When lenders may deduct loan expenses.

IRS regulations issued in 2004 generally require lenders to capitalize loan expenses paid to third parties.

However, lenders may still deduct various loan expenses (such as employee compensation, overhead, and de minimis costs not exceeding $5,000 per transaction) for income tax purposes, even if lenders capitalize such expenses for accounting purposes. {1}

A lender making, purchasing, renewing or renegotiating a loan, may incur a variety of expenses to third parties in connection with such loan, such as broker commissions, appraisals, and environmental and engineering reports. The IRS has asserted that these expenses, to the extent incurred by a lender, must generally be amortized over the life of the loan rather than deducted in the year the loan is made.{2}

However, no capitalization is required for the costs of the lender's loan origination and acquisition department (such as compensation paid to employees, including bonuses and commissions, and overhead), {3} and de minimis costs (generally not exceeding $5,000 per loan), which are treated as deductible amounts. {4} Commissions paid to third parties are not employee compensation and are not included in the term de minimis costs, {5} and therefore generally must be capitalized.

Generally, the "de minimis" exception is $5,000 per loan. If the lender's costs exceed $5,000, then no portion of the costs qualifies for this exception. {6}

If a lender is acquiring a portfolio of loans, then the $5,000 amount applies to the entire portfolio. {7}

Since the expenses of the typical secondary market purchaser are far in excess of this amount, therefore generally such purchasers will be unable to rely on the de minimis exception.

Some courts have rejected the IRS requirement for capitalization of loan origination expenses and have allowed current deduction of such expenses. {8}

However, until the U.S. Supreme Court rules, it is not clear what the result will be in all jurisdictions.

Therefore, lenders should try to avoid incurring loan expenses directly, to the extent paid to third parties.

Instead, their borrowers should ideally pay all of these loan expenses.

Even if a lender has the right to deduct various loan expenses for tax purposes, it may still elect to capitalize them. Such election may be made separately for each transaction, or for any of the following categories of costs in such transaction: employee compensation, overhead, or de minimis costs.{9}

The 2004 IRS regulations requiring the capitalization of a lender's loan expenses are generally effective for expenses incurred on or after December 31, 2003, although expenses which have been previously incurred may also be affected by the new regulations.

{1} Accounting for Nonrefundable Fees and Costs Associated With Originating or Acquiring Loans and Indirect Direct Costs of Leases, Statement of Financial Accounting Standards No. 91 (Fin. Accounting Standards Bd. 1986).

{2} Treas. Reg. [subsections] 1.263(a)-4(b)(l)(v), 1.263(a)-4(e)(l)(i).

{3} Treas. Reg. [section] 1.263(a)-4(e)(5), Example 8.

{4} Treas. Reg. [section] 1.263(a)-4(e)(4)(iii).

{5} Treas. Reg. [section] 1.263(a)4(e)(4)(iii)(B).

{6} Treas. Reg. [section] 1.263(a)4(e)(4)(iii)(A).

{7} Treas. Reg. [section] 1.263(a)-4(e)(5), Example 7.

{8} PNC Bancorp. Inc. v. Comm'r, 212 F.3d 822 (3d Cir. 2000).

{9} Treas. Reg. [section] 1.263(a)-4(e)(4)(iv).

{10} T.D. 9107 (Jan. 5, 2004), 68 Fed. Reg. 436-01.

Brook Boyd has been a practicing attorney since 1978 and has represented JP Morgan Chase Bank, Citibank, N.A., Wachovia Corporation, Finnair Oy, IBM, Barney Skanska Construction, Thyssen AG, and a wide variety of other companies, investors, builders and owners. He is the author of Real Estate Financing (Law Journal Press 2004).