Rental Property Expense?

[Koss]

Paid with borrowed funds

Burke wrote:

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.

But what if the taxpayer borrows money from a bank to pay business expenses, and then never make any payments to the bank?

In that case, it is still income to the vendor, because the vendor actually got paid. Meanwhile, on the taxpayer side, he gets the deduction in the year he took the loan and paid the expense. If he never pays the loan, he may well have income from cancellation of debt in a later year...

What Burke, MichaelG, and others seem to be saying is that there is a substantive difference in how this type of transaction works when the taxpayer gives a promissory note to the vendor instead of a third party lender.

I agree that this may well change the treatment for the vendor, in the sense that the vendor may not report the income until the he receives payments on the note. But I don't see exactly how that changes anything for the taxpayer who issued the promissory note...

I recognize that there IS an important difference between borrowing from a third party versus issuing a promissory note directly to the vendor. And maybe that does in fact have an impact on how the taxpayer treats the item.

But I'm not buying the argument that the taxpayer's treatment is somehow determined by whether the vendor reports it as income. I think there is more to it than this...

BMK

[Koss]

Further thoughts...

I have begun to research this question in greater depth. There appears to be some case law to support the position that a promissory note given to the vendor is not a deductible expense in the year in which the note is issued. But the issue is not as clear-cut as it seems.

I haven't found any case law that is directly on point.

It hinges on what it means for an expense to be "paid" when the taxpayer is on the cash method, and whether the issuance of a negotiable instrument falls within the meaning of the word "paid" in this context.

In 1976, the US Supreme Court took up this question, and ruled that the issuance of a promissory note did NOT allow an employer to take a deduction for a contribution to an employee profit-sharing plan. But the decision specifically referred to "statutory policy that the profit-sharing plan receive full advantage of any
contribution that entitles the employer to a tax benefit." So in this particular fact pattern, the Court came to the conclusion that the applicable law, which involves profit-sharing plans, effectively requires that the profit-sharing plan receive full payment, with unrestricted rights to the money, in order for the employer to claim a tax benefit.

This principle is not necessarily applicable to ordinary business expenses, because the party receiving the payment is not a profit-sharing plan.

But it does lend support to the notion that under certain circumstances, the manner in which an item is treated by the payee can have an impact on how it is treated by the party making the payment...

I haven't reached a conclusion. I'm still studying this. I appreciate everyone's input.

BMK

[taxea]

taxea wrote:



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

If you put it on a credit card the card pays the bill in full. If you sign an installment loan the bill is paid in installments. If you borrow the money from your cousin to pay the bill it is paid in full. You will pay your cousin back in installments and that would (if a business loan) be expensed as paid

[Burke]

But what if the taxpayer borrows money from a bank to pay business expenses, and then never make any payments to the bank?
In that case, it is still income to the vendor, because the vendor actually got paid. Meanwhile, on the taxpayer side, he gets the deduction in the year he took the loan and paid the expense. If he never pays the loan, he may well have income from cancellation of debt in a later year...

I agree with this.

What Burke, MichaelG, and others seem to be saying is that there is a substantive difference in how this type of transaction works when the taxpayer gives a promissory note to the vendor instead of a third party lender.

That is correct.

But I'm not buying the argument that the taxpayer's treatment is somehow determined by whether the vendor reports it as income. I think there is more to it than this.....BMK

I don't either. Did I say that? I don't think so.

[DexEA]

If you put it on a credit card the card pays the bill in full. If you sign an installment loan the bill is paid in installments. If you borrow the money from your cousin to pay the bill it is paid in full. You will pay your cousin back in installments and that would (if a business loan) be expensed as paid

If you borrow the money from your cousin to pay the bill it is paid in full. You will pay your cousin back in installments and the interest would be expensed as paid, however your purchase, if a business expense is deducted at the time of purchase, not as you pay back your cousin.