note taxes question - Posted by Bob Smith

Posted by Jimmy on April 01, 2006 at 09:13:04:

I know just enough to know about the OID and AMD rules, which puts me ahead of 99.99% of the world. But actually applying them is another thing entirely.

Here’s the rub. You may have to talk to 100 CPA’s before you find one who knows these rules cold. These issues don;t come up that often in general practice. They do come up in big business, and you will find the expertise in the Big 4. But their fees are astronomical.

I encountered these rules while a tax geek at Deloitte in the mid-80’s, but only enough to recognize them


note taxes question - Posted by Bob Smith

Posted by Bob Smith on March 30, 2006 at 03:10:03:

If I borrow money from an investor (or a bank, or whoever) and buy a note, is the interest I receive reported on Form 1040, Schedule B, Part I, and the interest I pay to the investor an itemized deduction on Form 1040, Schedule A, Line 13 as “Investment Interest”? This seems consistent with publication 550, which treats notes as capital assets producing investment income. Or is all this reported on some other form or schedule?

If I understand Publication 550, when I buy a $100 note for $60, and convince the payor to make a quick payoff of $80, my $20 of profit is short-term capital gain, not interest. Payoffs by the debtor are considered retirements or redemptions, which are treated as a sale or trade. Is that your understanding?

Re: note taxes question - Posted by Jimmy

Posted by Jimmy on March 31, 2006 at 12:41:55:

sounds like you are in the ballpark, but I’m not sure you are right about the $20 gain. There are rules in the tax code known as the OID rules (Original Issue Discount) and and AMD rules (Accrued Market discount). OID deals with debt instruments issued with a discount. they would not apply here. The AMD rules deal with existing debt instruments acquired at a discount. I think they do apply. If I’m right, the $20 would be considered AMD, which, as I recall from a tax class 20 years ago, is ordinary income and not capital gain.

I reserve the right to be wrong!!!

Re: note taxes question - Posted by Bob Smith

Posted by Bob Smith on March 31, 2006 at 16:41:59:

Am I right about reporting interest payment? Reporting them on Schedule A as investment interest rather than business interest is seriously awful, because it makes your interest deduction subject to AMT rules and deduction phaseouts.

From Publication 550, Page 15: “When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply: You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount”

From Publication 550, Page 49: “Treat your gain or loss on the sale, redemption, or retirement of a bond or other debt instrument originally issued at a discount or bought at a discount as capital gain or loss, except as explained in the following discussions.”

Since I, like most note buyers, choose to accrue the discount using the constant yield method, the clause noted above from page 15 doesn’t apply. I conclude that means any amount received in a redemption or retirement must be capital gain, long or short depending on my hold period.