Accounting question

[oceanlovin'ea]

Client has rental house in a partnership LLC - They refinanced the mortgage last year and have an adjustable rate mortgage with 4 payment options.

Because of deferred interest, the balance on the loan is higher than when they started loan. I'm having trouble making the correct entry to reflect the interest that was deductible for the year, the correct loan balance and knowing what account to put the deferred interest into. I looked in the QF bookkeeping book and it told what deferred interest is but not what to do with it.

Can anyone help?

Thanks.

[Joe Btfsplk]

Deferred Interest

If the interest is not paid, it is not deductible. It sounds like a negative amortization loan in which the payment covers none of the principal and only part of the interest. The unpaid interest is added to the principal making the mortgage increase each month until, eventually, the chickens come home to roost.

[OldJack]

Will for simplification I would, in Quickbooks, charge/debit the full payments made on the loan to the liability account. Then I would make a general journal entry debiting interest expense and crediting the loan account to bring the loan account up to the actual loan balance. The only question here then, is does the interest expense qualify for a tax deduction. I would probably contend that it does qualify as a deduction as this is business interest expense and that the added loan was simply a way to pay the interest.

If the interest is not deductible then a deferred interest account should be setup in the other assets category of the balance sheet and the debit would go there until actually allowable as a deduction.

[jainen]

excellent question!

>>does the interest expense qualify for a tax deduction<<

What an excellent question! And a good answer, OldJack. I agree with you on this one! Although the deferred interest was not used to acquire the subject property, it does have a clear business purpose other than increasing a tax deduction.

It improves cash flow management for business operations in the same way a line of credit does, and it shields the property from foreclosure when payments lag. Joe says the chickens will eventually come home to roost. Hopefully, that is true because you can't collect any eggs until they do.

[Zee]

OK. I'll disagree with the two heavyweights here

>>does the interest expense qualify for a tax deduction<<

What an excellent question! And a good answer, OldJack. I agree with you on this one! Although the deferred interest was not used to acquire the subject property, it does have a clear business purpose other than increasing a tax deduction.

It improves cash flow management for business operations in the same way a line of credit does, and it shields the property from foreclosure when payments lag. Joe says the chickens will eventually come home to roost. Hopefully, that is true because you can't collect any eggs until they do.

In my opinion, the deductibility of the deferred interest would depend on whether the taxpayer reports on a cash or accrual basis. An accrual basis taxpayer would deduct the interest as the liability was incurred, a cash-basis taxpayer would deduct the interest when paid. If the client is a tax-basis taxpayer, it would be helpful to separately account for the deferred liability so it can be deducted as paid. It might be possible to reduce the deferred amortization before the loan maturity.

[Snaggletooth]

Deductible Interest Exists

...in any case under any treatment, even under cash basis accounting. Yes, a third answer, but true.

The interest under this loan arrangement is accumulating faster than it can be paid. As such, NONE of the payments are principle. The entirety of payments made under this loan scenario are all interest and no principle because none of the chickens are coming home to roost. And ALL of the interest paid is deductible. The amortization schedule will show this, and it will also show application of interest greater than what is being paid.

Only that portion of interest which represents the increase in principle balance is in question. An accrual basis taxpayer must report the higher principle and the interest which occurs because of this for financial purposes.

I believe there is a special regulation which limits deductible interest to the amount paid, even for an accrual basis taxpayer. The reportable (but non-deductible) interest becomes a "timing difference."

Maybe this can be best illustrated. Taxpayer borrows $500,000 on a 6% loan. Loan is in effect for 6 months in 2006. In the early years of the loan, payments are only $2300 per month. Interest for the first month alone is $2500 and is being assessed faster than the payment can retire even the interest. After 6 months, the principle balance is $501,215.

Interest PAID is $13,800 which is the total of all 6 payments. The principle balance has grown to $501,215. This means the actual interest expense is $15,015, which consists of the interest paid plus the additional $1215 added to the principle. There will be an interest deduction of $13,800 regardless of which position you take on the additional $1215.

[OldJack]

This is business interest expense and not limited like home mortgage interest on refinancing.

Contrary to some people's thinking cash basis does not just mean a disbursement from a checking account!! This interest has been paid by way of loan proceeds, much the same as if the loan had been paid to the taxpayer and the taxpayer then wrote a check from the checking account paying the interest. The loan company is not going to charge the same interest on the same balance again so any deferral is in the mind of the debtor.

I would also point out that proof of payment is covered by Rev Proc 92-71 where it says that a statement can be used as proof of payment.

.03 An account statement prepared by a financial institution showing a credit card charge ( i.e. , an increase to the cardholder's "loan" balance) will be accepted as proof of payment if the statement shows:

1. the amount of the charge,
2. the date of the charge by the cardholder ( i.e. , the transaction date), and
3. the name of the payee.

edit: Therefore in Snag's example $15,015 has been PAID. If the taxpayer is on the accrual basis then there probably is additional interest that should be accrued for interest due between the last payment/loan and the last day of the year.

[oceanlovin'ea]

interest deductibe

is part of the question.

Refinanced mortgage in June. Closing statement shows $364 on interest paid at closing by client.
Six payments of $1019.12 were made for a total of 6114.72. 1098 shows 6478.72 which is the total of the 6114.72 and 364.00.

Balance of loan started out at 374,400.00 and ending balance on 12/31 was 382,667.87 which is 8267.87.

I posted the payments to the loans payable account. So I need to make a journal entry that debits Mortgage interest expense and credits the loan payable. Then another entry to credit loans payable and debit a new asset account called Deferred Interest.

I can only deduct the mortgage interest that shows on the 1098. Is that also correct?

Most of this I had figured out but wanted to have confirmation. Also I wasn't sure what asset account should be debited or if a new account should be set up.

Thanks for all your help.

Linda F

[Davc]

This is business interest expense and not limited like home mortgage interest on refinancing.

Contrary to some people's thinking cash basis does not just mean a disbursement from a checking account!! This interest has been paid by way of loan proceeds, much the same as if the loan had been paid to the taxpayer and the taxpayer then wrote a check from the checking account paying the interest. The loan company is not going to charge the same interest on the same balance again so any deferral is in the mind of the debtor.

I would also point out that proof of payment is covered by Rev Proc 92-71 where it says that a statement can be used as proof of payment.


edit: Therefore in Snag's example $15,015 has been PAID. If the taxpayer is on the accrual basis then there probably is additional interest that should be accrued for interest due between the last payment/loan and the last day of the year.

Not the same. When you pay with a bank CC the other party has been paid. When you "pay" with an increase in the loan balance they haven't.

[peggysioux]

Old Jack,

So, if taxpayer had a construction loan on home which is accruing interest and he received a 1098 showing interest for loan in 2006, but taxpayer did not make payments in 2006 (interest will be paid by adding onto new loan in 2007 at end of construction), would taxpayer be able to deduct the interest shown on the 1098 based on your explanation that interest is being added on to loan, thus basically being paid?? If not deductible in 2006, would the interest shown on the 2006 1098 ever be deductible?

[Zee]

Not the same. When you pay with a bank CC the other party has been paid. When you "pay" with an increase in the loan balance they haven't.

I agree, the interest hasn't been "paid with loan proceeds", or any other form of payment. It's simply additional interest added to the liability by the lender. There's no question, the additional amount is "interest", and the entire original payment is also interest. The question is when is it deductible (timing as noted in the other post)? In my opinion, it becomes deductible when it is "paid" not when it's recorded. It's most likely correct that a cash-basis or accrual basis taxpayer would treat the interest expense the same. Hopefully, the Tax Book author's will provide their thoughts.

[OldJack]

If not deductible in 2006, would the interest shown on the 2006 1098 ever be deductible?

Interest on a construction loan must be capitalized as part of the cost of the property and is therefore deductible as cost when the property is sold.

[OldJack]

Not the same. When you pay with a bank CC the other party has been paid. When you "pay" with an increase in the loan balance they haven't.

If you audited the loan company books you would see that indeed they treat it as income as to them it is paid and taxable income. They have double entry bookkeeping that requires them to debit/increase the loan receivable and credit/increase interest income for the interest added to the loan.

[GIMoe]

Construction loan

Interest on a construction loan must be capitalized as part of the cost of the property and is therefore deductible as cost when the property is sold.

So, would you say that this is true if the T/P actually made payments (which are usually interest only) on the construction loan and received a 1098 for interest paid? Or, is it just when the interest is added back into the loan and no payments have been made?

[Zee]

If you audited the loan company books you would see that indeed they treat it as income as to them it is paid and taxable income. They have double entry bookkeeping that requires them to debit/increase the loan receivable and credit/increase interest income for the interest added to the loan.

I'll be darned...that appears to be true. Banking accounting rules allow the banks to record negative amortization as income. During Jan-Mar, 2005, Washington Mutual recorded $25 million of NA as income and in the same period Jan-Mar 2005, they recorded $203 million.
Old Jack, you may be right. I wonder if the banks will include the negative amortization on the 1098 forms?