Gains & Losses
The current economic environment gives taxpayers a significant opportunity to purchase loans at a discount (often referred to as “buying paper”). Amounts received by the holder on retirement of any debt instrument are considered amounts received in exchange for the debt instrument (Sec. 1271(a)(1)). Consequently, it would appear that amounts received in retirement of a debt instrument that are in excess of the holder’s basis in the loan would be treated as a capital gain. However, the market discount bond rules supersede this general principle.
Market discount is the excess, if any, of the stated redemption price at maturity of the bond over the buyer’s tax basis at the time of the purchase (Sec. 1278(a)(2)). The term “bond” means “any bond, debenture, note, certificate, or other evidence of indebtedness” (Sec. 1278(a)(3)). Market discount accrues using a straight-line method, unless the taxpayer elects to use a yield-to-maturity method (Sec. 1276(b)). Gain on the disposition of any market discount bond is treated as ordinary income to the extent it does not exceed the accrued market discount on the bond (Sec. 1276(a)(1)). This means that any gain on the sale of a market discount bond is treated as ordinary income until the accrued market discount has been recognized. Assuming the market discount bond is a capital asset, any gain over and above the accrued market discount is capital.
Example 1: A debt instrument is originally issued at $100,000 with a 6% coupon rate. The debt instrument is interest only, due and payable in 10 years. At the end of year 6, the debt instrument is sold for $60,000. Buyer Q has a tax basis in the debt instrument of $60,000 and a market discount of $40,000. Q does not elect to use the yield-to-maturity method. The interest-only payments are made annually. At the end of each year, Q receives $6,000 and treats it as interest income.
The recognition of this coupon interest is unaffected by the market discount. If at the end of year 8 the debt instrument is sold for $90,000, Q will recognize $20,000 of ordinary income/interest ($40,000 market discount with four years to maturity will accrue at $10,000 per year) and $10,000 of capital gain (assuming the debt instrument is a capital asset). If at the end of year 8 the debt instrument is sold for $70,000, Q will recognize $10,000 of ordinary income/interest and no capital gain.
Any partial principal payment on a market discount bond will be included in gross income as ordinary income to the extent the payment does not exceed the accrued market discount on the bond (Sec. 1276(a)(3)(A)). This means any payments that the original debt instrument holder would have applied to principal are instead first applied to any accrued market discount. Payments over and above the accrued market discount are treated as a return of capital. Assuming the market discount bond is a capital asset, payments over and above the accrued market discount and the taxpayer’s basis in the debt instrument are treated as capital.
Example 2: A debt instrument is issued at $1 million with a 6% interest rate and is amortized over 10 years. At the end of year 6, approximately $480,000 of principal remains on the loan, which is sold for $240,000. Market discount will accrue at $60,000 per year over the remaining 4 years.
In year 7, the taxpayer will receive approximately $26,000 of interest and approximately $108,000 of what originally would have been applied to principal. However, since this is now subject to the market discount rules, the first $60,000 will be treated as ordinary income/interest. The remaining $48,000 is applied to principal. Consequently, at the end of year 7, the buyer’s basis in the debt instrument is $192,000. In year 8, the taxpayer will receive approximately $19,000 of interest and approximately $114,000 of what originally would have been applied to principal. The first $60,000 will be treated as ordinary income/interest, and the remaining $54,000 is applied to principal. At the end of year 8, the buyer’s basis in the debt instrument is $138,000.
If at the beginning of year 9 the borrower defaults on the loan, the buyer recognizes a capital loss of $138,000. Economically, the buyer had a cash outlay of $240,000 and received payments of $267,000. The overall return on the investment is $27,000. However, the buyer recognizes $165,000 of ordinary income/interest and a capital loss of $138,000, which is clearly a poor tax result. Assuming the buyer could not currently utilize the capital loss and there is a 40% tax rate on the recognition of the ordinary income/interest, the buyer would have a tax liability of approximately $66,000. This means the after-tax economics result in the buyer’s actually losing $39,000 on the investment before utilizing the capital loss.
The outcome would become even more distorted if the borrower were to default at the beginning of year 8. The buyer would have a cash outlay of $240,000 and receive payments of $134,000, resulting in an economic loss of $106,000. However, for tax purposes the buyer would recognize $86,000 of interest/ordinary income and a $192,000 capital loss. Assuming the buyer could not currently utilize the capital loss and there is a 40% tax rate on the recognition of the ordinary income/interest, the buyer would have a tax liability of approximately $34,000. This means the after-tax economics result in the buyer actually losing $140,000 on the investment before utilizing the capital loss.
A popular real estate strategy in the current economic environment is to “buy paper” with the hope of obtaining the property through the voluntary conveyance of the borrower in satisfaction of the debt or by foreclosure. Under either scenario, gain or loss is the difference between the basis for the debt and the fair market value of the property received (Bingham, 105 F.2d 971 (2d Cir. 1939); Spreckels, 120 F.2d 517 (9th Cir. 1941)). To the extent the excess represents discount, it is taxable as ordinary income (Robinson, Federal Income Taxation of Real Estate, ¶10.07 (WG&L 1998)). Consequently, potential investors need to be aware of the market discount rules when contemplating these transactions. Depending on the investment, the investor could recognize ordinary income/interest upon receipt of the property and potentially even ordinary income/interest along with a capital loss in a situation similar to the example above.
It is important to note that the term “market discount bond” does not include:
- Short-term obligations (any obligation with a fixed maturity date not exceeding one year from the date of issue);
- U.S. savings bonds;
- Installment obligations (any installment obligation to which Sec. 453B applies) (Sec. 1278(a)(1)(B)); or
- Tax-exempt obligations (Sec. 1278(a)(1)(C)).
In addition, the legislative history suggests that Treasury should exempt “an obligation that was demand debt when issued” because the computational mechanisms of the market discount rules would not work for such an instrument (Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84) at 95 (1984)). Consequently, a bond that becomes payable on demand upon the occurrence of a default is not subject to the market discount bond rules. However, the legislative history does not address bonds that become demand notes after they are issued. As a result, there is substantial uncertainty on the treatment of market discount bonds upon the occurrence of a default.
When taxpayers are contemplating buying paper, it is important to advise them of the potential impact of the market discount bond rules. If a taxpayer has an opportunity to purchase a debt instrument that is in default or has a fixed maturity date of less than a year, it may become a much more attractive investment because it is excluded from the market discount bond rules and the potential for recognizing ordinary income has been mitigated. If a taxpayer is considering purchasing a debt instrument that is subject to the market discount bond rules, the potential tax implications need to be included when considering the return on the investment.
EditorNotes
Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
