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What is excluded from gross income?
Exclusions from gross income are only those provided by statute. These include most proceeds from life insurance contracts, gifts and inheritances (these may, however, give rise to transfer taxes, i.e., estate and gift taxes, upon the transferor) and most damages received for personal injuries. The taxation of personal injury recoveries is quite complicated, however, and a tax attorney should be consulted before settling any such claim.
A well-known exclusion is interest from state and municipal bonds. Some of these bonds, however, may be subject to an alternative minimum tax, and persons having substantial income from municipal bonds should consult a tax adviser concerning the availability of the exclusion.
You should be aware that most states having an income tax have a different set of rules. Most states exclude only income from that state or its political subdivisions, and tax income from municipal bonds from other jurisdictions. Also, States cannot tax interest on federal government obligations, but the federal government can--and does--tax that interest. However, certain federal government bonds--such as Series EE bonds, have a special rule--interest is taxable only when the bond is cashed in unless the holder elects to be taxed currently. This was done to make the bonds more attractive to individual investors.
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