Rental Property Expense?

[Koss]

Individual taxpayer owns rental property, with income and expenses reported on Schedule E.

Independent contractor provides services to the taxpayer in connection with the rental property, such as repair, maintenance and management services. Assume for the sake of this discussion that the independent contractor status is not in doubt.

Instead of paying the contractor, the taxpayer gives him a promissory note.

Is this a deductible business expense?

Someone is going to say: No, not if the taxpayer is on the cash method of accounting, because he hasn't actually paid for the services yet.

But how is this any different than if he paid for the services with a credit card, or with money that he borrowed from some other source?

BMK

[MichaelG]

It isn't the same because, if the property owner had used a credit card or borrowed $ from someone else, the contractor would have received $ in 2012 and (presumably) reported it as 2012 income. Since the contractor only has a promise to be paid and hasn't actually received any $, he doesn't include it in his 2012 income. So the property owner won't be able to deduct anything until the contractor is actually paid hard, cold cash.

[Roland Slugg]

Yes, but the amount deductible is limited to the FMV of the promissory note, if less than face value. The deductible amount is equal to the amount reportable as income by the person who performed the services. See Code §83(h) and Regs §1.61-2(d)(4).

[Koss]

Promissory Note

Roland Slugg wrote:

the amount deductible is limited to the FMV of the promissory note, if less than face value.

This makes sense. But how do you determine the FMV of the promissory note?

MichaelG wrote:

Since the contractor only has a promise to be paid and hasn't actually received any $, he doesn't include it in his 2012 income. So the property owner won't be able to deduct anything until the contractor is actually paid hard, cold cash.

I don't think I agree with this analysis. Whether the contractor has income is a separate question. I think in this case the contractor does have income, even assuming that the contractor is also on the cash method. But I also think that whether the contractor has income is irrelevant. The tax treatment of the party making the payment is not always a mirror image of the tax treatment of the party receiving the payment; one does not hinge on the other.

If the property owner writes a check and puts it in the mail on December 30, he has a deductible expense. If the contractor does not receive the check until January 2, he reports the income in the following year, even though the property owner took the deduction in the previous year.

That's not what happened here. But it is a simple, well-known example that demonstrates that the treatment by one party is not dependent on the treatment by the other party. In preparing the tax return for the property owner, I have no way of knowing when the contractor received the check--and I don't need to know. The contractor is not my client, and it is totally irrelevant.

MichaelG, I think you are confusing this scenario with a situation where the contractor has billed the customer for services, on an "open account," or "net 30" basis, and the customer has not made payment as of the last day of the year. That's not a promissory note. It's an unpaid bill, that may or may not be past due. The customer may have a contractual obligation to pay, and in that sense it is a "promise to pay." But it is not a promissory note. A promissory note is a negotiable instrument that has an immediate, present value to the holder of the note.

I think Roland Slugg is on the right track...

BMK

[Burke]

I don't think I agree with this analysis. Whether the contractor has income is a separate question. I think in this case the contractor does have income, even assuming that the contractor is also on the cash method.
BMK

I don't think so. The contractor has received nothing but a promissory note. That is not income. And the payor (note signer) has not paid anything yet either, so I don't see how he can have a deductible expense. I agree with Mike G. I will agree that the promissory note has a certain value as an asset to the issuer and as such, it could be sold for value -- at which time the issuer would be in receipt of income. But other than an accounting figure for a business or an estate, it is not an expense. It would be on the balance sheet, not the P&L. As for the note-holder (i.e, the contractor), he has a note of certain value which can be filed against the payor in court as a judgement; but he would not report income until actual cash passed to him.

[Roberts]

I'll gladly pay you Tuesday for a hamburger today.

[Burke]

Roland Slugg wrote:
This makes sense. But how do you determine the FMV of the promissory note?
BMK

There is a mathematical formula for finding present value of a future benefit. It is based on the future value (FV), the rate of return (r) (interest rate) and the term of the payment period (n). It is PV = FV X 1/(1 + r)n.

[Gene V]

Promissory note

IRS says you can’t deduct promissory note for charitable contribution—I wonder if that holds true
for business expenses?

From Pub. 526
Promissory note. If you issue and deliver a promissory note to a charity as a contribution, it is not a contribution until you make the note payments.

[taxea]

Yes, but the amount deductible is limited to the FMV of the promissory note, if less than face value. The deductible amount is equal to the amount reportable as income by the person who performed the services. See Code §83(h) and Regs §1.61-2(d)(4).

trust me, the contractor is not going to show this as income until he receives the money. I trust you meant "rental expense" not business expense in your original post?
Did the property manager/contractor show this expense on his detailed end of year report? Is he or the TP collecting the rents? She would not be issuing a 1099 to the contractor if she were filing a Sch C because the work hasn''t been paid for.

A promissory note is like an installment loan. Principal and interest are deducted when paid.

[DexEA]

Hmmm

A promissory note is like an installment loan. Principal and interest are deducted when paid.

When an item is paid for with proceeds from an installment loan I thought you CAN take the deduction (whether fully deductible or depreciated) for the principal purchase plus interest actually paid in the current and each year after. Either you've been doing it incorrect or I've been doing it incorrect.

[Koss]

Installment Loan

taxea wrote:

A promissory note is like an installment loan. Principal and interest are deducted when paid.

So... if I have a business vehicle that needs repairs... and I don't have the money... so the mechanic at my local mom-n-pop auto repair shop agrees to take a promissory note...

I can't deduct the expense of the repairs until I actually make the payments??

How is this different than using my Firestone Credit Card to pay for the repairs? Or borrowing the money from my cousin, with a promissory note?

Why does it somehow make a difference that the holder of the note is also the guy who performed the services?

On this reasoning, taxea, if I pay tuition with borrowed funds, then I can't take the education credit until I actually make the loan payments...

Right?

BMK

[erchess]

My two cents

Burton you are attempting to impose on the tax code a requirement that its provisions make some kind of coherent sense. I do not know the answer to your question. We all know that if the landlord paid the expenses in cash or if he used a credit card that is not sponsored by the contractor or if he borrows funds from about any lender except the contractor and makes the payment then he has a current tax deduction. I don't know what if he gives the contractor a promissory note or pays with a credit card issued by a bank the contractor owns in whole or in part. I do know that in general businesses set up or use banks distinct from themselves to issue their credit cards and in such a case the landlord would have a deduction.

[taxea]

IRS says you can’t deduct promissory note for charitable contribution—I wonder if that holds true
for business expenses?

From Pub. 526
Promissory note. If you issue and deliver a promissory note to a charity as a contribution, it is not a contribution until you make the note payments.

and what happens if you never pay them?

[DexEA]

and what happens if you never pay them?

If you never pay them....you never deduct them.

[Burke]

So... if I have a business vehicle that needs repairs... and I don't have the money... so the mechanic at my local mom-n-pop auto repair shop agrees to take a promissory note...

I can't deduct the expense of the repairs until I actually make the payments??
How is this different than using my Firestone Credit Card to pay for the repairs? Or borrowing the money from my cousin, with a promissory note?
On this reasoning, taxea, if I pay tuition with borrowed funds, then I can't take the education credit until I actually make the loan payments... Right? BMK

Mike G answered this point in his post. With a credit card the recipient has received his money from the credit card provider. He reports it as income. The payor deducts it because the entire bill (expense) has been paid and he now owes the CC company the money -- like an installment loan if you wish. If you borrow the money from a bank and pay for a deductible expense, you can write it off right then and there in full, as the payee has received his funds. If you borrow $$$ for tuition, you deduct it in the year it is paid to a college, even though you pay the loan back much later. A promissory note to a vendor is nothing more than an IOU. It may never be paid.