Over the past few years, did you have your money on deposit in a bankrupt or insolvent financial institution that froze your account by limiting withdrawals?
If you did, and if you were not aware of the rule for reporting interest on frozen deposits, it's possible you paid taxes on income that you should have excluded from taxes.
The Rule: You don't pay tax on interest allocable to frozen deposits. The interest is taxable only when withdrawals are permitted.
Fore example, assume $100 of interest was credited to your frozen deposits during the year. In addition, you were only permitted to withdraw $80 for the entire year. Of the $100 credited to your account, only $80 must be included in your income; the reamining $20 is excluded.
The interest that is excluded is treated as credited to your account in the following year. However, you only include the interest in income in the year you are permitted to withdraw it even if you don't actually withdraw it (see the box below, which explains constructive receipt).
The rule for reporting interest on frozen deposits does not apply to officers and owners of at least a 1% interest in the financial institution or their relatives. These people must report the full amount of interest on frozen deposits.
Claiming a Refund
If you mistakingly reported interest allocable to frozen deposits in a prior year, you generally have until the later of three years from due date of the return or two years from the date the tax was actually paid to claim a refund for the excess tax paid. To claim a refund, file Form 1040X to amend your return.
How to Report Interest on a Frozen Account
If you receive Form 1099-INT from a financial institution that froze your account, do the following to report the interest:
- In Part I of Schedule B (Form 1040 and Form 1040A), list the full amount of interest shown on each Form 1099-INT.
- Next, on a separate line on Schedule B, subtract the amount of interest allocable to your frozen deposits (in the above example, this would be the $20). Label this line: Frozen Deposits. This is how you exclude the interest allocable to your frozen deposits from your taxable interest.
Here's the IRS Rule for Interest Income on Frozen Deposits
Exclude from your gross income interest on frozen deposits. A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because:
- The financial institution is bankrupt or insolvent, or
- The state where the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent.
- The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of:
- The net amount you withdrew from these deposits during the year, and
- The amount you could have [see constructive receipt below] withdrawn as of the end of the year (not reduced by any penalty for premature withdrawals of a time deposit).
Cash basis taxpayers not only report income in the year it is actually received, but also in the year it is constructively received. Constructive receipt refers to income that you do not have physical possession of (i.e. interest credited to your bank account), but it has been made available to you without restriction. In other words, you have constructive receipt of income when you have control over such income.