USA Nonbusiness Bad Debt Basis: Principal or Creditor Amount?

[G.Jefferson]

Third-party borrower stops paying on a real estate note for five years and files for bankruptcy after a demand for payment in full. The amount stated as owing to the creditor in the bankruptcy petition was the principal amount plus all accumulated interest and other misc fees (that was close to the total amount listed on the demand for payment in full). My question is what is the appropriate basis to write off as a loss on Schedule D? Only the principal still owing as of the demand for payment in full, or the total amount that was discharged during the bankruptcy?

 

[Bored Accountant]

Third-party borrower stops paying on a real estate note for five years and files for bankruptcy after a demand for payment in full. The amount stated as owing to the creditor in the bankruptcy petition was the principal amount plus all accumulated interest and other misc fees (that was close to the total amount listed on the demand for payment in full). My question is what is the appropriate basis to write off as a loss on Schedule D? Only the principal still owing as of the demand for payment in full, or the total amount that was discharged during the bankruptcy?

Full disclosure: I'm just a college student majoring in Accounting, so I'm not a tax expert; but I'll do my best to answer the question with the knowledge I have.

First of all, a loss is exactly that. It's the amount that you lost. So if the principle amount was $10,000, but you had already been paid $6,000, then the loss would be an obvious $4,000. You wouldn't be able to write off the full $10,000 because you have been paid $6,000 of that amount. That $6,000 can't be considered a loss because you have it in your possession.

Second of all, are you sure your note loss goes on a Schedule D? I thought only Capital Gains and Losses go on a Schedule D. Quoting my textbook "Fundamentals of Taxation" in chapter 7, page 5, paragraph 4, 3rd line:

The collection of an account or note receivable is ordinary income to a cash basis taxpayer when the cash is collected. Neither selling inventory nor collecting accounts or notes receivable requires reporting on Form 4797 or Schedule D.

I think your note would be treated as an ordinary loss, and not a capital loss. Schedule Ds are usually for §1221 - Capital Assets and §1231 - Trade or Business Assets. While the real estate property itself would be classified as a Capital Asset, the actual note receivable on the real estate property would not be classified as a Capital Asset.

Hope this helps.

 

[G.Jefferson]

Thanks. So essentially the accumulated interest that was due cannot be written off because there was no basis in that? There's no benefit at all for the seven years or so that it took to get to the discharge and make the debt worthless?

Here's another question: does the interest due and late fees, etc. that were successfully collected (before the non-payment to discharge period) reduce the initial basis or only the principal repayments do? This was an amortized loan.

Yes, this goes on Schedule D as a short-term loss subject to the $3K limitation (from Form 8949).

 

[Bored Accountant]

Thanks. So essentially the accumulated interest that was due cannot be written off because there was no basis in that? There's no benefit at all for the seven years or so that it took to get to the discharge and make the debt worthless?

Here's another question: does the interest due and late fees, etc. that were successfully collected (before the non-payment to discharge period) reduce the initial basis or only the principal repayments do? This was an amortized loan.

Yes, this goes on Schedule D as a short-term loss subject to the $3K limitation (from Form 8949).

Oh sorry, I failed to comprehend that this was a nonbusiness bad debt even though that fact is clearly stated in the title. Like my instructor has said, attention to detail is the most important thing in Accounting.

Anyways, unfortunately, yes the accumulated interest that was due cannot be written off because there was no basis in that. And, after maneuvering the clunky IRS website, I've even found the proof! You can read it right here:

https://www.irs.gov/publications/p550/ch04.html#en_US_2016_publink100010565

The part that you will want to read is the "Basis in Bad Debt Requirement" section, and I quote:

If you are a cash method taxpayer (most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.

So in other words, those fees and interest accumulations that you were talking about can't be included in the loss amount. If it were specifically, a business loan, then of course all those things can be deducted. But unfortunately, nonbusiness loans don't get that benefit.

As far as your second question goes, that's a tough one. In my accounting textbook, three main areas are covered as far as dealing with notes goes: giving out and collecting notes as part of normal operations, extending the credit period, and writing off bad debts using both the "Direct Write Off" method and the "Allowance" method. There isn't any specific information on how to handle a situation where a borrower accumulates a ton of interest, then finally makes a payment.

The book describes note payments and payments of interest as two separate things. For example, a $500 note with 12% interest for 60 days is paid in the amount of $510 where $500 is for the principle and $10 is for the interest. In fact, this is even accounted for separately being labeled as "Note Payable" to cover the principle and "Interest Expense" to cover the interest. That was in the chapter 11 "Current Liabilities". The only type of note payable listed in the chapter 14 "Long-Term Liabilities" are installment notes. Installment notes use perfectly equal payments over a period of time. At the beginning of the payback period, much of the installment payment is actually interest. As the note gets paid off, the amount of the payment that is actually interest decreases. This is known as "Decreasing Accrued Interest". For example, a 6 year installment note that required equal payments went down as follows:

Info: $60,000 at 8% for six years (equal payments of $12,979)

Year 1: 60,000 (principle) | [4800 (interest) + 8179 (principle payment = 12979-4800)] = 12979
Year 2: 51,821 (principle) | [4146 (interest) + 8833 (principle payment)] = 12979
Year 3: 42988 | [3439 + 9540] = 12979
Year 4: 33448 | [2676 + 10303] = 12979
Year 5: 23145 | [1852 + 11127] = 12979
Year 6: 12018 | [961 + 12018] = 12979

Notice how interest makes up a large chunk of the payment at the beginning of the installment payback period and decreases until interest barely makes up any part of the payment at all. The problem is that your note doesn't seem like it was an installment note, correct? Or was your note an installment note? Then maybe I answered your question? One other hint that I got from the Long-Term Liabilities section is in the case of a bond. The only thing that is actually paid is the interest until the bond matures. Only after the bond matures then is the principle paid. So again, it seems like interest is given preferential treatment in regards to being paid first. So with that being said, my educated guess (key word being "guess") is that any payments that you were able to collect reduces the interest first, then whatever is left over reduces the actual principle.

Finally, as I mentioned in my first paragraph, I realize now that your bad debt does indeed go on a schedule D.

Anyways, sorry that I couldn't be of more help to you in answering your second paragraph question. Unfortunately, book learning just can't cover everything that actual life experiences can.

 

[G.Jefferson]

Yes, this was an installment loan as I understand it. The borrower's payments were all equal except for the late fees when they occured. Part of the confusion here is my fault as the figure listed on the demand for payment in full was labeled as "principal balance due" which is definitely NOT referring to just the principal portion of the note balance still owing along with a separate line for the amount of the accumulated interest balance still owing -- or is it? Either way, this "principal balance due" amount definitely appears to be the paid-down, remaining amortized balance of the note as of the first due date when the borrower finally stopped paying. So this "principal amount due" is what will be written-off as that is the remaining basis after the initial amount lent. As you showed, interest and fees cannot be included and indeed on the bankruptcy petition, the creditor amount listed is virtually identical to the sum of the "principal amount due" plus the accumulated interest due and doesn't include any of the fees. (I don't know why there is a discrepancy.)

Now, technically, couldn't the sporadic fees received when payments were being made reduce the basis even more? I don't think there's enough records to reconstruct that with any certainty.

 

[Bored Accountant]

Yes, this was an installment loan as I understand it. The borrower's payments were all equal except for the late fees when they occured. Part of the confusion here is my fault as the figure listed on the demand for payment in full was labeled as "principal balance due" which is definitely NOT referring to just the principal portion of the note balance still owing along with a separate line for the amount of the accumulated interest balance still owing -- or is it? Either way, this "principal balance due" amount definitely appears to be the paid-down, remaining amortized balance of the note as of the first due date when the borrower finally stopped paying. So this "principal amount due" is what will be written-off as that is the remaining basis after the initial amount lent. As you showed, interest and fees cannot be included and indeed on the bankruptcy petition, the creditor amount listed is virtually identical to the sum of the "principal amount due" plus the accumulated interest due and doesn't include any of the fees. (I don't know why there is a discrepancy.)

Now, technically, couldn't the sporadic fees received when payments were being made reduce the basis even more? I don't think there's enough records to reconstruct that with any certainty.

I actually talked this one over with my instructor. He's a CPA. Turns out, my "educated guess" was right on the money (pun intended). When payments are being made, interest and late fees are paid off first. If there is any money left over from paying down the interest and fees, then only that left over money pays down the principle. This is especially true if there's a substantial amount of accumulated interest.

For example, let's say that $600 worth of interest has accumulated due to delayed payments. The borrower finally makes a payment of $500. You reduce the amount of accumulated interest by $500 leaving $100 worth of accumulated interest left. Notice that you don't even touch the principle, and it continues to earn interest.

And yes, the "principle balance due" is simply the amount of the original loan still due. The interest would, and should, be on a separate line. That part is correct. As far as if the sporadic payments received when payments were still being made reducing the basis even more, that would depend entirely on how much accumulated interest and late fees had built up between payments. But, like you said, you probably don't even have enough records to reconstruct the situation with any certainty. With that being said, I'd just leave that sleeping dog lie.