OID deferral opportunities.
Rev. Proc. 94-28
Rev. Proc. 94-28 provides procedures for taxpayers to change their method of accounting to comply with the final regulations relating to OID, and defines a "cut-off" date for the change. Taxpayers may elect the cut-off date as one of the following:
1. Dec. 22, 1992;
2. The first day of any tax year beginning after Dec. 22, 1992 and before Apr. 4, 1994; or
3. Apr. 4, 1994.
Since the accounting change is made on a cut-off basis, only those items arising on or after the beginning of the year of change are accounted for under the new method of accounting. Any items arising prior to that date to be accounted for under the former method. For example, if a calendar-year financial institution elects Dec. 22, 1992 as its cut-off date, only those loans originated or acquired between this date and Dec. 31, 1992 are eligible for the deferred treatment of loan fee income on the 1992 tax return. Loan fee income originated or acquired prior to the cut-off date must be recognized currently into taxable income, and no Sec. 481(a) adjustment is permitted or required.
Rev. Proc. 94-29
Rev. Proc. 94-29 outlines the method to be used in deferring loan fee income. This "principal-reduction" method applies only to loans that (1) are acquired by the taxpayer at origination; (2) do not have OID, or have de minimis OID; (3) are not issued at a premium; (4) are not subject to election under Regs. Sec. 1.1272-3 (election by a holder to treat all interest on a debt instrument as OID); and (5) produce ordinary gain or loss when sold or exchanged by the taxpayer. This procedure also identifies standard categories of loans, specifically:
* Category 1: Loans secured by one- to four-family residential real property that are not home equity lines of credit or construction loans.
* Category 2: Construction loans with original terms not greater than three years.
* Category 3: Loans secured by real property, not contained in category 1 or 2, and not home equity lines of credit.
* Category 4: Consumer loans with original terms not greater than seven years, not secured by real property and not revolving credit loans.
Note also that if any loans in one category of loans are accounted for under the principal-reduction method, this method must be used for the entire category. This requirement avoids the necessity of tracking de minimis OID on individual loans within each category.
Under the principal-reduction method of accounting, if a taxpayer holds a debt instrument with de minimis OID, the taxpayer must include that discount in income as stated principal payments are made.
Example: Company C properly adopts the method for all loans that it acquires that are included in category 1. In the first month of operations, C acquires at origination loans with an aggregate stated principal of $10,000,000 and an aggregate discount of $400,000. At the end of the month, the loans in this category had been paid down to $9,000,000. Thus, the discount to be included in taxable income for the first month would be $40,000 [$1,000,000 total repayment / $10,000,000 beginning stated principal current originations x $400,000 beginning discounts + current discounts). Note that for the first month of adoption, the beginning stated principal and the beginning discounts are both zero. This computation is required to be made on a monthly basis, so for C's second month of operations, assume $23,000,000 in new originations with $760,000 in new discounts. if $28,000,000 was the outstanding stated principal at the end of the second month, the income to be recognized would be $140,000 [($9,000,000 $23,000,000 - $28,000,000 total repayments) / $9,000,000 $23,000,000 beginning stated principal current originations) x ($360,000 / $760,000 beginning discounts current discounts)].
Rev. Proc. 94-30
Rev. Proc. 94-30 provides procedures for accounting method changes for loans acquired before the cut-off dates specified in Rev. Procs. 94-28 and 94-29. Under this ruling, a taxpayer can temporarily reverse out of taxable income a portion of the de minimis OID income that was recognized on loans originated prior to the cut-off date selected. Taxpayers that previously recorded points as taxable income in the year the points were treated as being paid have two options. First, the taxpayer may use a method by which the discount (including discount attributable to points) on each loan is accounted for as each loan's stated principal payments are made. Second, the revised loan liquidation method may be used. Under the revised loan liquidation method, the amount of discount income taken into account in any tax year is the remaining discount at the end of the preceding year multiplied by a fraction, the numerator of which is the excess of the outstanding principal at the end of the prior year over the outstanding principal at the end of the current year, and the denominator of which is the outstanding principal at the end of the prior year. Note that taxpayers previously using any deferred recognition method to account for points on some or all of their loans can only change to the revised loan liquidation method.
For taxpayers that previously accounted for points under the current inclusion method, a Sec. 481(a) adjustment is permitted, essentially calculated as the difference between the old methods used and the new methods adopted. Rev. Proc. 94-30 specifically states that the taxpayer is considered to be changing to a category B method, resulting in the Sec. 481(a) adjustment being taken into account ratably over a period not to exceed six tax years, beginning with the year of change. For those taxpayers previously accounting for points under a deferred recognition method, no Sec. 481(a) adjustment is necessary; the revised loan liquidation method would be applied only to the remaining balance of unrecognized discounts.
These new regulations will give certain taxpayers, such as financial institutions and other mortgage originators, the ability to defer the tax recognition of points, regardless of whether the points have been paid or financed by the borrower. In addition, some benefit may be obtained by electing to apply the new regulations to transactions that occurred prior to the selected cutoff date by temporarily reversing out of current income some of the previously recognized de minimis OID income, and amortizing this amount over a period of not more than six years. From a tax deferral perspective, the earliest available cut-off date should be elected; however, from an administrative standpoint, the new regulations may be more easily adopted as of the beginning of a tax year.
Depending on the selected cutoff date, amended returns may need to be prepared in order to apply the new provisions. The preparation and filing of election statements to adopt the new regulations must be completed no later than Dec. 31, 1994. However, taxpayers that elect to apply the new provisions to original returns filed on or after June 17, 1994 could be required to complete this process sooner.
From Jeffrey E. Alligood, Charlotte, N.C.
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|Title Annotation:||original issue discount|
|Author:||Alligood, Jeffrey E.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 1994|
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