IRS reaffirms and clarifies its position on nonaccrual loan interest.

• Author: Sanders, Jennifer M.

For accrual-basis financial institutions, there has long been a debate on the taxability of interest for loans that are past due. This debate centers on the difference in treatment between federal banking and IRS rules. Bank regulatory guidance always requires that the interest on a loan that is more than 90 days past due may no longer be accrued into income, and the interest previously recognized into income must also be reversed. However, the IRS has long disagreed with this treatment and has required current recognition of income provided a reasonable expectation of payment exists. In May 2007, in an effort to both reaffirm and clarify its position on accrued but uncollected interest, the IRS issued Rev. Rul. 2007-32 and Rev. Proc. 2007-33.

Rev. Rul. 2007-32

Rev. Rul. 2007-32 provides guidance on a specific factual situation. The key issues addressed are: (1) the recognition of uncollected accrued interest, (2) the impact of the bad-debt conformity election on the recognition of uncollected interest, and (3) the treatment of any subsequent payments that the bank receives on the loan. In the ruling, X, a banking corporation, determines its taxable income using the accrual method of accounting and is a calendar-year taxpayer.

X is regulated by federal banking authorities and is required to comply with federal banking rules when preparing regulatory financial statements. Unless a loan is both well secured and in the process of collection, regulatory rules require that X suspend the recognition of uncollected accrued interest into income and reverse any previously recognized interest if certain factors are met. These factors include: (1) the loan is maintained on a cash basis because of deterioration in the borrower's financial condition; (2) payment in full of principal or interest is not expected; and (3) payment of principal or interest has been in default for a period of 90 days or more. A loan meeting these criteria is referred to as a "nonaccrual loan receivable" in the ruling.

Generally, federal banking rules also require X to apply any payment received on a nonaccrual loan receivable as a reduction to its recorded investment in the loan, to the extent necessary to eliminate the doubt of uncollectibility. Thus any payment received by X on a nonaccrual loan receivable is treated as a reduction in the loan balance until the loan balance is reduced to an amount deemed to be fully collectible. Any amounts received that exceed the loan balance would then be recorded as interest income.

In the ruling, X classifies Loan A as a nonaccrual loan receivable for regulatory financial statement purposes on January 16, 2007, because an amount of principal or interest on the loan has become more than 90 days past due. X reasonably expects the borrower of Loan A to continue making some but not all payments on the loan. The uncollected accrued interest on Loan A on January 16, 2007, is $9,000, of which $8,000 is attributable to 2006 and $1,000 is attributable to 2007. For regulatory financial statement purposes, X recognized the $9,000 as income prior to January 17, 2007. An additional $23,000 of accrued interest becomes due on Loan A during the period January 17-December 31, 2007.

Under federal banking rules, on January 16, 2007, X is required to reverse the $9,000 of uncollected accrued interest that had previously been recognized. The $23,000 of accrued interest attributable...