Private money loan balloon payment

Technical topics regarding tax preparation.
#1
LDCPA  
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Taxpayer lent $600k to a real estate development project for a $1 million note secured by the property.
The note is 2% interest only during construction and $1 million balloon payment due on on the close of escrow when the property is sold. The project will take about 18 months to complete.
Will $400k profit he'll make be all interest income recognized in the year received or is there a capital gain component? ($1 million balloon payment minus $600k original loan = $400k profit)
 

#2
Nilodop  
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There's no capital gain component. Even if the lender is not in the lending business.

It's all ordinary income; interest or some other fancy term that equates to interest.

And it will get recognized during the time it's unpaid, whether 18 months or not.

And it's treated as contingent because the term is unknown.

And it doesn't matter what the lender's accounting method is.

And it would be nice to know what the entities of the lender "taxpayer" and the borrower "real estate development project" are. But it probably does not matter.

Amd if the lender is also the seller of the property, which you would have told us, right, the answer needs to be different.

If not already done, you may want to read sections 1272 through 1275 nad some regs.
 

#3
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Thanks Nilodop, that's what thought.
Taxpayer is an individual, he's not in the business of lending money, but I know it doesn't matter. I think there might be SE tax issue if he was. He's not the seller of the property.
The borrower is an LLC and I don't know what they are for tax.

"And it will get recognized during the time it's unpaid, whether 18 months or not."
We are reporting 2% interest income per the note during construction. Is this what you meant?
Assuming both lender and borrow are on cash basis and calendar year, the $400k income from the balloon payment will be recognized in the year it's received, correct?
 

#4
Nilodop  
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No, not what I meant and not correct.

Why would the way you report the income have anything to do with its being in construction?

The balloon payment will be recognized when it's earned over the term of the loan, not when it's received.

Please read the sections mentioned.

Ot at least an article or two on original issue discount and applicable federal rate. Here's an outline that's OK for a start but I wouldn't stop there.
 

#5
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I didn't even think about OID. Thanks for pointing this out!
Never came across a transaction structured like this.
The note was originated early in 2022 when AFR was below 2%.
Looks like for this transaction an election can be made under IRC 1274A by lender and borrow to elect out of the OID rules and take the interest under the cash method.
 

#6
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I am wondering if this is a usurious loan.
Steve
 

#7
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Looks like for this transaction an election can be made under IRC 1274A by lender and borrow to elect out of the OID rules and take the interest under the cash method.. You pretty sure of that?

I am wondering if this is a usurious loan.. No idea. Would that make a tax difference?
 

#8
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If usurious, I presume the interest would not be owed and thus not have to be reported as OID.

LDCPA is in CA. I took a quick look at the CA usury law. It's complex, so I'm not sure I'm correct, but it looks like a usurious loan to me.

My experience is that usury can usually be avoided via planning. For example, it may be that making it a $600k loan with a $400k contingent kicker would work.
Steve
 

#9
Nilodop  
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If usurious, I presume the interest would not be owed and thus not have to be reported as OID.
While your presumption and related conclusion might both be correct, my instincts on the matter are:

1 - I find it hard to believe the lender would do the deal w/o checking the legality/collectibility of the interest;

2 - If at some point the interest does in fact become uncollectible, for whatever reason, I'd guess the OID regs. tell us how to handle it from that time on;

3 - Therefore, I'd say the OID still has to be reported.

I hope OP comes back and clarifies why he says 1274A applies.
 

#10
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[quote="Nilodop"]Looks like for this transaction an election can be made under IRC 1274A by lender and borrow to elect out of the OID rules and take the interest under the cash method.. You pretty sure of that?

Not so sure now. I reread 1274A election requirements and one of them is "1274A(c)(2)(C) section 1274 would have applied to such instrument but for an election under this subsection" Sec 1274 is for debt instruments issued for property. In this case the note is secured by the property (borrower has the deed of trust), but it's not debt for sale/exchange of property.

Is there no way around recognizing OID in this situation?
 

#11
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Nilodop,
Usury law is tricky and often not understood by attorneys and other professionals. I've dealt with it many times. The usury issue in the instant fact pattern is more likely to be recognized before execution because it is in the form of a promissory note. If the same economics were structured via some other vehicle, such as an agreement, usury could still apply and be more likely to be missed by the professionals. Clients are usually surprised to see that it is an issue.
Steve
 

#12
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LDCPA, you got it. Sec 1274A(c)(1) says the election applies to a cash method debt instrument, which in (c)(2) requires that it start out as a qualified debt instrument which (b) defines as having been given in consideration for the sale or exchange of certain property. Those are not your facts.

I know of no other way around OID recognition in your facts but I'm all ears if there is one.
 

#13
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The usury issue in the instant fact pattern is more likely to be recognized before execution because it is in the form of a promissory note.
Well, OP's client did the deal so I guess he did not recognize it before execution.
 

#14
Nilodop  
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Back to OP wanting to avoid OID. If we saw the actual agreement, maybe there's language that in substance makes the lclient/lender a partner witha 2% guaranteed payment and a share of profits at closing, but limited to $400,000. I doubt it but stranger things have happened.
 

#15
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gatortaxguy wrote:If usurious, I presume the interest would not be owed and thus not have to be reported as OID.

LDCPA is in CA. I took a quick look at the CA usury law. It's complex, so I'm not sure I'm correct, but it looks like a usurious loan to me.

My experience is that usury can usually be avoided via planning. For example, it may be that making it a $600k loan with a $400k contingent kicker would work.


Interesting idea, but I doubt it would work.
In CA a loan made to an entity that has $2 million in assets and is over $300k (plus a few other requirements) is exempt from usury laws. The borrower entity meets the exemption from what I was told.
 

#16
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If borrower sues for usury, don’t think they’ll get another loan in the future

Would usury even apply to a commercial loan?
 

#17
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Nilodop wrote:Back to OP wanting to avoid OID. If we saw the actual agreement, maybe there's language that in substance makes the lclient/lender a partner witha 2% guaranteed payment and a share of profits at closing, but limited to $400,000. I doubt it but stranger things have happened.


I agree that the actual wording of the agreement is very important. I'd want to see if the loan agreement expresses a term for the loan.

A loan with payback contingent on both construction and sale has to include language about what happens if there are delays. I've seen loans that were intended as short term that nevertheless contained language about long-term treatment as a fall back for unexpected problems. Maybe it's technically a 30-year mortgage with a penalty for early repayment?
 


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