Paying Tax on Late Grandparents' Savings Bonds

Dear Tax Talk, My grandparents are now deceased. They had a number of savings bonds. How is the savings bond interest reported? The original purchase price was approximately $33,000. Interest accumulated to date is approximately $80,000. The six heirs will divide the bonds. Is the interest accumulated from the savings bonds until the date of death used on the last personal tax Form 1040? Or is all the interest received from them placed on the final estate taxes? Thank you. -- Marcia

Dear Marcia, There are generally two ways to report the interest on U.S. savings bonds: Annually on the owner's tax return or at maturity. When there is a change of ownership, as in your case, the method of reporting can be changed. These bonds are known as Series E, EE or I bonds. Series HH bonds are taxed as you go because the interest is paid twice a year. If you've determined your grandparents have not reported the annual interest on these bonds, then there are tax consequences as a result of their death. According to IRS Publication 550:

If the transferred bonds were owned by a decedent who had used the cash method and had not chosen to report the interest each year, and who had bought the bonds entirely with his or her own funds, all interest earned before death must be reported in one of the following ways.

1. The surviving spouse or personal representative (executor, administrator, etc.) who files the final income tax return of the decedent can choose to include on that return all interest earned on the bonds before the decedent's death. The person who acquires the bonds then includes in income only interest earned after the date of death.
2. If the choice in (1) is not made, the interest earned up to the date of death is income in respect of the decedent and should not be included in the decedent's final return. All interest earned both before and after the decedent's death (except any part reported by the estate on its income tax return) is income to the person who acquires the bonds.

If that person uses the cash method and does not choose to report the interest each year, he or she can postpone reporting it until the year the bonds are cashed or disposed of or the year they mature, whichever is earlier. In the year that person reports the interest, he or she can claim a deduction for any federal estate tax paid on the part of the interest included in the decedent's estate.

So basically, if the bonds are not maturing and are being distributed in kind to the beneficiaries, then the interest can continue to be deferred until maturity. At maturity, the beneficiary would include all the savings bond interest, including the portion that belonged to the grandparents.

Alternatively, and probably the method that will result in the least tax, is to make the election in No. 1 above and include it on your grandparents' final Form 1040. If you choose to report it on the estate's tax return, which you would have to do if they were cashed in and you don't make the election in No. 1, then the tax will probably be higher. The tax rates applicable to an estate income tax return are higher than those that would probably apply to your grandparents.

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