Prop. Regs. create capital gains and losses for non-bank lenders.

• Author: Thornton, David A.

On August 7, 2006, the IRS issued Prop. Regs. Sec. 1.1221-1(e), in an attempt to clarify the character of gains and losses resulting from sales of loans and notes receivable acquired through purchase or loan origination; see REG-109367-06. While the character of such gains and losses has never been entirely clear, previous IRS rulings and judicial precedent have generally found such receivables to fall within the scope of Sec. 1221(a)(4), thus providing ordinary gain or loss on their disposal. The proposed regulations would overturn this historical application by expressly providing that such assets fall outside the scope of Sec. 1221(a)(4). If ultimately adopted, they could result in capital loss limitations for some lenders who anticipate selling off devalued loan portfolios, but they could also result in capital gain treatment for those selling off appreciated loan portfolios.

Background

Sec. 1221 defines a capital asset as any property held by a taxpayer (whether or not connected with the taxpayer's trade or business) other than those types of property specifically enumerated in that section as falling outside the definition. For debt instruments, the only applicable exception listed is Sec. 1221(a)(4), which holds that accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or for the sale of inventories are specifically excepted from capital treatment.

The purpose of Sec. 1221(a)(4) is to prevent a potential character mismatch between the ordinary gain or loss resulting from the sale of inventory or provision of services by the taxpayer and the resulting gain or loss from the sale of the underlying account or note receivable received as consideration in the initial sale. If the gain or loss from the sale of the note receivable is capital, the entire income recognized on the overall transaction (initial sale plus the sale of the note receivable) has the potential to be treated as part ordinary and part capital gain. This could produce a seemingly unfair result to a taxpayer who sells inventory at an ordinary gain and later sells the resulting note receivable at a discount (a capital loss).

The application of the Sec. 1221 (a)(4) exception to capital-asset treatment in a lending scenario was first addressed in Burbank Liquidating Corp., 39 TC 999 (1963), which involved a scenario under which a savings and loan association originated mortgage loans and later sold those loans to a third...