Is there a tax deduction for loan default interest not-paid?

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Is there a tax deduction for loan default interest not-paid?

Paresh Patel
Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes

Hello.  I would like to pose a question relating to the tax treatment of Loans made though any of the leading Real Estate Crowdfunding Portals that go into Default.

Many of the CF sites may reasonably be expected to eventually experience defaults from their borrowers.

Therefore, consider a scenario such as this on any of the real-estate debt crowdfunding sites:

  • - The borrower pays regularly for 9 months, but then defaults.
  • - Default interest rate of, say, 20% kicks in thereafter
  • - Loan remains unpaid for the following, say, 18 months before the crowdfunding site is finally is able to foreclose and sell the property but the Property can only be sold with enough cushion to repay investors' principal and only a little extra interest, but not all. (and certainly not all the extra interest that accrued at the higher default interest rate. )

Question : Do we, as investors, then get to claim a tax deduction or write-off for all the interest - including the default interest - that was not paid? (Is there a tax form issued for such?)

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Dan Rudolph
Investor · Corvallis, OR · Member since 2015 · 92 posts · 57 votes
9y

But wait, when my stock broker says that TESLA is going to double in 6 months, and it doesn't, I can write that off, right? ;-)

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  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    9y

    Paresh, you are thinking creatively. I am not a tax expert but I don't see how you possibly can deduct it.

    0Reply
  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    Someone here on BP had mentioned something that seemed quite reasonable: Creditors can issue a 1099-c to the borrower for forgiveness of debt, which apparently is considered income by the IRS:

    https://www.irs.gov/taxtopics/tc431.html

    Anyone with detailed tax or accounting knowledge care to weigh in?

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  • Christopher Smith
    Investor · brentwood, CA · Member since 2016 · 1k+ posts · 730 votes
    9y

    For the interest never paid, If you are a cash basis taxpayer (which I will assume that you are as an individual), how could you take a deduction for something you never previously brought into taxable income. Its like trying to take a bad debt deduction for rental payments not received from a tenant, but that were never recorded as taxable income to you in the first place since you were on the cash basis of tax accounting. 

    For tax purposes you have sustained no loss.

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    I think I see what you are saying....  This too sounds reasonable.

    But consider the case of  a "normal" 1099-Misc issued by a company or person to, say, an outside contractor or vendor.  This is income to the contactor, and expense to the issuer of the 1099.

    How is this different?

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    9y

    Paresh: 

    Question : Do we, as investors, then get to claim a tax deduction or write-off for all the interest - including the default interest - that was not paid?

    No, you cant claim tax deduction for this.  1099c is relevant to someone on the other side of the situation you mentioned. If some defaults on the your loan and loan gets forgiven,  than that's the income for the borrower because lender can write it off on their books. 

    For interest:  

    Think about this. After the foreclosure, you already got the principle back. Now you have  not invested it, but would you pay a tax on the interest that you would have earned if you had re-invested it? You would not. Same way, you cant take take deduction for the interest that you were going to get paid but did not. Its like" Oh, I need to go into this new business, but I think I lose a money, so let me take deduction for that loss".  

    Borrower will never report the interest that was supposed to be paid as deduction on the their tax return, the same way you will not include the interest you were supposed to be paid as income. The transaction did not happened. 

    If you were accrual based and had booked interest receivable in the books, than you could write it off because it was already booked as income on your books. 

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  • John Thedford
    Real Estate Broker · Naples, FL · Member since 2013 · 9k+ posts · 6k+ votes
    9y

    You do NOT get a write-off for money not received. You can 1099 the borrower in default for the loan balance.

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  • Dan Rudolph
    Investor · Corvallis, OR · Member since 2015 · 92 posts · 57 votes
    9y

    But wait, when my stock broker says that TESLA is going to double in 6 months, and it doesn't, I can write that off, right? ;-)

    1Reply
  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    @Ashish Acharya  Thank you so much for your extremely valuable input. It is greatly appreciated.

    My theory was not that the borrower would take a deduction for the interest he was supposed to pay, but didn't. On the contrary.  That any interest that a borrower is contractually obligated to pay but doesn't, can then legally be booked against him as valid taxable Income, per the IRS. 

    Thoughts?

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    Here is an interesting citation i found. I concede that its reliability is highly questionable since I found it randomly on the internet, but here it is.  In particular, please look at point # 10.

    http://blog.credit.com/2013/01/what-is-a-1099-c-yo...

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    9y

    Paresh,

    My theory was not that the borrower would take a deduction for the interest he was supposed to pay, but didn't. 

    Borrower is never going to take the deduction for the interest that he was going to pay.  Even if he was allowed to deducted that (He is not allowed to do this, but just to make a point), the interest would you income on your books, not another deduction. That is two deductions on two different books. One has to be income right. 

    On the contrary. That any interest that a borrower is contractually obligated to pay but doesn't, can then legally be booked against him as valid taxable Income, per the IRS.

    No- the interest is not income to borrower even if he defaults. If the loan gets forgiven, the principle is income, not the interest that he would pay over the time.  So, it the interest  is not income to him and not reported, it is  not an deduction for you. 

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    Ashish: Thank you once again.  

    Are you 100% certain about this?  This seems to directly contradict what the IRS published.

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    Further IRS reading. Reliable Source.

    "Amount of canceled debt. The amount in box 2 of Form 1099-C may represent some or all of the debt that has been canceled or treated as canceled. The amount in box 2 will include principal and may include interest and other nonprincipal amounts (such as fees or penalties). Unless you meet one of the exceptions or exclusions discussed later, the amount of the debt that has been canceled is ordinary income and must be reported on the appropriate form as discussed earlier.

    Interest included in canceled debt. If any interest is included in the amount of canceled debt in box 2, it will be shown in box 3. Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it. See Deductible Debt under Exceptions, later."

    Here is the link:  https://www.irs.gov/publications/p4681/ch01.html (About 3/4 of the way down)

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    Following up on above: Since a professional real estate borrower can indeed deduct interest he does pay, according to the IRS, interest he is contractually obligated to pay but doesn't, can apparently be considered income against him, and thus expense to the lender

    @Dan Rudolph  - Your comment is well-taken (love Tesla :-)   but there is a key difference: Tesla is not contractually obligated to its stock traders to pay $X.    A borrower is. 

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  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    9y
    Originally posted by :

    Following up on above: Since a professional real estate borrower can indeed deduct interest he does pay, according to the IRS, interest he is contractually obligated to pay but doesn't, can apparently be considered income against him, and thus expense to the lender

    While the amount of the forgiven debt is ordinary income to the borrower, the borrower is just forgiving a debt.  The lender may be able to take a bad debt expense for the  principal amount of the loan that was not received, though I seriously doubt the lender will be able to deduct the amount of interest income that was never received.  

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y
    Originally posted by @Dave Toelkes:

    While the amount of the forgiven debt is ordinary income to the borrower, the borrower is just forgiving a debt.  

    The lender may be able to take a bad debt expense for the  principal amount of the loan that was not received, though I seriously doubt the lender will be able to deduct the amount of interest income that was never received.  

    Thanks Dave. Did you mean the "Lender" is the one forgiving a debt?

    Apparently, "Forgiven debt" can include either Principal, or Interest, or Fees, or all of the above, or only some of the above.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    9y
    The answer to your original question is No. None of this other crap you are trying to bring into the conversation applies.
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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    9y
    Originally posted by @Paresh Patel:

    Further IRS reading. Reliable Source.

    "Amount of canceled debt. The amount in box 2 of Form 1099-C may represent some or all of the debt that has been canceled or treated as canceled. The amount in box 2 will include principal and may include interest and other nonprincipal amounts (such as fees or penalties). Unless you meet one of the exceptions or exclusions discussed later, the amount of the debt that has been canceled is ordinary income and must be reported on the appropriate form as discussed earlier.

    Interest included in canceled debt. If any interest is included in the amount of canceled debt in box 2, it will be shown in box 3. Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it. See Deductible Debt under Exceptions, later."

    Here is the link:  https://www.irs.gov/publications/p4681/ch01.html (About 3/4 of the way down)

    hey, if the backed interest gets canceled, than yes it can be income for borrower, but not the interest that he was going to pay if he hadn't defaulted.  

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    @Wayne Brooks  

    I have info direct from a CPA that indicates (preliminarily at least) that this is defensible tax treatment. 

    Are you a CPA, accountant or tax attorney? 

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    9y

    @Ashish Acharya  Thanks for your input. As a CPA, it is highly valued.

    May I ask what you mean by "backed" interest?

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  • Andy J.
    Ashburn, VA · Member since 2016 · 7 posts · 2 votes
    8y

    @Paresh Patel - Thanks for taking the initiative & research on this tricky topic. Our tax system is complex and its helpful for us regular people to understand if such an avenue exists. A lot of the resources you've pulled together don't rule it out entirely. I'll discuss this with my tax advisor and see if he's got any perspective on this

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  • Paresh Patel
    OP
    Investor · Litchfield County, CT · Member since 2017 · 54 posts · 9 votes
    8y

    @Andy J.

    It's my pleasure. Thank you. 

    In my opinion, one of the advantages of the realm of real-estate crowdfunding is that even in a worst case scenario -  loss of due interest or even principal - at least we can get a 1099-C write-off for it.  

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