Prop. Regs. Create Capital Gains and Losses for Non-bank Lenders

By David A. Thornton, CPA, Columbus, OH

Editor: Frank J. O'Connell, Jr., CPA, Esq.

On August 7, 2006, the IRS issued Prop. Regs. Sec. 1.1221-1(e), in  an attempt to clarify the character of gains and losses resulting from sales of loans and notes receivable acquired through purchase or loan origination; see REG-109367-06. While the character of such gains and losses has never been entirely clear, previous IRS rulings and judicial precedent have generally found such receivables to fall within the scope of Sec. 1221(a)(4), thus providing ordinary gain or loss on their disposal. The proposed regulations would overturn this historical application by expressly providing that such assets fall outside the scope of Sec. 1221(a)(4). If ultimately adopted, they could result in capital loss limitations for some lenders who anticipate selling off devalued loan portfolios, but they could also result in capital gain treatment for those selling off appreciated loan portfolios.


Sec. 1221 defines a capital asset as any property held by a taxpayer (whether or not connected with the taxpayer’s trade or business) other than those types of property specifically enumerated in that section as falling outside the definition. For debt instruments, the only applicable exception listed is Sec. 1221(a)(4), which holds that accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or for the sale of inventories are specifically excepted from capital treatment.

The purpose of Sec. 1221(a)(4) is to prevent a potential character mismatch between the ordinary gain or loss resulting from the sale of inventory or provision of services by the taxpayer and the resulting gain or loss from the sale of the underlying account or note receivable received as consideration in the initial sale. If the gain or loss from the sale of the note receivable is capital, the entire income recognized on the overall transaction (initial sale plus the sale of the note receivable) has the potential to be treated as part ordinary and part capital gain. This could produce a seemingly unfair result to a taxpayer who sells inventory at an ordinary gain and later sells the resulting note receivable at a discount (a capital loss).

The application of the Sec. 1221(a)(4) exception to capital-asset treatment in a lending scenario was first addressed in Burbank Liquidating Corp., 39 TC 999 (1963), which involved a scenario under which a savings and loan association originated mortgage loans and later sold those loans to a third party. The Tax Court did not address Sec. 582 (see below), which renders all debt instruments held by a bank as ordinary assets. The court held that loans made in the ordinary course of a taxpayer’s business fall within the Sec. 1221(a)(4) exception to capital-asset treatment. This decision was made on the grounds that the process of originating the loans is tantamount to acquiring a note receivable (the loan) in exchange for services rendered (the process of originating the loan).

The holding in Burbank is commonly used to support ordinary gain or loss treatment on sales of loans by non-bank lenders. The IRS acquiesced in the decision, and it was cited in a series of rulings that applied ordinary treatment to loans originated by a variety of commercial lenders; see, e.g., Rev. Ruls. 72-238, 73-558, 80-56, and 80-57.

Similarly, in Federal Nat’l Mortgage Ass’n, 100 TC 541 (1993) (FNMA), the Tax Court held that the acquisition of loans by purchase was integral to the business operations of the taxpayer. As a result, the purchase of loans was found to be closely associated with the process of origination, thus making the character of such purchased loans ordinary in accordance with previous rulings.

Sec. 582

Sec. 582 specifically addresses the character of gains and losses resulting from sales of debt instruments by financial institutions. Sec. 582(c)(1) provides that all debt obligations held by a financial institution shall be treated as ordinary assets. Sec. 582(c)(2) applies this treatment expressly to banks, savings and loan associations, certain small business investment companies, and certain business development corporations.

While Sec. 582 addresses the character issue for banks, thrifts, and the other specialized taxpayers mentioned, its provisions do not extend to taxpayers closely associated with these entities, even though the taxpayers may be part of the same affiliated group. For example, a finance company, a REIT, or some other type of non-bank lender, whether existing as a stand-alone entity or as part of a bank affiliated group, would not be covered by Sec. 582. These entities have historically relied on the rulings previously discussed to determine the character of gains and losses on acquired or originated loans.

Prop. Regs. Sec. 1.1221-1(e)

The IRS issued Prop. Regs. Sec. 1.1221-1(e) to address the “expansive” interpretation of Sec. 1221(a)(4), concluding that the previous rulings had stretched the application of this section beyond congressional intent. The preamble to the proposed regulations states that Treasury and the Service view the “extension” of Sec. 1221(a)(4) to notes acquired through purchase and notes originated in a lending transaction as being inconsistent with congressional intent. It also states that the interpretations of Sec. 1221(a)(4) set forth in Burbank and FNMA impede the effective administration of the tax laws by causing taxpayers to make judgments as to whether lending transactions or loan purchases constitute the provision of services, and the preamble notes that such judgments foster “uncertainty and disputes.”

Prop. Regs. Sec. 1.1221-1(e)(1) states that an account or note receivable is not described in Sec. 1221(a)(4) if the account or note is acquired for more than de minimis consideration (other than the property or services described in Sec. 1221(a)(1)), or the obligor on the note or account receivable is a person other than the person acquiring the property or services. In addition, Prop. Regs. Sec. 1.1221-1(e)(2) goes on to state definitively that an account or note receivable is not described in Sec. 1221(a)(4) just because the taxpayer’s act of acquiring (including originating) the account or note receivable constitutes, or includes, the provision of a “service” as that term is used in Sec. 1221(a)(4). While the proposed regulation does provide that the issuance of a separate note in exchange for the value of the specific services rendered in the loan’s acquisition would cause that note to fall within Sec. 1221(a)(4), the balance of the note issued in the transaction would not qualify.

Thus, the proposed regulation holds that notes and accounts receivable acquired through purchase and those originated by the taxpayer do not fall within the scope of Sec. 1221(a)(4). Purchased loans would not qualify because the purchase price constitutes an amount in excess of a de minimis amount (other than property or services delivered in direct exchange for the receivable) to acquire the receivable. Loans and notes originated by the taxpayer generally would not qualify because the regulation specifically excludes services provided in originating the loan from qualifying as “services” under Sec. 1221(a)(4), unless such services are separately invoiced to the borrower in exchange for a separate note (a very uncommon scenario).

As a result, the proposed regulation would effectively render purchased and originated notes and accounts receivable as falling outside of the Sec. 1221(a)(4) exception to capital-asset treatment. Thus, unless ordinary-asset treatment is achieved under a different Code section, gains and losses on the disposal of these assets would be capital in nature. This poses a particular problem if the sale of these assets results in a loss, due to the various limitations on deducting capital losses. However, if capital gains would result from the sale of these assets, the capital-asset treatment could be beneficial.

While the proposed regulation would exclude these notes and accounts receivable from the application of Sec. 1221(a)(4), ordinary-asset treatment could still apply to these assets under other Code sections. For example, as mentioned above, Sec. 582 treats all debt obligations held by banks and certain other financial institutions as ordinary assets. Taxpayers who originate loans for the express purpose of selling those loans could potentially treat those loans as ordinary assets under the Sec. 1221(a)(1) exception to capital-asset treatment for property held primarily for sale to customers.


The proposed regulations would change the long-standing ordinary-asset treatment applied to loans, accounts, and notes receivable purchased or originated by non-bank taxpayers. They would expressly remove such assets from the scope of Sec. 1221(a)(4), even though taxpayers have historically relied on IRS pronouncements and judicial precedent to the contrary. Those taxpayers not protected by other Code sections offering ordinary-asset treatment would no longer be protected against capital-loss treatment on the sale of these assets, but those selling at a gain may find the capital-gain treatment beneficial.

The regulations are proposed to be effective on a cutoff basis and applied to notes and accounts receivable acquired after the date the final regulations are published in the Federal Register.


Frank J. O'Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.

Unless otherwise noted, contributors are independent members of Crowe Chizek.

If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.