When is loan interest considered income?

Question

I do private lending. I have a primary borrower. When a transaction closes, the principal and the interest are rolled to another loan. Thus, I never touch any of the money. Is that interest considered income for tax purposes when I haven't "touched" it?

Basit Siddiqi · Answer

@Paul WinkaThe IRS has a terminology of "constructive receipt".

If you have the control or means to collect the principal and interest upon the close of a transaction - then you should report the interest income.

If the terms of the loan is lending $100,000 at 10% with interest and principal to be paid in 1 year. If you say something to your borrower like "hey it looks like your doing good flipping homes; hold the $110,000 and buy another property. Then I would say this is constructive receipt and you should report it as income.

However, if the transaction is something more negative and the borrower is not doing good and doesn't have the $110,000 to pay you and you are extending him additional time/credit in hopes of him turning things around - then yes I would argue that you wouldn't report income in this case.

Paul Winka · Answer

Account Closed

You're absolutely right, there is more than one way to do it as your Money Magazine example indicates. When learning accounting in an academic setting years ago, I remember the term GAAP. If you know that term, you'll know that this accounting stuff is subject to interpretation and there is more than one way to analyze a tax situation. Being consistent with you apply your own methodology in filing your taxes probably needs to stay constant though. Overall, it seems to be a good thing.

Paul Winka · Answer

Account Closed Yes, you situation is similar. Do you think your borrower was acting in bad faith with never intending to pay you back, but reporting interest paid on a 1099-INT?

Hmmm, I supposed you would pay on that interest since it is reported for that year, then if you never get your principal back you would reverse that in the following tax years as a loss. In the end, it would "zero" out, because they way I see it, if you don't get your principal back, then you never received interest in the first place.

Account Closed · Answer

@Paul Winka

No bad faith.  It's a loan servicer sending the 1099, that's what they do.  It's a pool of 2nds, don't know if I will get principal back in the end or not.  If there's a profit in the end my taxable income will be reduced thus offsetting the tax I paid in earlier years, so, I think it does 'zero' out.

I don't think anybody truly understands how this all should be done, probably not even the IRS.  I take a math perspective, no matter how you slice it, if I make money I pay taxes, if I lose money I get to reduce my taxable income.  Whether it's done this tax year or in future tax years, doesn't matter to me.

I remember years ago Money Magazine would do a yearly tax preparer comparison.  They would give a somewhat complex fake tax scenario to a number of different tax preparers... tax preparers, EA's, CPA's, tax attorneys.  They would all come up with a different tax and they were all different than what the IRS came up with.  I figure I can do just as good (bad) as the best of them:)

Account Closed · Answer

@Paul Winka

I have a similar situation, only the "interest" I got was reported on a 1099-Int, even though I haven't gotten all my principal back, and may never get it back, we'll see.  I'm paying tax on the interest because what else can I do since it's reported, if I don't eventually get my principal back it will be a loss I can either write off or carry forward.  I do my own taxes so am guessing at all this.

Paul Winka · Answer

@Basit Siddiqi Bravo for that answer. I like the way you explained it.

You mentioned if borrower isn't doing so good. Well, I did have one borrower that I foreclosed on. He made some payments of course, strung me along for a while. Finally I foreclosed. In this case here, I did not consider my interest payments as interest, but rather as return of principal. Seems reasonable.  Now I am keeping the house as a rental, and offset his "interest payments" as return of principal and reducing my basis for the house. For example, he borrowed $25K, paid me $3K in "interest", now I foreclose, have my purchase basis as $22K now, and am adding the costs of rehab and the foreclosure itself as part of the depreciable basis on top of that $22K, then will have my total basis here soon right before I put the house in service. Just curious if you had any comments on how I did this. My CPA will weigh in too in a couple weeks. :)

When is loan interest considered income?

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