Taxes - a sanity check

[mikedave]

Do I treat losses from selling bad loans on Folio different that losses sustained for charge offs?

[jpildis]

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.

If our investments are considered Contingent Payment Debt Instruments by the IRS, any capital losses are reported as Ordinary Losses and they are not subject to capital loss limits or the lower capital loss/gain rates.  LC explicitly raises this possibility in their prospectus (though the prospectus states that LC does not believe these are CPDI's).  This is the best possible outcome for larger investors who, like me, already have capital loss carryovers from other investing activities.

I plan to file this way and go back and revise by 2011 and 2012 taxes.  As always, this is not advice for you... talk to your tax people.

[Lovinglifestyle]

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.

If our investments are considered Contingent Payment Debt Instruments by the IRS, any capital losses are reported as Ordinary Losses and they are not subject to capital loss limits or the lower capital loss/gain rates.  LC explicitly raises this possibility in their prospectus (though the prospectus states that LC does not believe these are CPDI's).  This is the best possible outcome for larger investors who, like me, already have capital loss carryovers from other investing activities.

I plan to file this way and go back and revise by 2011 and 2012 taxes.  As always, this is not advice for you... talk to your tax people.

Where would one report Ordinary Losses?  On a separate sheet to justify declaring less OID income?

[Boatguy]

I don't know exactly where it gets reported, but I'm sure there is a line or form somewhere.

The tricky part is that LC does not report defaults to the IRS at all (see the note on the 1099B).  The IRS has no way to verify the number we would insert as an ordinary loss (or as a cap loss for that matter) which seems like an invitation to an audit.

Very different than a brokerage 1099 which clearly shows the ST and LT cap gains/losses.

[Boatguy]

If our investments are considered Contingent Payment Debt Instruments by the IRS, any capital losses are reported as Ordinary Losses and they are not subject to capital loss limits or the lower capital loss/gain rates.  LC explicitly raises this possibility in their prospectus (though the prospectus states that LC does not believe these are CPDI's).  This is the best possible outcome for larger investors who, like me, already have capital loss carryovers from other investing activities.

I plan to file this way and go back and revise by 2011 and 2012 taxes.  As always, this is not advice for you... talk to your tax people.

I agree it is a much better outcome.  What changed your perspective from the way you prepared your 2011/2012 taxes?

[jpildis]

If our investments are considered Contingent Payment Debt Instruments by the IRS, any capital losses are reported as Ordinary Losses and they are not subject to capital loss limits or the lower capital loss/gain rates.  LC explicitly raises this possibility in their prospectus (though the prospectus states that LC does not believe these are CPDI's).  This is the best possible outcome for larger investors who, like me, already have capital loss carryovers from other investing activities.

I plan to file this way and go back and revise by 2011 and 2012 taxes.  As always, this is not advice for you... talk to your tax people.

I agree it is a much better outcome.  What changed your perspective from the way you prepared your 2011/2012 taxes?

I have a high marginal tax rate and a ton of capital loss carry-overs.  I'm making a solid net pre-tax return (12+%) but post-tax, it's about 3-4% because I cannot take the losses against the income.  I think the IRS would understand as I'm simply trying to pay tax on my net return from LC and Prosper.

[BruiserB]

I have a high marginal tax rate and a ton of capital loss carry-overs.  I'm making a solid net pre-tax return (12+%) but post-tax, it's about 3-4% because I cannot take the losses against the income.  I think the IRS would understand as I'm simply trying to pay tax on my net return from LC and Prosper.

You think the IRS would understand you bent the rules in your favor?  Good luck with that!

 

Seriously though, I guess you can give it a shot, the worst that will happen is you'll get audited or they will rule against you.  You may not pay a penalty if you claim you made a good faith effort to report the losses properly.  However I'd think you'd have less of a case in filing the amended past returns since you reported them as capital losses previously and now are trying to reclassify those losses.

[loan_trader]

I have a high marginal tax rate and a ton of capital loss carry-overs.  I'm making a solid net pre-tax return (12+%) but post-tax, it's about 3-4% because I cannot take the losses against the income.  I think the IRS would understand as I'm simply trying to pay tax on my net return from LC and Prosper.

Whoa, big difference in rates after the tax man takes his piece. I'm trying to wrap my head around a scenario that makes this better... Is there any way that this isn't as harsh (other than classifying as CPDI's, which I doubt holds much water). If you have short-term gains (elsewhere) to offset the short-term losses, does that make it better? 

So LC doesn't report any of the losses to the IRS?  If it's up to us to "qualify" them then maybe the CPDI isn't out of the question. sounds pretty murky and open to interpretation....

[core]

The IRS has no way to verify the number we would insert as an ordinary loss (or as a cap loss for that matter) which seems like an invitation to an audit.

Very different than a brokerage 1099 which clearly shows the ST and LT cap gains/losses.

Basis reporting for such transactions did not begin until 2011.  Somehow we made it through nearly a century without the world ending.

[jpildis]

I have a high marginal tax rate and a ton of capital loss carry-overs.  I'm making a solid net pre-tax return (12+%) but post-tax, it's about 3-4% because I cannot take the losses against the income.  I think the IRS would understand as I'm simply trying to pay tax on my net return from LC and Prosper.

You think the IRS would understand you bent the rules in your favor?  Good luck with that!

 

Seriously though, I guess you can give it a shot, the worst that will happen is you'll get audited or they will rule against you.  You may not pay a penalty if you claim you made a good faith effort to report the losses properly.  However I'd think you'd have less of a case in filing the amended past returns since you reported them as capital losses previously and now are trying to reclassify those losses.

Based on my research, making these CPDI is actually more conservative than the LC & Prosper Approach... you lose the ability to get a reduced LT capital gains rate.  The IRS gets touch when you try to off-set income with made-up or tax-motivated transactions.  In this case, my looses are true losses and they are off-setting true gains from the very same security.  The CPDI rules were set-up to stop tax cheats.

[Boatguy]

Based on my research, making these CPDI is actually more conservative than the LC & Prosper Approach... you lose the ability to get a reduced LT capital gains rate.  The IRS gets touch when you try to off-set income with made-up or tax-motivated transactions.  In this case, my looses are true losses and they are off-setting true gains from the very same security.  The CPDI rules were set-up to stop tax cheats.

Yes, your loss is a loss, but I'm not sure what the word "true" is meant to imply.  Losing money is not inherently an ordinary loss.

If I understand your approach, you are independently making the determination that the notes are CPDI and you will report:

OID:  Interest income
1099B Charge offs:  Ordinary loss
1099B trading activity:  ST or LT cap gain / loss per each note traded

Take the charge offs on the ordinary income line and attach the statement from LC?

I can see an argument that says the interest not paid is an ordinary loss because they are reporting accrued interest, not actually paid, as pointed out in the prospectus:

"On the other hand, if a payment on a Note is not made in accordance with such payment schedule, for example because the borrower member did not make timely payment in respect of the corresponding member loan, a U.S. Holder will be required to include such amount of OID in taxable income as interest even though such interest has not been paid."

Unfortunately on defaults LC doesn't report the unpaid interest number, only the principal, so it's impossible to even know the amount of unpaid interest which could reasonably be deducted from the OID interest.  Is that the source of the CPDI rules - the difference between cash and accrual accounting?  The trade off is that since we're paying taxes on interest we never received, we can take the principal as ordinary loss?

So my understanding is that you've found or interpreted the IRS code regarding CPDI and concluded that you can take principal at default as ordinary loss.

Is that an accurate summary?  Can you direct me to the CPDI section of the IRS code that led you to that conclusion?

Like you I'm in a higher marginal bracket and also have significant cap loss carry forwards which makes the LC cap losses of no immediate value.  This is a critical point for any LC investor who would exceed the $3K cap gain deductibility limit so I appreciate your participation.  My own tax preparer doesn't know this area of the IRS code.

[Boatguy]

Whoa, big difference in rates after the tax man takes his piece. I'm trying to wrap my head around a scenario that makes this better... Is there any way that this isn't as harsh (other than classifying as CPDI's, which I doubt holds much water). If you have short-term gains (elsewhere) to offset the short-term losses, does that make it better?

So LC doesn't report any of the losses to the IRS?  If it's up to us to "qualify" them then maybe the CPDI isn't out of the question. sounds pretty murky and open to interpretation....

Cap losses certainly offset cap gains.  If you have less than a total of $3K of cap losses the subject is moot because you can deduct those as ordinary losses.

And yes, LC has left this very murky and open to interpretation.

[Boatguy]

This section from IRS publication http://www.irs.gov/publications/p1212/ar02.html#en_US_201312_publink1000206288 suggests that previously reported interest due to accrual accounting can be taken as a loss, but the principal is a capital loss.  It also says that if you take the CPDI approach, trading gains are also ordinary income:

Treatment of gain or loss on sale or exchange.   If you sell a contingent payment debt instrument at a gain, your gain is ordinary income (interest income), even if you hold the debt instrument as a capital asset. If you sell a contingent payment debt instrument at a loss, your loss is an ordinary loss to the extent of your prior OID accruals on the debt instrument. If the debt instrument is a capital asset, treat any loss that is more than your prior OID accruals as a capital loss.

[jpildis]

This section from IRS publication http://www.irs.gov/publications/p1212/ar02.html#en_US_201312_publink1000206288 suggests that previously reported interest due to accrual accounting can be taken as a loss, but the principal is a capital loss.  It also says that if you take the CPDI approach, trading gains are also ordinary income:

Treatment of gain or loss on sale or exchange.   If you sell a contingent payment debt instrument at a gain, your gain is ordinary income (interest income), even if you hold the debt instrument as a capital asset. If you sell a contingent payment debt instrument at a loss, your loss is an ordinary loss to the extent of your prior OID accruals on the debt instrument. If the debt instrument is a capital asset, treat any loss that is more than your prior OID accruals as a capital loss.

I got my info from this publication: http://www.irs.gov/publications/p1212/ar02.html  (look about half way down for a section entitled - Contingent Payment Debt Instruments.

Here's the critical section on the capital portion of a CPDI:

Treatment of gain or loss on sale or exchange.   If you sell a contingent payment debt instrument at a gain, your gain is ordinary income (interest income), even if you hold the debt instrument as a capital asset. If you sell a contingent payment debt instrument at a loss, your loss is an ordinary loss to the extent of your prior OID accruals on the debt instrument. If the debt instrument is a capital asset, treat any loss that is more than your prior OID accruals as a capital loss.

Do what you will, Boatguy.  I think this is a reasonable approach and LC's or Prosper's thoughts on the taxabiity of their offering is moot.  It's between me and Mr. IRS.  This is a good faith, statute-supported, filing approach.  If the IRS disagrees, so be it.... I'm gonna fight the good fight.

[Rob L]

May the force be with you.