you purchased, you do not have income from the reduction. The reduction of the debt is treated as a purchase price adjustment and reduces your basis in the property. Bankruptcy exclusion. If your debt is canceled in a bankruptcy case under title 11 of the United States Code, do not include the canceled debt in your gross income. However, you must reduce your tax attributes (but not below zero) by the canceled amount that is not included in your income. See Publication 908, Bankruptcy Tax Guide, for more information. Insolvency exclusion. If your debt is canceled when you are insolvent, you do not include the canceled debt (up to a certain limit) in your gross income. However, you must reduce your tax attributes (but not below zero) by the canceled amount that is not included in your income. This exclusion applies only to the amount by which you are insolvent. See Publication 908 for more information. Qualified farm debt exclusion. If you have qualified farm debt that is canceled, it is excluded from your income (up to certain limits). See chapter 4 of Publication 225, Farmer's Tax Guide, for more information. Qualified real property business indebtedness (QRPBI) exclusion. QRPBI is certain debt connected with business real property. If you have QRPBI that is canceled, you can elect to exclude (up to certain limits) the canceled debt from your gross income. If you make the election, you must reduce the basis of your depreciable real property by the excluded amount. (A C corporation cannot make this election.) See chapter 5 of Publication 334 for more information. Order of exclusions. If the canceled debt occurs because of a title 11 bankruptcy case, the bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, or QRPBI exclusions. If the canceled debt occurs because you are insolvent, the insolvency exclusion takes precedence over qualified farm debt or QRPBI exclusions. Partnership Income A partnership is not a taxable entity. The income, gains, losses, credits, and deductions of a partnership are "passed through" to the partners based on each partner's distributive share of these items. Partner's distributive share. Your distributive share of partnership income, gains, losses, deductions, or credits is your share of these items of the partnership. Your share of these amounts is generally based on the partnership agreement, whether or not they are actually distributed to you. Generally, your distributive share of the partnership losses is limited to the adjusted basis of your partnership interest at the end of the partnership year in which the losses took place. Partnership agreement. The partnership agreement usually covers the distribution of profits, losses, and other items. However, if the agreement does not state how a specific item of gain or loss will be shared, generally each partner's distributive share is figured according to the partner's interest in the partnership. Partnership return. Although a partnership pays no tax, it must file an information return on Form 1065, U.S. Partnership Return of Income. This shows the result of the partnership's operations for its tax year and the items that must be "passed through" to the partners. Partner's return. You must generally treat partnership items on your individual return the same as they are reported on the partnership return. That is, if the partnership had a capital gain, you report your share on Schedule D (Form 1040). You report your share of partnership ordinary income on Schedule E (Form 1040). Schedule K-1 (Form 1065). You should receive from each partnership in which you are a member a copy of Schedule K-1 (Form 1065) showing your share of income, deductions, credits, and tax preference items of the partnership for the tax year. Generally, Schedule K-1 will tell you where to report each item of income on your individual return. Retain Schedule K-1 (Form 1065) for your records. Do not attach it to your Form 1040. More information. For more information, get Publication 541, Partnerships. S Corporation Income In general, an S corporation does not pay tax on its income. Instead, the income and expenses of the corporation are "passed through" to the shareholders. S corporation return. An S corporation must file a return on Form 1120S, U.S. Income Tax Return for an S Corporation. This shows the results of the corporation's operations for its tax year and the items of income, gains, losses, deductions, or credits that affect the shareholders' individual income tax returns. Shareholder's return. If you are a shareholder in an S corporation, you must include on Form 1040 your share of the corporation's items of income, loss, deduction, or credit in the same way as a partnership would report these items. All current year income or loss and other tax items are taxed to each shareholder at the corporation's year end. Generally, these items passed through to you as a shareholder will increase or decrease the basis of your S corporation stock as appropriate. Distributions. Generally, S corporation distributions are a nontaxable return of your basis in the corporation stock. However, in certain cases, part of the distributions may be taxable as a dividend, or as a long-term or short-term capital gain, or as both. The corporation's distributions may be in the form of cash or property. Schedule K-1 (Form 1120S). You should receive from the S corporation in which you are a shareholder a copy of Schedule K-1 (Form 1120S) showing your share of income, credits, and deductions of the S corporation for the tax year. Your distributive share of the items of income, gains, losses, deductions, or credits of the S corporation must be shown separately on your Form 1040. The character of these items generally is the same as if you had realized or incurred them personally. Generally, Schedule K-1 (Form 1120S) will tell you where to report each item of income on your individual return. Do not attach Schedule K-1 to your Form 1040. Keep it for your records. More information. For more information, see the instructions for Form 1120S. Recoveries A recovery is a return of an amount you deducted or took a credit for in an earlier year. Generally, you must include all or part of the recovered amounts in your income in the year the recovery is received. The most common recoveries are refunds, reimbursements, and rebates of deductions itemized on Schedule A (Form 1040). Non-itemized deduction recoveries include such items as payments you receive on previously deducted bad debts and recoveries of items for which you previously claimed a tax credit. If you recover amounts that are for itemized deductions and non-itemized deductions you deducted in a previous year, recompute your taxable income first as shown in Non-Itemized Deduction Recoveries before you determine the amount to include in your income as shown in Itemized Deduction Recoveries. Federal income tax refund. Refunds of federal income taxes are not included in your income because they are never allowed as a deduction from income. Form 1099-G. If you received a state or local income tax refund in 1998, you may receive a statement, Form 1099-G, Certain Government Payments, from the payer of the refund (or credit or offset) by February 1, 1999. The IRS will also receive a copy of the Form 1099-G. Interest. Interest on any of the amounts you recover must be reported as interest income in the year received. For example, report any interest you received on state or local income tax refunds on line 8a of Form 1040. Recovery and expense in same year. If the refund or other recovery and the deductible expense occur in the same year, the recovery reduces the deduction and is not reported as income. Recovery for 2 or more years. If you receive a refund or other recovery that is for amounts you paid in 2 or more separate years, you must allocate, on a pro rata basis, the recovered amount between the years in which it was paid. This allocation is necessary to determine the amount of recovery from any earlier years and to determine the amount, if any, of your allowable deduction for this item for the current year. Example. You paid 1997 estimated state income tax of $4,000 in four equal payments. You made your fourth payment in January 1998. You had no state income tax withheld during 1997. In 1998, you received a $400 tax refund based on your 1997 state income tax return. You claimed itemized deductions each year on your federal income tax return. You must allocate the $400 refund between 1997 and 1998, the years in which you paid the tax on which the refund is based. Since you paid 75% ($3,000 ÷ $4,000) of the estimated tax in 1997, 75% of the $400 refund, or $300, is for amounts you paid in 1997 and is a recovery item. If all of the $300 is a taxable recovery item, you will include $300 on line 10, Form 1040, for 1998, and attach a copy of your computation showing why that amount is less than the amount shown on the Form 1099-G you received from the state. The balance ($100) of the $400 refund is for your January 1998 estimated tax payment. When you figure your deduction for state and local income taxes paid during 1998, you will reduce the $1,000 paid in January by $100. Your deduction for state and local income taxes paid during 1998 will include the January net amount of $900 ($1,000 - $100), plus any estimated state income taxes paid in 1998 for 1998, and any state income tax withheld during 1998. If you did not itemize deductions in the year for which you received the recovery, do not include any of the recovery amount in your income. Example. In 1997, you filed your federal income tax return on Form 1040A. In 1998 you received a refund from your 1997 state income tax. Do not report any of the refund as income because you did not itemize deductions in 1997. Itemized Deduction Recoveries Total recoveries generally included in income. If you recover any amount that you deducted in an earlier year on Schedule A (Form 1040), you must generally include the full amount of the refund or recovery in your income in the year you receive it. This is true if for the earlier taxable year: Your itemized deductions were not subject to the limit on itemized deductions. (If your deductions were limited, see Previously limited itemized deductions, later.) Your deduction for the item recovered exceeds the amount recovered. (If your deduction was less than the amount recovered, see Recovery limited to deduction, later.) You had taxable income. (If you had no taxable income, see Negative taxable income, later.) Your itemized deductions exceeded the standard deduction by at least the amount of the refund or recovery. (If your itemized deductions did not exceed the standard deduction by at least the amount of the recovery, see Total recoveries not included in income, later.) You had no tax credits. (If you had tax credits, see Tax credits--earlier year, later.) You were not subject to alternative minimum tax. (If you were subject to alternative minimum tax, see Alternative minimum tax--earlier year, later.) Where to report. Enter your state and local income tax refund on line 10 of Form 1040, and the total of all other recoveries as other income on line 21 of Form 1040. You cannot use Form 1040A or Form 1040EZ. Example. For 1997, you filed a joint return. Your taxable income was $20,000 and you were not entitled to any tax credits. Your standard deduction was $6,900, and you had itemized deductions of $8,000. In 1998, you received the following recoveries for amounts deducted on your 1997 return: Medical expenses $200 State and local income tax refund 400 Refund of mortgage interest       325 Total recoveries      $925 None of the recoveries were more than the deductions taken for 1997. Because your total recoveries are less than the amount by which your itemized deductions exceeded the standard deduction ($8,000 - $6,900 = $1,100), you must include your total recoveries in your income for 1998. Report the state and local income tax refund of $400 on line 10 of Form 1040, and the balance of your recoveries, $525, on line 21 of Form 1040. Worksheet for refunds of itemized deductions. If your itemized deductions were not limited, you had no tax credits, and you were not subject to the alternative minimum tax, you can use Table 5 at the end of this publication to determine the amount of your recovery of amounts deducted after 1986 to include in your income. Standard deduction for earlier years. To determine if amounts recovered in 1998 must be included in your income, you must know the standard deduction for your filing status for the year the deduction was claimed. The standard deduction tables for 1997, 1996, and 1995 are at the end of this publication (Tables 2, 3, and 4.) If you need the standard deduction amounts for years before 1995, see the copy of your return for that year. For information on the standard deduction, get Publication 501, Exemptions, Standard Deduction, and Filing Information. Total recoveries not included in income. The total recovery that must be included in your income is limited to the itemized deduction amount that reduced your tax for the earlier year. (See Tax Benefit Rule, later.) You are generally allowed to claim the standard deduction if you do not itemize your deductions. Only your itemized deductions that are more than your standard deduction are subject to the recovery rule (unless you are required to itemize your deductions). If your total deductions on the earlier year return were not more than your income for that year, include in your income this year the smaller of: Your recoveries, or The amount by which your itemized deductions exceeded the standard deduction. Example. You filed a joint return for 1997 with a taxable income of $25,000. Your itemized deductions were $8,700. The standard deduction that you could have claimed was $6,900. In 1998, you recover $2,400 of your 1997 itemized deductions. None of the recoveries were more than the actual deductions for 1997. Include $1,800 of the recoveries in your 1998 income. This is the smaller of your recoveries ($2,400) or the amount by which your itemized deductions were more than the standard deduction ($8,700 - $6,900 = $1,800). Negative taxable income. If your taxable income was a negative amount, reduce the recovery you must include in your income by the negative amount. Example. In the previous example assume you had a negative taxable income of $200 in 1997. You would include $1,600 in your 1998 income, rather than $1,800. Recovery limited to deduction. You do not include in your income any amount of your recovery that is more than the amount you deducted in the earlier year. The amount you include in your income is limited to the smaller of: The amount deducted on Schedule A (Form 1040), or The amount recovered. Example. During 1997, you paid $1,700 for medical expenses. From this amount you subtracted $1,500, which was 7.5% of your adjusted gross income. Your actual medical expense deduction was $200. In 1998, you received a $500 reimbursement from your medical insurance for your 1997 expenses. The only amount of the $500 reimbursement that must be included in your income in 1998 is $200 -- the amount actually deducted. Allocation of recoveries to be included. If you are not required to include all of your recoveries in your income, and you have both a state income tax refund and other itemized deduction recoveries, you must allocate part of the taxable recoveries to report as a state tax refund on line 10 of Form 1040. The balance of your taxable recoveries is reported as other income on line 21 of Form 1040. You can use Table 5 at the end of this publication to figure the part to report as a state tax refund, or you can figure that part as follows. Divide your state income tax refund by the total of all your itemized deduction recoveries. The result is the percentage that the state income tax refund represents of the total recoveries. Multiply the amount of taxable recoveries by the percentage. Example. Assume you recovered in 1998 $2,500 of your 1997 itemized deductions, but that the recoveries you must include in your 1998 income are only $1,500. Of the $2,500 you recovered, $500 was due to your state income tax refund. The amount you report as a tax refund on line 10 of Form 1040 is $300 [($500 ÷ $2,500) × $1,500]. The balance of the taxable recoveries, $1,200, is reported as other income on line 21 of Form 1040. Non-Itemized Deduction Recoveries This section discusses recovery of deductions other than those deducted on Schedule A (Form 1040). Recovery of tax credits is discussed later. Total recoveries included in income. Recovery of amounts deducted in an earlier year must be included in your income in the year received to the extent the deduction reduced your tax in the year of the deduction. (See Tax Benefit Rule, later.) Total recoveries not included in income. If your taxable income is a negative amount, reduce the recovery by that negative amount. Include this reduced recovery in your income. Itemized and non-itemized deduction recoveries. If you recover amounts due to both itemized deductions and non-itemized deductions taken in the same year, you must determine the amounts to include in your income as follows: Figure your non-itemized deduction recoveries, Add the non-itemized deduction recoveries to your taxable income, and then Figure your itemized deduction recoveries. This order is required because your taxable income will change and you must use taxable income to figure your itemized deduction recoveries. Amounts Recovered for Credits If you received a recovery in 1998 for an item on which you claimed a tax credit in an earlier year, you must increase your 1998 tax to the extent the credit reduced your tax in the earlier year. You have a recovery if there is a downward price adjustment or similar adjustment on the item for which you claimed a credit. This rule does not apply to the investment credit or the foreign tax credit. Recoveries of these credits are covered by other provisions of the law. See Publication 514, Foreign Tax Credit for Individuals, or Form 4255, Recapture of Investment Credit, for details. Tax Benefit Rule If you recover an amount that you deducted in an earlier year, include the recovery in your income only to the extent the deduction reduced your tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year. Generally, you can figure the deduction amount that reduced your tax in the earlier year by using the methods discussed earlier. These methods are for the most common situations and are comparatively simple because you are not required to recompute the earlier year's tax. Itemized deductions limited. Special rules apply if your itemized deductions on Schedule A (Form 1040) were limited in a prior year and in a later year you receive a recovery of amounts deducted in the prior year (for example, state income taxes or mortgage interest). When the limit applies, you must reduce your itemized deductions by the lesser of: 3% of the amount by which your adjusted gross income (AGI) exceeds a specified base amount ($121,200 for 1997, $60,600 if you were married filing separately), or 80% of your otherwise allowable itemized deductions affected by the limit. Previously limited itemized deductions. If you received a refund or recovery of an itemized deduction that was limited as explained earlier under Itemized deductions limited, the refund or recovery is, in general, fully included in your gross income in the year you received it. If your 1997 AGI was more than $121,200 ($60,600 if you were married filing separately), you should complete the following steps to determine if you can include less than the full refund or recovery in your gross income. This is also true if the 80% limit applied to your itemized deductions (for example, line 4 was smaller than line 8 on the Itemized Deduction Worksheet in your 1997 Form 1040 instructions). To determine the portion of the refund or recovery you must include in income, follow the five steps below. If your earlier tax year does not involve negative taxable income or an unused tax credit, skip steps 1 and 2 and start with step 3. If your taxable income for the earlier year was a negative amount, reduce your recovery by the negative amount. If your tax for the earlier year was reduced to zero by a tax credit that was not fully used in that year, and if reducing your deduction for that year by the recovery would result in tax for that year, reduce your recovery by an amount equal to your recovery multiplied by the following fraction: Your tax for the earlier year, determined after reducing your deductions by the recovery and applying the credit; over The total increase in your tax for the earlier year, determined by subtracting your as-filed earlier year's tax (without applying the credit) from your earlier year's tax determined after reducing your deductions by the recovery (without applying the credit). Determine your deduction for itemized deductions you actually claimed in the earlier year after applying the limit on itemized deductions. Figure the greater of: The standard deduction for the earlier year, or Your itemized deductions for the earlier year figured as you would have claimed them (after taking into account the limit on itemized deductions) if you had paid the proper amount of the item for which you later received a refund or recovery. The proper amount is the amount you actually paid reduced by the refund or recovery (as reduced under steps 1 or 2, if necessary). For example, if you paid $12,000 in state income taxes in 1997 and in 1998 you received a $2,000 refund of 1997 state income taxes, $10,000 is the proper amount, and you would figure your itemized deductions for 1997 as though you had paid only $10,000 in state income taxes in 1997. Note. If you were required to itemize your deductions in the earlier year, use step 4(b) and not step 4(a). Subtract the amount in step 4 from the amount in step 3. The difference is the amount of the refund or recovery to include in your gross income in the year you receive the refund or recovery. Example. Eileen Martin is single. She had an AGI of $1,121,200 and itemized her deductions on her federal income tax return for 1997. She was not subject to alternative minimum tax and was not entitled to any credit against income tax. Her only allowable deduction was $40,000 of state income taxes. However, Eileen deducted only $10,000 in 1997 because her otherwise allowable deductions of $40,000 were reduced by $30,000. In 1998, she received a $5,000 refund of her state income taxes for 1997. The following table shows how Eileen calculated the $30,000 reduction and other amounts from the 1997 Itemized Deduction Worksheet in her Form 1040 package. These amounts are needed to figure the portion of the $5,000 refund that Eileen must include in her income for 1998. AGI for 1997 $1,121,200 State income taxes paid in 1997 $40,000 3% reduction (amount on line 8 of  1997 Itemized Deduction Worksheet)   [($1,121,200 - $121,200) × 3%] $30,000 80% reduction not applied (amount  on line 4 of 1997 Itemized Deduction  Worksheet) ($40,000 × 80%) $32,000 1997 deduction (amount on line 10 of  1997 Itemized Deduction Worksheet)  ($40,000 - $30,000) $10,000 Refund received in 1998 of 1997 state  income taxes $5,000 Proper amount of 1997 state income  taxes ($40,000 - $5,000) $35,000 If Eileen had paid only $35,000 in state income taxes in 1997, her otherwise allowable itemized deductions of $35,000 would have been reduced by $28,000 ($35,000 × 80%). This is the amount that would have been entered on line 4 and on line 9 of the 1997 Itemized Deduction Worksheet. Further, $28,000 is less than the amount that would have been entered on line 8 ($30,000). She would have claimed a deduction in 1997 of $7,000 ($35,000 - $ 28,000). She derived a tax benefit to the extent of the $3,000 difference between her deduction for 1997 ($10,000) and the deduction for 1997 that she would have claimed ($7,000) had Eileen paid the proper amount of state income taxes in 1997 and not received a state income tax refund in 1998. Only $3,000 ($10,000 - $7,000) of the $5,000 state income tax refund that Eileen received in 1998 is includible in her gross income in 1998. If you need more information, see Revenue Ruling 93-75. This ruling can be found in many libraries and IRS offices. Special situations. These rules apply only if your itemized deductions for the year you deducted the recovered amount were not limited. If, because of your AGI, your itemized deductions were limited, see Previously limited itemized deductions, earlier. If a deduction reduced your taxable income, but did not reduce your tax because you either were subject to the alternative minimum tax or had unused tax credits, you will need to recompute the earlier year's tax to determine whether you can exclude the recovery amount from your income. Tax credits--earlier year. If you recover an item deducted in an earlier year in which you had unused tax credits, you must refigure the earlier year's tax to determine if you must include the recovery in your income. To do this, add the amount of the recovery to your earlier year's taxable income and refigure the tax and the credits on the recomputed amount. If your tax, after application of the credits, does not change, you did not have a tax benefit from the deduction. Do not include the recovery in your income. If the recomputed tax, after application of the credits, is more than the tax in the earlier year, include the recovery in your income to the extent it reduced the tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year. Example. In 1997, Jean Black filed as head of household and itemized her deductions. Her taxable income was $5,260 and her tax was $791. She claimed a child care credit of $1,200. The credit reduced her tax to zero and she had an unused tax credit of $409 ($1,200 - $791). In 1998, Jean recovered $1,000 of her itemized deductions. She adds $1,000 to her 1997 taxable income and recomputes that year's tax, but the child care credit exceeds the recomputed tax of $941, as shown in the following table: 1997 Taxable Income Tax        Tax Credit Net Tax    As Filed $ 5,260 791 1,200 $ 0 Recovery + 1,000    Recomputed $ 6,260 941 1,200 $ 0 Jean's tax liability for 1997 has not changed by including the recovery in her income for that year. She did not have a tax benefit from the recovered deduction and does not include any of the recovery in her income for 1998. Alternative minimum tax--earlier year. If you were subject to the alternative minimum tax in the year of the deduction, you will have to recompute your tax for the earlier year to determine if the recovery must be included in your income. This will require a recomputation of your regular tax, as shown in the example for tax credits, and a recomputation of your alternative minimum tax. If inclusion of the recovery does not change your total tax, you do not include the recovery in your income. However, if your total tax increases by any amount, you received a tax benefit from the deduction and you must include the recovery in your income to the extent the deduction reduced your tax in the earlier year. Rental of Personal Property If you rent out personal property, such as equipment or vehicles, how you report your income and expenses is generally determined by: Whether or not the rental activity is a business, and Whether or not the rental activity is conducted for profit. Generally, if your primary purpose is income or profit and you are involved in the rental activity with continuity and regularity, your rental activity is a business. See Publication 535 for details on deducting expenses for both business and not-for-profit activities. Reporting business income and expenses. If you are in the business of renting personal property, report your income and expenses on Schedule C or C-EZ. The form instructions have information on how to complete them. Reporting nonbusiness income. If you are not in the business of renting personal property, report your rental income on line 21 of Form 1040. List the type and amount of the income on the dotted line to the left of the amount you report on line 21. Reporting nonbusiness expenses. If you rent personal property for a profit, report your rental expenses on line 32 of Form 1040. Enter the amount and "PPR" on the dotted line to the left and include the amount of your deductible expenses in the total amount you enter on line 32. If you do not rent personal property for a profit, your deductions are limited and you cannot report a loss to offset other income. You report these rental expenses on Schedule A (Form 1040). Chapter 1 of Publication 535 has details on how to claim these expenses. Repayments If you had to repay an amount that you had included in your income in an earlier year because at that time you thought you had an unrestricted right to it, you can deduct the amount repaid from your income in the year in which you repay it. Type of deduction. The type of deduction you are allowed in the year of repayment depends on the type of income you included in the earlier year. For instance, if you repay an amount that you previously reported as a capital gain, deduct the repayment as a capital loss. If you repaid social security or equivalent railroad retirement benefits, get Publication 915. If you repaid other railroad retirement benefits, get Publication 575. Repayment--$3,000 or less. If the amount you repaid was $3,000 or less, deduct it from your income in the year you repaid it. If you reported it as wages, unemployment compensation, or other ordinary income, enter it on line 22 of Schedule A (Form 1040). If you reported it as a capital gain, deduct it on Schedule D (Form 1040). Repayment--over $3,000. If the amount you repaid was more than $3,000, you can either take a deduction for the amount repaid (Method 1) or you can take a credit against your tax (Method 2). Figure your tax under both methods and use the method that results in less tax. Method 1. Figure your tax for 1998 claiming a deduction for the repaid amount. Method 2. Follow these steps. Figure your tax for 1998 without deducting the repaid amount. Refigure your tax from the earlier year without including in income the amount you repaid in 1998. Subtract the tax in (2) from the tax shown on your return for the earlier year. This is the credit. Subtract the answer in (3) from the tax for 1998 figured without the deduction (step 1). If the amount from Method 1 is less tax, deduct the amount repaid on the same form or schedule on which you previously reported it. For example, if you reported it as self-employment income, deduct it as a business deduction on Schedule C or Schedule C-EZ (Form 1040). If you reported it as wages, deduct it as an individual deduction on line 27 of Schedule A (Form 1040). If using Method 2 results in less tax, claim the credit on line 63 of Form 1040, and write "I.R.C. 1341" next to line 63. Example. For 1997 you filed a return and reported your income on the cash method. In 1998 you repaid $5,000 included in your 1997 gross income under a claim of right. Your filing status in 1998 and 1997 is single. Your income and tax for both years are as follows: 1997 With Income 1997 Without Income Taxable Income $15,000 $10,000 Tax Liability $ 2,254 $ 1,504 1998 Without Deduction 1998 With Deduction Taxable Income $49,950 $44,950 Tax Liability $10,698 $ 9,298 Your tax under method (1) is $9,298. Your tax under method (2) is $9,948, figured as follows: Tax previously determined for 1997 $2,254 Less: Tax as refigured      - 1,504 Decrease in 1997 tax         $750 Regular tax liability for 1998 $10,698 Less: Decrease in 1997 tax        - 750 Refigured tax for 1998       $9,948 Because you pay less tax under method (1), you should take a deduction for the repayment in 1998. Repayment does not apply. This discussion does not apply to: Deductions for bad debts, Deductions from sales to customers, such as returns and allowances, and similar items, or Deductions for legal and other expenses of contesting the repayment. Year payment deducted. If you use the cash method, you can take the deduction for the tax year in which you actually make the repayment. If you use any other accounting method, you can deduct the repayment only for the tax year in which it is a proper deduction under your accounting method. For example, if you use an accrual method, you are entitled to the deduction in the tax year in which the obligation for the repayment accrues. Royalties Royalties from copyrights, patents, and oil, gas, and mineral properties are taxable as ordinary income. You generally report royalties on Part I of Schedule E (Form 1040). However, if you hold an operating oil, gas, or mineral interest or are in business as a self-employed writer, inventor, artist, etc., report your gross income and expenses on Schedule C or Schedule C-EZ (Form 1040). Copyrights and patents. Royalties from copyrights on literary, musical, or artistic works, and similar property, or from patents on inventions, are amounts paid to you for the right to use your work over a specified period of time. Royalties are generally based on the number of units sold, such as the number of books, tickets to a performance, or machines sold. Oil, gas, and minerals. Royalty income from oil, gas, and mineral properties is the amount you receive when natural resources are extracted from your property. The royalties are based on units, such as barrels, tons, etc., and are paid to you by a person or company who leases the property from you. Depletion. If you are the owner of an economic interest in mineral deposits or oil and gas wells, you can recover your investment through the depletion allowance. For information on this subject, see chapter 13 of Publication 535. Coal and iron ore. Under certain circumstances, you can treat amounts you receive from the disposal of coal and iron ore as payments from the sale of a capital asset, rather than as royalty income. For information about gain or loss from the sale of coal and iron ore, get Publication 544, Sales and Other Dispositions of Assets. Interest in the property sold. If you sell your complete interest in the oil, gas, or mineral rights, the amount you receive is considered payment for the sale of your property, not royalty income. Under certain circumstances, the sale is subject to capital gain or loss treatment on Schedule D (Form 1040). Part of future production sold. If you own mineral property but sell part of the future production, you generally treat the money you receive from the buyer at the time of the sale as a loan from the buyer. Do not include it in your income or take depletion based on it. When production begins, you include all the proceeds in your income, deduct all the production expenses, and deduct depletion from that amount to arrive at your taxable income from the property. Retained interest. If you retain a royalty, an overriding royalty, or a net profit interest in a mineral property for the life of the property, you have made a lease or a sublease, and any cash you receive for the assignment is ordinary income subject to a depletion allowance.

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