Author Topic: Contemplating P2P as a Business for Tax Purposes  (Read 7060 times)

jpildis

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Contemplating P2P as a Business for Tax Purposes
« on: February 02, 2013, 09:30:47 AM »
I'm sure this has been discussed before, but I would like everyone's thoughts...

I have a significant amount in both Prosper and LC and, after reviewing my 2012 tax forms, I see that I have $10k+ of long-term capital losses.  This is fine as my income far exceeds that number but the difference in taxation is concerning.  My marginal tax rate is 33% so I'm looking at a 15% (factoring in the 2.9% medicare tax on wages) tax difference between my P2P interest and my P2P LT capital losses.

An extra $1500 of tax isn't the end of the world but it's enough to make me really think about whether I should organize my P2P as a schedule c business.

AmCap

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #1 on: February 02, 2013, 10:52:56 AM »
See generally http://online.wsj.com/article/SB122039907716592937.html and the IRS publications on how the Service distinguishes between a trader and an investor.  Generally, it's very difficult to take the position that your dealings in securities rise to the level of your trade or business.  I think Peter has discussed the topic on the main blog.

See also, http://www.smartmoney.com/taxes/income/tallying-your-capital-gains-and-losses-9868/.  A very succinct description of the netting rules.

Remember your short-term losses don't go away to the extent they exceed $3k (less if you are married, I think).  Also the limit only kicks in to the extent that the losses exceed your other capital gains.  The idea is to limit your ability to use capital losses to shelter your ordinary income; you get the tax benefit of a capital loss against the capital gains you have without limit.  You are entitled to a carryforward, so not all is lost there.  Consult your tax person, if you have one.

Look, the bottom line is that the Code treats the holders of debt rather harshly.  Interest is taxed at ordinary income rates.  Your gains get ordinary treatment, but your losses get capital treatment, which is the ultimate "the Service wins, the taxpayer loses" situation.  This is a disadvantage of P2P investing (and really investing in debt generally). 


jpildis

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #2 on: February 04, 2013, 03:38:15 PM »
So I've pulled together the numbers for my 2012 taxes and it's not pretty...

Gross Return: 16%

Defaults: 6.9%

Net Return: 9.1% - I'm happy with this considering I've dramatically improved my loan selection and all of the defaults are from 2011 vintage loans

Net Return After Federal Tax: 4.9% - This sucks... my all in tax rate for p2p is 46.5%!!!

I'm getting killed by the difference between the LT Capital Loss taxation and my marginal income taxation.  This is a major issue with investing in the higher-yield loans in a taxable account.  I'm going to have to start selling my distressed loans within a year of purchase to ensure I don't get bitten next year.

AmCap

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #3 on: February 04, 2013, 09:10:20 PM »
So I've pulled together the numbers for my 2012 taxes and it's not pretty...

Gross Return: 16%

Defaults: 6.9%

Net Return: 9.1% - I'm happy with this considering I've dramatically improved my loan selection and all of the defaults are from 2011 vintage loans

Net Return After Federal Tax: 4.9% - This sucks... my all in tax rate for p2p is 46.5%!!!

I'm getting killed by the difference between the LT Capital Loss taxation and my marginal income taxation.  This is a major issue with investing in the higher-yield loans in a taxable account.  I'm going to have to start selling my distressed loans within a year of purchase to ensure I don't get bitten next year.

Actually, I think that isn't a very helpful way to think about it for a couple reasons.  You have to look at it over the life of the entire debt instrument, not just in one year.  That is because you include OID in your gross income on a schedule that doesn't match with the cash interest that you are actually paid in any one year.  Over the life of the entire instrument, your OID should equal the cash interest you were paid, but in any one particular year comparing the tax you paid as opposed to your "returns" just isn't a very useful number.

The other reason, and this is really a big issue, is that I don't think that people are including the OID they pay tax on in their adjusted basis of the note.  If you just deduct your cost basis on a chargeoff, and don't include OID, then you aren't taking into account that you should recover that tax that you already paid.  Put more plainly, if you don't adjust your basis to take account of the OID you accrued, you won't deduct enough on a chargeoff.

jpildis

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #4 on: February 05, 2013, 08:00:23 AM »
 


The other reason, and this is really a big issue, is that I don't think that people are including the OID they pay tax on in their adjusted basis of the note.  If you just deduct your cost basis on a chargeoff, and don't include OID, then you aren't taking into account that you should recover that tax that you already paid.  Put more plainly, if you don't adjust your basis to take account of the OID you accrued, you won't deduct enough on a chargeoff.

Can you explain the point a bit further?  Do I not just use the cost basis reported by Prosper/LC?

AmCap

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #5 on: February 05, 2013, 11:20:44 PM »
Sure!  For any property, your gain or loss for tax purposes is the amount you receive when you sell the property minus your adjusted basis in the property.  Your adjusted basis is generally what you paid for it, plus or minus various adjustments.  For a debt instrument w/ OID, your adjusted basis is increased by the OID as it accrues, and is decreased by payments of interest and principal other than qualified stated interest.

Let me explain by hypothetical.  Let's say you bought a financial instrument for $100 dollars today, and it matured in 5 years.  You get no payments during the 5 years, just a final payment of $150 5 years from now.

From an intuitive level the tax is simple enough, you'd pay capital gains tax on the $50 of gain when you sold the instrument at maturity.  $150 on sale, minus $100 of cost basis.

All that basis does is measure the capital investment you have in property that should be returned to you tax free when you sell the property.  In the prior example, the $100 basis is what you shouldn't have to pay tax on because it is just return of your capital.

Now take the same instrument, but add in a rule that says that when you buy a financial product with a defined gain and maturity, you have to pay tax on that gain equally over the life of the instrument.  So, let's just say that the tax man makes you pay tax on the $50 of gain at a rate of $10 per year, regardless of when you get the cash. 

When you finally get to maturity and the instrument pays you back the $150, you certainly wouldn't feel that you should pay capital gains tax on the $50. You already paid tax on it!  That is what I mean when I say that you have to adjust your basis to account for OID.  OID says that when you buy a debt instrument at a discount, you include and pay tax on OID over the life of the instrument.  To make sure that you don't double count your gain upon a sale or disposition, your basis has to be adjusted upward by the amount of OID.  If you actually get paid any principal and non-qualified stated interest, then your basis has to be adjusted back down to reflect that you actually received the money you're being taxed on.

Ok, keeping with the example...a $100 instrument that makes no payments and matures with a payout of $150 bucks.  Let's also assume that you have to include OID of $10 per year.  Now let's say at the end of year 3, the instrument becomes worthless.  Worthlessness is considered a sale or disposition; basically you are treated as though you sold it for $0.  You might say, ok I should get to deduct $100 because that is my cost basis.  But that's not right, because in addition to the $100 you lost, you paid tax on $30 of OID but never got the cash.  So, you should also get to take a deduction for the $30 because you paid tax on it, but never received any money.  In this situation, if you don't adjust your basis, you'll just give away the tax you paid on the $30. 

The OID you pay is interest income, which is taxed at ordinary rates.  But, the basis adjustment essentially turns that ordinary income into basis in a capital asset.  Because the OID you payed tax on is wrapped into your basis in a capital asset, you pay tax on the income at ordinary rates, but have to take the loss as a capital loss. 

rawraw

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #6 on: February 06, 2013, 05:41:57 PM »
Sure!  For any property, your gain or loss for tax purposes is the amount you receive when you sell the property minus your adjusted basis in the property.  Your adjusted basis is generally what you paid for it, plus or minus various adjustments.  For a debt instrument w/ OID, your adjusted basis is increased by the OID as it accrues, and is decreased by payments of interest and principal other than qualified stated interest.

Let me explain by hypothetical.  Let's say you bought a financial instrument for $100 dollars today, and it matured in 5 years.  You get no payments during the 5 years, just a final payment of $150 5 years from now.

From an intuitive level the tax is simple enough, you'd pay capital gains tax on the $50 of gain when you sold the instrument at maturity.  $150 on sale, minus $100 of cost basis.

All that basis does is measure the capital investment you have in property that should be returned to you tax free when you sell the property.  In the prior example, the $100 basis is what you shouldn't have to pay tax on because it is just return of your capital.

Now take the same instrument, but add in a rule that says that when you buy a financial product with a defined gain and maturity, you have to pay tax on that gain equally over the life of the instrument.  So, let's just say that the tax man makes you pay tax on the $50 of gain at a rate of $10 per year, regardless of when you get the cash. 

When you finally get to maturity and the instrument pays you back the $150, you certainly wouldn't feel that you should pay capital gains tax on the $50. You already paid tax on it!  That is what I mean when I say that you have to adjust your basis to account for OID.  OID says that when you buy a debt instrument at a discount, you include and pay tax on OID over the life of the instrument.  To make sure that you don't double count your gain upon a sale or disposition, your basis has to be adjusted upward by the amount of OID.  If you actually get paid any principal and non-qualified stated interest, then your basis has to be adjusted back down to reflect that you actually received the money you're being taxed on.

Ok, keeping with the example...a $100 instrument that makes no payments and matures with a payout of $150 bucks.  Let's also assume that you have to include OID of $10 per year.  Now let's say at the end of year 3, the instrument becomes worthless.  Worthlessness is considered a sale or disposition; basically you are treated as though you sold it for $0.  You might say, ok I should get to deduct $100 because that is my cost basis.  But that's not right, because in addition to the $100 you lost, you paid tax on $30 of OID but never got the cash.  So, you should also get to take a deduction for the $30 because you paid tax on it, but never received any money.  In this situation, if you don't adjust your basis, you'll just give away the tax you paid on the $30. 

The OID you pay is interest income, which is taxed at ordinary rates.  But, the basis adjustment essentially turns that ordinary income into basis in a capital asset.  Because the OID you payed tax on is wrapped into your basis in a capital asset, you pay tax on the income at ordinary rates, but have to take the loss as a capital loss.
I love your posts.  Thanks, I really appreciate stalking your written words on the forum :)

AmCap

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #7 on: February 06, 2013, 10:28:17 PM »
Well thank you! - I just hope to be helpful as we all learn more.

PennySaved

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #8 on: February 07, 2013, 11:48:12 PM »
I am totally confused by the OID numbers and how to use them to adjust basis for losses.  In 2010, I only had two charge-offs, one at Prosper and one at Lending Club.  But I did not have that many loans.  Then I ramped up my investment.  I did not have any chargeoffs in 2011, but now I have 21 loans charged-off in Lending Club.  This is the first year I am getting OID reported from Lending Club.  Before I just used the interest total from the year end statement for reporting interest income on my taxes.  From what I can tell, my total 2012 OID reported from Lending Club is less than the total interest reported on the year end statement.  The difference seems to be about the year's total of service charges,which I calculated from each month's statement. 

When I go and look at my charged-off loan list in Lending Club online, the table list show  Accrued interest column as zero for all charged- off loans.   I went and tallied the 2011 and 2012 interest for each charged off note and compared it the 2012 OID reported for each note.  In all cases, the 2012 OID was just a little less than the 2012 interest reported by looking at each individual loan's payment history.  The slight difference, mostly a cent or two per  loan, is due to the service fees.  So I don't think I need to adjust anything on my basis for figuring capital loss on the charged off loan as bad debt.  All I need is the unpaid principal amount per loan.  I got that easily from the CSV download file filtered for the charged off loans.  Then I just had to delete the few loans that were charged off prior to 2012 and the couple charged off in 2013.

I have not bought or sold any loans in 2012, so I could see where accrued interest and OID interest numbers may have to be used in figuring basis for loss.  But not for my charge-offs.

AmCap

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #9 on: February 12, 2013, 12:39:27 AM »
Interesting.

We don't know very much about how LC is adjusting the basis it's reporting on the 1099-B; if as you say they are tracking closely, it could be that LC is calculating the basis adjustment property, which is an encouraging sign. 

Your OID and actually interest received should be pretty close, but if you had a loan go late for 4 months and paid no interest, then there should be a difference, if LC is applying the law correctly.  OID instruments accrue OID until they are declared worthless, and on LC a charge-off generally occurs 4 months after payments stop.  So there should be some accrual in there that would get moved into your basis on a charge off event.

Another possibility is that, if all of your notes are small, the OID effect on basis is so small that it isn't being captured.  Aggregated over a portfolio, however, those little bits add up.  I haven't had time to actually run the OID numbers on small notes so I don't know. 

I think everyone is just trying to do their best with the tax issue.

graceful

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #10 on: February 12, 2013, 01:12:59 PM »
Another question.

Since Capital losses are capped at $3,000 per year, this makes a taxable P2P account get pretty unattractive as it gets larger. I'm already  rolling over losses that could make it impossible to write off the losses in anywhere close to the investment term.

It seems more appropriate to match the losses with the income, and then pay taxes on the profit. Has anyone done it this way?

Graceful


AmCap

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #11 on: February 12, 2013, 10:11:04 PM »
Another question.

Since Capital losses are capped at $3,000 per year, this makes a taxable P2P account get pretty unattractive as it gets larger. I'm already  rolling over losses that could make it impossible to write off the losses in anywhere close to the investment term.

There's no hard $3k cap on capital losses.  You can deduct all the capital loss you want to the extent of your capital gain; the cap only hits if your capital loss exceeds your capital gain by $3k.  Congress doesn't want you to shield your ordinary income with losses from dealings in property.

Quote from: graceful
It seems more appropriate to match the losses with the income, and then pay taxes on the profit. Has anyone done it this way?
Graceful

Eh not really.  A debt instrument is property, and gain or loss on the disposition of property is almost always capital.  Income that that property produces is almost always ordinary.  Reasoning by analogy, let's say you had an investment that you bought for $100k it decreased in value to $80k after 2 years, but you collected $70k  in rent during that time period (nice catch!).  You're saying that you should be taxed on $50k of rental income, but really you should be taxed on $70k of rental income, and $20k of capital loss. 

In the case of an OID instrument, I don't really know why Congress has said that you basically have to capitalize your losses, but that's that the statute and regulations say.  Any other treatment would be contrary to law.


PennySaved

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #12 on: February 12, 2013, 11:24:48 PM »
Interesting.

We don't know very much about how LC is adjusting the basis it's reporting on the 1099-B; if as you say they are tracking closely, it could be that LC is calculating the basis adjustment property, which is an encouraging sign. 

Your OID and actually interest received should be pretty close, but if you had a loan go late for 4 months and paid no interest, then there should be a difference, if LC is applying the law correctly.  OID instruments accrue OID until they are declared worthless, and on LC a charge-off generally occurs 4 months after payments stop.  So there should be some accrual in there that would get moved into your basis on a charge off event.

Another possibility is that, if all of your notes are small, the OID effect on basis is so small that it isn't being captured.  Aggregated over a portfolio, however, those little bits add up.  I haven't had time to actually run the OID numbers on small notes so I don't know. 

I think everyone is just trying to do their best with the tax issue.

All my loans are small, $25 each.  For each of my charged off loans in 2012, the 2012 OID interest reported on Form 1099-OID was slightlyLESS than the actual interest collected on each loan.   So there was no reported accrued interest for the months the borrower should have been making payments before the loan was eventually charged off. 

Lending Club sent me an email on Feb 7 saying they would be" issuing corrected 2012 IRS Forms 1099-OID and 1099-INT in addition to providing a new IRS Form 1099-B for recoveries of principal amounts from previously charged-off loans by February 19, 2013."  So maybe they calculated the OID amounts wrong on the 2012 form 1099-OID I downloaded.   I will be closely comparing the new 1009-OID for my charged off loans with the individual interest payments on those loans.  Also will be interesting to see what they report as losses for those chargeoffs on Form 1099-B

severancejoan

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #13 on: February 11, 2019, 05:15:04 AM »
Another question.

Since Capital losses are capped at $3,000 per year, this makes a taxable P2P account get pretty unattractive as it gets larger. I'm already  rolling over losses that could make it impossible to write off the losses in anywhere close to the investment term.

It seems more appropriate to match the losses with the income, and then pay taxes on the profit. Has anyone done it this way?

Graceful

YES, this year I'm going to pay taxes on the profit - i have too many charge offs this year and i netted almost nothing.  i'm not paying taxes when my net is close to zero in 2018.

severancejoan

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Re: Contemplating P2P as a Business for Tax Purposes
« Reply #14 on: February 11, 2019, 06:39:50 AM »
I'm sure this has been discussed before, but I would like everyone's thoughts...

I have a significant amount in both Prosper and LC and, after reviewing my 2012 tax forms, I see that I have $10k+ of long-term capital losses.  This is fine as my income far exceeds that number but the difference in taxation is concerning.  My marginal tax rate is 33% so I'm looking at a 15% (factoring in the 2.9% medicare tax on wages) tax difference between my P2P interest and my P2P LT capital losses.

An extra $1500 of tax isn't the end of the world but it's enough to make me really think about whether I should organize my P2P as a schedule c business.

DO IT... OR I WILL FOLLOW YOUR ADVICE...