Taxes - a sanity check

[Boatguy]

Three years ago I concluded that the tax treatment of LC notes was so awful they weren't worth holding in a taxable account and shuffled my money so that my LC allocation was in an IRA.  2011 was not a great year for LC notes so I'd like to run the logic by this esteemed group and see if my logic checks out.

These numbers are round for the simplicity of discussion, but I think they are valid for discussion.  Let's assume a $10,000 portfolio of Grade C notes.  Rounding off the numbers, grade C has an average rate of 15% and a default rate of 5%.  Let's also assume that my tax rate on ordinary income is 30% and 15% on capital gains.  Here is how I see this playing out after tax.

Interest income = $1,500
Charge offs = $500
Net cash = $1,000
Pre-tax gain = 10%

OID Income = $1,500
Income tax = 30% x $1,500 = $450
Offsetting capital loss (assumes I have other cap gains) = 15% x $500 = $75

After tax cash = $1,000 - $450 + $75 = $625
After tax return = 6.25%

And if I was in a max bracket at 45% combined fed + state (California) and 20% on cap gains it would look more like this:

Income tax = 45% x $1,500 = $675
Offsetting capital loss = 20% x $500 = $100
After tax cash = $1,000 - $675 + 100 = $425
After tax return = 4.25%

This is for Grade C notes, for Grade D/E/F notes it is much worse since the taxable OID income goes up much faster than the charge off cap loss offset.

Does this example look pretty accurate to you guys?

 

[storm]

I'm no tax expert or math whiz, but I'll take a crack at it...

Where are you getting the 30% tax rate?  If your tax rate is that high, you likely don't qualify for an IRA.  Your effective tax rate is highly dependent on any other income and will be less than the tax bracket you might fall in.  That is because your income is taxed in tiers by the IRS.  In 2013, for single filers, the first $8,925 earned is taxed at 10%.  Income from $8,926 to $36,250 is taxed at 15%.  $36,251 to $87,850 is taxed at 25%.  And so on.  Let's say my adjusted gross income is $75k for the year.  Subtract the single standard deduction of $6,100 for a taxable income of $68,900. Looking at the tax tables, my tax is $13,160 making my effective tax rate less than 18%.  I'm not even going to get started on state taxes as I am in a different state.

Charge-offs = capital loss and are used to offset capital gains.  If there are no capital gains, then they are essentially subtracted from your income to give you your AGI.  Capital losses are not taxed.

Let's say I received a W-2 for $74k.  I add my $1500 OID interest income.  I fill out the Schedule D, with my $500 charge-off/capital loss.  That brings my AGI to $75k.  $1000 net gain x 18% tax rate = $180.  So after taxes, I made $820.  Divide that into $10k, and my after-tax return is 8.2%.

[Jmar42]

Welcome to new America.

[BruiserB]

I'm no tax expert or math whiz, but I'll take a crack at it...

Where are you getting the 30% tax rate?  If your tax rate is that high, you likely don't qualify for an IRA.  Your effective tax rate is highly dependent on any other income and will be less than the tax bracket you might fall in.  That is because your income is taxed in tiers by the IRS.  In 2013, for single filers, the first $8,925 earned is taxed at 10%.  Income from $8,926 to $36,250 is taxed at 15%.  $36,251 to $87,850 is taxed at 25%.  And so on.  Let's say my adjusted gross income is $75k for the year.  Subtract the single standard deduction of $6,100 for a taxable income of $68,900. Looking at the tax tables, my tax is $13,160 making my effective tax rate less than 18%.  I'm not even going to get started on state taxes as I am in a different state.

Charge-offs = capital loss and are used to offset capital gains.  If there are no capital gains, then they are essentially subtracted from your income to give you your AGI.  Capital losses are not taxed.

Let's say I received a W-2 for $74k.  I add my $1500 OID interest income.  I fill out the Schedule D, with my $500 charge-off/capital loss.  That brings my AGI to $75k.  $1000 net gain x 18% tax rate = $180.  So after taxes, I made $820.  Divide that into $10k, and my after-tax return is 8.2%.

First, you can qualify for a traditional IRA at any income.  You may not be able to deduct your contribution, but you can still contribute and shield your interest earnings from taxation.  It's also possible to roll funds from a 401(k) to an IRA. Roth IRA contributions may be prohibited at a certain income level.

Next, your effective tax rate makes no difference....it's your marginal tax rate that determines how the additional 1000 is taxed.  In your example your taxable income puts you in the 25% marginal tax bracket so you will give 250 to Uncle Sam and your effective earnings are 7.5%

The original poster was also correct that if you have other capital gains, then your losses offset those rather than ordinary income.  So your 500 loss might be offsetting income that is taxed at 15 or 20% rather than 25 or 28% if you are in a higher tax bracket.  So your deduction is devalued since it doesn't offset the OID income which is taxed at your marginal rate.

The original poster was entirely correct in his math if his State and Federal marginal rates are 45% except I think he is maybe missing the state deduction for his losses.  In any case you pay full tax on your gross gains but may end up deducting your losses against lower taxed income....so yea, the after tax effect can be a lot less than you might expect.

[Boatguy]

Thank you for your confirmation on the basic numbers.

As you point out, essentially any retirement funds can be rolled into an IRA when you leave a company.  My IRA contains funds from a variety of different types of retirement plans during my career.

The top rate in California is 9.6% and is reached at $50K of taxable income.  Adjusting for the deduction on max Fed taxes ((1-.4)*9.6) the top marginal rate is thus closer to 46%.

Of more relevance is that the combined marginal tax rate for a California resident with taxable income of $50K is (.25 + ((1-.25)*9.6) =  32.2%.

The bottom line is that most investors here probably have a marginal rate over 25% and 30% is not a wild number.

My point was that taking charge offs as cap losses, which is not the way that LC calculates Adj Net Return, has a significant impact on after tax income.  Further, the impact worsens in the lower grade loans (D-E-F) as the percentage of loans charged off rises.

Additionally, there is a $3K / yr cap on deducting capital losses.  If for example an investor placed $50K in a portfolio that had 7% charge offs, the resulting $3,500 of capital losses would not be fully deductible without capital gains from some other investment.

Investing in LC is not like buying a bond.

[BruiserB]

Exactly, Boatguy!  I just realized this myself this year as I was entering my tax info last month.  If you have no other capital gains and your account is small enough that you can avoid going over $3000 per year of charge offs, then your write-offs for losses will happen at your marginal tax rate.  Or if you have short term capital gains to offset and you have no long term gains then you are fine. 

But if you have long term gains that would be taxed at a low rate, your losses will wipe them out.

I started an IRA with LC last year and contributed already for this year, even though my income is too high to write off the contributions.  I think I can withdraw funds from my work 401(k) and roll them to an IRA and I may consider doing that at some point.  I'm waiting on that to see how the industry shakes out...if it becomes impossible for the little guy to invest it may not continue to be worth it.

[BruiserB]

Your point on higher risk loans being more likely to have this adverse tax effect is something I didn't ever think of.  I had been focusing on higher risk loans, but I may adjust this strategy.  Many of the loans that p2p-picks.com selects in its "Profit Maximizer" model are C grade loans....I may increase my weight there.

So thanks for your insightful post!

[Boatguy]

So thanks for your insightful post!

You're welcome.

That said, I was kind of hoping someone would find a flaw in the thinking, so if anyone is lurking who doesn't see it this way I'd appreciate hearing from you.

[BruiserB]

Yea, I wish it wasn't true either!  It's definitely better than having money languish in a CD but you are going to pay taxes immediately as your balance grows. I do like the idea of holding notes in an IRA.  My goal is to have my taxable account generate my IRA contribution each year, and then continue to grow my balance in a tax sheltered way.

I have been afraid to dabble in Folio trading as the rules for accounting for OID when notes are bought at a premium or discount seem to be a nightmare...way too much record keeping for a $25 note.  I don't understand how Folio users here manage to do their taxes.

I thought that it would make sense to do Folio trading in my IRA account, but according to posts on here, that is questionable as well as Folio is not approved as a custodian apparently.  I'm hoping that eventually clears up.

[Boatguy]

An IRA is definitely the best place for LC investing.  You can trade with Foliofn from an IRA, not a problem.

Trading from the IRA avoids the tax inefficiencies of the LC model and sidesteps the non-existent basis tracking by LC and Folio

My sense is that LC income/losses are being reported in a broad variety of "creative" methods and that P2P transactions are currently below the IRS radar.  One day they'll wake up clarify the treatment and allow LC to take all the weasel words and ambiguity on taxes out of their prospectus.

[BruiserB]

An IRA is definitely the best place for LC investing.  You can trade with Foliofn from an IRA, not a problem.

Trading from the IRA avoids the tax inefficiencies of the LC model and sidesteps the non-existent basis tracking by LC and Folio

My sense is that LC income/losses are being reported in a broad variety of "creative" methods and that P2P transactions are currently below the IRS radar.  One day they'll wake up clarify the treatment and allow LC to take all the weasel words and ambiguity on taxes out of their prospectus.

Somebody just started this thread:

http://www.lendacademy.com/forum/index.php?topic=2134.0

Looks like there is speculation that losses should be treated as ordinary losses, but as you said there hasn't yet been a definitive ruling.

I wonder how Peter's hedge fund will handle this on the end of year 1099's they send to investors?  Will each person receive OID income and long and short term losses or will they just get a statement with a net amount of earnings?  If it's the latter, it could be an argument for investing through a fund rather than individually (even with the extra fees).

And I know you can technically CAN trade on Folio with an IRA (I have it approved for my account too, but haven't traded yet).  I hesitate to after reading this long thread.....apparently it is prohibited by LC's terms and conditions even though they will activate it on your account!

http://www.lendacademy.com/forum/index.php?topic=1674.0

[Boatguy]

The PPM for Peter's fund sets it up as a partnership so everything will flow through, there is no reconfiguration of income.

What I don't understand is why P2P notes would be treated differently than any other bond.  If a corporate bond defaults, it's a cap loss, not ordinary loss.  These are just junk bonds; high interest rate and high default rate.  Interest on bonds is taxed on a cash basis, discounts are OID income spread over the term of the bond and premiums are amortized over the life of the bond.  Why the accrual accounting at LC?

[rawraw]

The PPM for Peter's fund sets it up as a partnership so everything will flow through, there is no reconfiguration of income.

What I don't understand is why P2P notes would be treated differently than any other bond.  If a corporate bond defaults, it's a cap loss, not ordinary loss.  These are just junk bonds; high interest rate and high default rate.  Interest on bonds is taxed on a cash basis, discounts are OID income spread over the term of the bond and premiums are amortized over the life of the bond.  Why the accrual accounting at LC?

Read the prospectus to see these aren't just regular bonds you are buying -- hence the OID

[Boatguy]

LC prospectus or Lend Academy PPM?

[Fred93]

What I don't understand is why P2P notes would be treated differently than any other bond.  ... Interest on bonds is taxed on a cash basis, discounts are OID income spread over the term of the bond and premiums are amortized over the life of the bond.  Why the accrual accounting at LC?

The LC notes make contingent payments.  (They only pay you if the borrower pays on his loan.)  The IRS says contingent bond payments are treated as OID.   

Don't blame me.  I didn't make the rule.