First, let me say this: I am fairly certain that the taxation of acquired judgment payments has been addressed at some point in the past, whether by statute (congress), regulation (Treasury), or case law (tax court, court of claims, appeals courts, etc.). I have never researched the issue, and do not know the specific answer. and neither have you. I can cite some general rules which apply in related situations. and you can cite some very generalized IRS publications. The specific will always trump the general. You, or your advisor, need to go the the law library, and stick your nose in one of the tax services. I prefer the RIA and BNA services.
to your specific points:
if the AMD is taxed as ordinary income, and so is the interest, then you just made ALL of the income ordinary income, and there is no capital gain potential. that was my point about notes not being capital assets.
a layman will find many aspects of the tax code confusing. I’m a 20+ year tax lawyer, and I find parts of the tax code confusing (the ones I don’t use very often, like the OID/AMD rules). You have to understand that the tax code is enacted by congress, which makes it a 100% political organism. ordinary v. capital is easy enough to understand. you have a sale or other disposition of an asset. the issue is whether the gain/loss is ordinary or capital or personal. there is a ton of law out there governing what is a capital asset. Gains will be either capital or ordinary. Losses can be capital, ordinary or personal. [it may seem unfair, but a gain from your personal residence can be taxable if high enough, but a loss is non-deductible]. The portfolio/passive distinction came about in 1986. the idea was to limit the deductibility of losses from “passive activities.” What they were targeting were the proliferation of real state limited partnerships which generated tons of losses for investors with little chance of profit. With some exceptions, passive losses are only deductible against passive gains or income. Portfolio income (dividends, interest, OID, AMD, royalties) are explicitly NOT passive, so we can’t offset the portfolio income with a passive loss. Bottom line: once you understand why a particular rule is there, it easier to understand.
I did not suggest that YOU were buying too many judgments. My point was that its easy to convert a capital aset into a business asset. That’s what “dealer” status is all about.
hot assets refer to assets that will always create ordinary income. they are “hot” and ths need to be handleD carefully. inventory, receivables, notes are classic examples. and by the way, the least favorable variety of ordinary income is employment income (or income from a trade or business activity).
What kind of income does a judgment produce? - Posted by Bob Smith
Posted by Bob Smith on November 21, 2006 at 18:27:25:
I buy a $3,000 judgment for $300. I receive a payment in full of $2000, for a profit of $1700. What kind of income have I received? Interest? Is the answer different if I buy judgments on a regular and continuing basis?
Same judgment. I receive 30 monthly payments of $100. Again, is the gap between basis and face value interest income to me, or something else?
the easy part is this: judgments usually accrue interest at a rate established by state law (the “statutory rate”). whatever portion of your collections represents interest is treated as such for tax purposes.
now the hard part: if the judgment is one you secured as a plaintiff (not your facts, but bear with me), then you would look to the nature of the judgment award to determine how to characterize them for tax purposes. if the court awarded you back rent, then the cllections would be treated as rental income. if the award was for a personal injury, the collections would be excluded from taxation.
but you are not the plaintiff here. you are an unrelated third party who buys judgments. I do not know the answer, but I can give you three possible tax scenarios.
a. capital assets. it is possible that these judgments would be treated as capital assets, which would prodice capital gains or losses. [I doubt this is the proper treatment].
b. Trade or business income. If you do enough of these deals, you activities may constitute a trade or business for tax purposes. this creates ordinary income, and is potentially sunject to the full slate of employment taxes.
c. buying existing judgments which carry the statutory interest rate is VERY MUCH like buying existing notes. and there is a full set of rules governing the taxation of acquired notes (the AMD rules–accrued market discount). It would not surprise me if what you are doing would come within these rules, or within a similar arrangement. the bottom line is this: an acquired note is not a capital asset, and any gain or loss is not capital in nature.
when your tax advisor researches this and gets you a concrete answer, be sure to post it here.
Hi Bob, sorry to disapoint, but I have no answer for you,but I do have a question. I am interested in buying judgements as well, but have never done it. Do you just go to the courthouse and find the judgements in the public records, and contact the lien holders and offer them money? Thanks for any help you can give me.
I think (c) is the real answer. Market discount is treated as capital gain (loss) on a redemption (full payoff) and as interest when received over time as periodic payments. (b) doesn’t make sense, unless you’re buying to resell. Why would buying many capital assets turn them into non-capital assets?
Its been 17 years since I studied the OID and AMD rules of Sections 1272-76 of the tax code. and I never reallly encountered them in my practice. so I reserve the right to be WRONG.
but. my understanding is that the AMD is treated as ordinary income, as is OID. I think Section 1276 says so in its first sentence. and it is taxed as it is collected.
I’m not going to argue aboue what is, or is not, a capital asset. the AMD rules trump that classification. there have always been special rules for notes, inventory and receivables. these are “hot” assets in the tax law, and create ordinary income.
and YES, you absolutely can convert otherwise capital assets into non-capital assets (inventory). If you buy and sell 10 homes in a year, you will be considered a dealer, and the houses are your inventory.
Posted by Bob Smith on November 24, 2006 at 17:56:19:
>my understanding is that the AMD is treated as ordinary income, as is OID. I think Section 1276 says so in its first sentence. and it is taxed as it is collected.
How does that contradict what I said? Interest was, the last time I looked, ordinary income.
The tax code seems to confusingly use “ordinary” in two senses: ordinary vs capital, and ordinary vs portfolio vs passive. Interest is ordinary/portfolio. Rents from real property are ordinary/passive. Discount is treated as interest according to the relevant publication.
As to conversion of capital assets to non-capital, I was responding to the implication that buying “too many” judgments turns them into business assets, and therefore producers of self-employment income. Note I never said I was buying and selling them, I was just buying them.
I’m note sure what you mean by “hot”, but notes produce portfolio income unless they’re compensation for services or consideration for the sale of inventory (see instructions for both form 1065 and schedule C), in which case the interest therefrom is self-employment income.