Posted by David Butler on February 05, 2011 at 01:22:43:
Hello Abdenour,
You are welcome, such as it was. As to the your additional question here now, Bob has provided an accurate answer, and one that I did
not clarify at all in my explanation. In general, and for most note investors, the income in the scenario you describe would be capital
gains, and, if short-term (less than one-year holding period on the overall investment) would be taxed at ordinary rates, rather than
capital gains rates.
Bob also pointed out that SE tax is not generally a typical scenario for investors who are buying notes and reselling in short-term
scenarios (generally less than one-year); unless you have set your business up in a manner that facilitates “dealer” status.
There are some complexities, and intracacies in the statutes, and case law in that regard, which I’ll address in a moment.
I’m not certain that “…‘most’ investors are looking for quick payoffs…” however. A number of note investors, depending on the deal
structure in a given note transaction, and broader investment objectives, like to hold their notes for at least a couple of years, particularly
if they are oriented toward building a strong income stream. This is particularly so if the discount creates a very high yield; or a subsequent
rework of the note payment schedule accomplishes the same thing; or both - whereby high interest income is occurring in relation to erosion
of actual note principal balance.
This secondary “tweaking” is enhances the very result you are describing here in your second question with regard to the resale value of
the note. There is point, as I discussed in my “Tin Can Alley” course years ago, where many investors base their sell decision primarily on
total dollar value of income stream remaining, once they have maximized the yield return on the notes in their investment portfolio. This
“fine-tuning”, is in response to an investor’s concern of having for finding appropriate investments, the costs associated with that, and
the declining nature of the note asset base.
So, if and when an opportunity to get another note(s) which will increase the total dollar future income stream, at close to, or even
better overall yield return as well… they look to sell one or more of the notes they have maxed out, so they can get a very good resale
price, and then plow that profit back into acquiring the new note(s), and starting the process over again on the new notes added.
Outside of the SE issue, a very effective way to defer taxes on capital gains income (as opposed to interest income), whether short-term,
or long-term, is to arrange a 1031 tax-deferred exchange, depending on your liquid cash objectives. The exchange has to be like-kind
(in this case note[s] for note[s]), but can include some cash if desired (taxable) in the course of balancing equities.
Now back to the primary question of your original post, and as restated a bit differently here:
“If ordinary income, is it subject to social security taxes (like wage income),
or exempt (like interest income)?”
The Code treats investors (and traders) differently from dealers in securities. Investors and traders receive capital gain or loss treatment
on sales. (The Special Rules for Traders don’t apply for note investors generally, also explained in Publication 550).
On the other hand, dealers in securities receive ordinary gain or loss treatment on security sales, unless (under Sec. 1236(a)):
-
The security was, before the close of the day on which it was acquired, clearly identified in the dealer’s records as a security held for
investment; and -
The security was not, at any time after the close of that day, held by the dealer primarily for sale to customers in the ordinary course
of his trade or business.
A dealer in securities, as a self-employed individual, is subject to SE tax. Therefore, if an individual is considered a dealer and has net gains
for a tax year, not only would these gains be taxed at ordinary rates - they would also be subject to SE tax.
Although the impact on self-employed individuals is greater (because they pay these taxes at twice the rate of employees), a self-employed
individual can deduct half of any federal self-employment taxes. More importantly, dealers in securities receive more favorable treatment
in the case of a net loss.
In addition to other considerations in your overall tax planning, this distinction, particularly over the past four or five years, where many
investors are finding themselves in the position of having to foreclose, or take over, abandoned properties - and the properties themselves
have suffered severe devaluation of collateral, bears some very detailed discussion with your tax planner.
Under Sec. 1211(b), net losses from sales or exchanges of capital assets, equipment, property, and funds owned by a business by
noncorporate taxpayers are allowed against ordinary income only up to the lower of $3,000 (generally) or the net loss. However, under
Sec. 165, a dealer can deduct all ordinary losses against ordinary income. Therefore, characterization as capital losses (as an investor),
rather than ordinary losses (as a dealer) could have severe tax consequences for net securities losses. If an individual has such net losses
and cannot establish dealer status, his deduction against ordinary income cannot exceed $3,000 a year.
But the decision is not an “elective” option, per se.
Through the years, the courts have developed a distinction between dealers and investors. A dealer is a person who purchases securities
with the expectation of realizing a profit "not because of a rise in value… but merely because they have or hope to find a market of buyers
who will purchase from them at a price in excess of their cost. This excess or mark-up represents remuneration for their labors as a middle
man bringing together buyer and seller. The determination of whether an individual has “customers” is essential in determining dealer
versus investor status. Only dealers have customers. (Steven M. Wood, 943 F2d 1048 (9th Cir. 1991)).
Dealers in securities also must maintain an inventory of securities held for resale; see Regs. Sec. 1.471-1 and Stern Bros & Co., 16 TC 295
(1951), acq., 1951-2 CB 4.
I noticed an excellent post by David Krulac last week over in the main board, that although not purely in the note context, offers some
interesting discussion and real world practical application of the complexities and intracacies related to dealer status, albeit presented
in the real estate investor context, in his reply:
“its not always easy”
http://www.creonline.com/wwwboard/messages/97029.html
So, as you can see, there is some ground to cover with your own tax counsel, in determining which approach (investor v. dealer) is the
best model for reaching your objectives, and whether or not you can structure your note investing operation to coincide with that.
Hope this helps, and very sorry for the delay. Been a very busy two weeks, and what time I had to post responses got consumed in some
important threads over on the main board.
Many Happy Returns
David P. Butler
Nascent Equity &
Hotspur Investment Group