Borrowing and Lending

• Author: Deborah A. Geier
• Pages: 260-289

Chapter 9: Borrowing and Lending

This chapter addresses the income tax treatment of the borrowing, lending, and repayment of

principal, as well as the payment and receipt of interest, which compensates the lender for the time

value of money. (You can think of interest as “rent” paid to use someone else’s cash, just as “rent”

can be paid to use someone else’s real estate.) At least, this chapter describes those tax

consequences when everything goes according to plan and all payments are made as expected.

A. The basic rules of the road

Assume that Betty Borrower borrows $100,000 from Larry Lender on January 1 of Year 1 under

a loan agreement that req uires Betty to repay the $100,000 after 10 years (on December 31 of Year

10) and also requires that she pay 4% interest, compounded annually, on December 31 of Year 10

when she repays the original principal. In Year 10, she would have to pay to Larry $148,024.43.1

What is the income tax treatment of these payments and receipts for each party?

Let’s start with Larry Lender. Does Larry’s transfer of $100,000 to Betty constitute a current

wealth decrease—an “expense”? If it is an expense, it would be deductible because Larry is

pursuing an investment return in the form of interest. Or has Larry merely changed the form in

which he is holding his wealth—a nondeductible “capital expenditure”—because Larry has

replaced his cash with a claim against Betty? In Chapter 4, you learned that Treas. Reg. §§

1.263(a)-4(d)(2)(i)(B) and (d)(2)(vi), Ex. (1), confirm the latter characterization. Thus, Larry

cannot deduct the $100,000 transferred to Betty in Year 1, but that nondeduction immediately

creates a $100,000 basis in the loan. Of the aggregate $148,024.43 that Larry will receive in Year

10, $100,000 is tax-free basis recovery, but the remaining $48,024.43 is new wealth to Larry in

the form of interest, includable in his Gross Income under § 61(a)(4). For now, we shall gloss over

the timing of Larry’s interest inclusions, discussed in Part C., infra.

Is Betty’s Year-1 receipt of $100,000 in cash includable in her Gross Income? The usual

response is that the receipt is not a wealth accession because of the offsetting obligation to repay

the $100,000 in Year 10. For example, if we created a balance sheet for Betty, with assets listed

on the left and liabilities listed on the right, we would add $100,000 to both sides, so her “net

worth” (assets less liabilities) would remain unchanged.

Assets Liabilities (face amount of principal repayment obligation)

$100,000 $100,000

No increase in her net worth (assets less liabilities)

Betty’s ability to exclude borrowed loan principal is often referred to as the “borrowing

exclusion,” but it is important to appreciate that no statutory “exclusion” provision exists to prevent

inclusion of her receipt. Rather, the receipt is not considered to rise to the level of Gross Income

within the meaning of § 61’s residual clause in the first place—solely because of the offsetting

1 If you would like to find such figures yourself, the amount can be found usin g an online compound interest calculato r,

of which there are many, by filling in the appropriate slots with the necessary information, such as the interest rate,

the number of times compounded, and the borrowed amount.

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obligation to repay. Were it not for Betty’s promise to repay in Year 10 the $100,000 cash received

in Year 1, the receipt would clearly constitute an immediate wealth accession under Glenshaw

Glass’s interpretation of the § 61 residual clause.

Does Betty’s repayment of the $100,000 principal amount in Year 10 constitute a wealth

reduction that might generate a deduction for her? If we stick with this “balance sheet” approach,

the answer is “no.” While we remove $100,000 in assets from the left side of her balance sheet—

which might superficially look like a wealth reduction—we simultaneously remove the $100,000

liability from the right side of her balance sheet, which means that Betty’s net worth (assets less

liabilities) is not reduced.

Notice that Betty is effectively taxed on the loan proceeds, though not in the year of receipt but

rather in the year of repayment (through deduction denial). In other words, borrowed principal is

not intended to be permanently tax-free for Betty. As a sneak preview of what is coming in the

next chapter, what would happen if the borrower never repays? The exclusion of the cash receipt

in Year 1 was acceptable solely because she promised to repay it with after-tax (i.e., undeducted)

dollars. Thus, § 61(a)(12) will generally generate Gross Income if her obligation to repay

disappears, or else Betty will have received permanently tax-free cash back in Year 1. But we are

getting ahead of ourselves!

Betty’s interest payment, on the other hand, is another matter, as it does constitute a current

wealth decrease, i.e., an “expense.” Section 163 provides the detailed rules under which interest

expense is, or is not, deductible. If she spends the loan principal in her business, the interest would

be deductible under § 163(a). If she uses the loan principal to, say, buy a personal-use boat, the

interest would not be deductible. See § 163(h)(1). Deductible “qualified residence interest”

(including a loan used to acquire a personal residence) is a tax expenditure that is carved out of

otherwise nondeductible “personal” interest, which we shall explore in Chapter 17. We shall also

examine the deductibility of “investment interest” under § 163(d) in Chapter 15.

As with the timing of Larry’s interest inclusion, let’s gloss over (for now) the timing of Betty’s

interest deduction, assuming that the interest is, in fact, deductible under § 163.

Notice that Larry’s tax analysis was grounded in routine SHS analysis that you learned in

Chapter 1. In contrast, the analysis described above for Betty—which looked to her balance sheet

and permitted evaluating whether a cash receipt in Year 1 is a wealth accession by looking to what

we expect to happen in a future year—is new and different. Other than § 83 (studied in Chapter 5,

pertaining to the receipt of property as compensation for services rendered if that property is

subject to a substantial risk of forfeiture), the annual accounting principle prevents the

expectation of a future repayment to negate what would otherwise be a current accession to wealth

(in the absence of considering that future repayment obligation). Rather, under the annual

accounting principle introduced in Chapter 1, you learned that we usually analyze each year in

isolation. Such an approach would require the inclusion of borrowed money in Gross Income when

received and the deduction of principal repayments when made (similar to the approach under a

cash-flow consumption tax). The ability of taxpayers to invest with pre-tax dollars under the

borrowing exclusion has led to all sorts of distortions and tax shelter problems inconsistent with

income tax principles, leading to the enactment of provisions like § 7872 (described below in Part

B.) and those discussed in Chapter 15 (Tax Shelters).

So where does the borrowing exclusion come from? As recounted in earlier chapters,

interpreters of the early income tax tended to borrow from other disciplines (such as trust and