Buying paper: tax implications for purchasing loans at a discount.

• Author: Dodge, Justin

The current economic environment gives taxpayers a significant opportunity to purchase loans at a discount (often referred to as "buying paper"). Amounts received by the holder on retirement of any debt instrument are considered amounts received in exchange for the debt instrument (Sec. 1271(a)(1)). Consequently, it would appear that amounts received in retirement of a debt instrument that are in excess of the holder's basis in the loan would be treated as a capital gain. However, the market discount bond rules supersede this general principle.

Market discount is the excess, if any, of the stated redemption price at maturity of the bond over the buyer's tax basis at the time of the purchase (Sec. 1278(a)(2)). The term "bond" means "any bond, debenture, note, certificate, or other evidence of indebtedness" (Sec. 1278(a)(3)). Market discount accrues using a straight-line method, unless the taxpayer elects to use a yield-to-maturity method (Sec. 1276(b)). Gain on the disposition of any market discount bond is treated as ordinary income to the extent it does not exceed the accrued market discount on the bond (Sec. 1276(a) (1)). This means that any gain on the sale of a market discount bond is treated as ordinary income until the accrued market discount has been recognized. Assuming the market discount bond is a capital asset, any gain over and above the accrued market discount is capital.

Example 1: A debt instrument is originally issued at $100,000 with a 6% coupon rate. The debt instrument is interest only, due and payable in 10 years. At the end of year 6, the debt instrument is sold for $60,000. Buyer Q has a tax basis in the debt instrument of $60,000 and a market discount of $40,000. Q does not elect to use the yield-to-maturity method. The interest-only payments are made annually. At the end of each year, Q receives $6,000 and treats it as interest income.

The recognition of this coupon interest is unaffected by the market discount. If at the end of year 8 the debt instrument is sold for $90,000, Q will recognize $20,000 of ordinary income/interest ($40,000 market discount with four years to maturity will accrue at $10,000 per year) and $10,000 of capital gain (assuming the debt instrument is a capital asset). If at the end of year 8 the debt instrument is sold for $70,000, Q will recognize $10,000 of ordinary income/interest and no capital gain.

Any partial principal payment on a market discount bond will be included in gross income as...