Debt has been a ubiquitous form of finance for millennia, and one might reasonably assume that we have a good handle on exactly what it is by now. It turns out that may not be the case.
A loan is commonly understood as the lender’s transfer of funds to the borrower on condition that the funds be repaid, with interest due in the interim. That is, the transaction is framed as a swap of loan proceeds on one hand for promises to pay interest and the amount borrowed back on the other. Call this the “standard view.” Under it, the receipt of the loan proceeds is treated as a net zero for balance sheet purposes because of the offsetting liability entry on the ledger. Further, as principal is repaid, the reduction in cash assets is matched by a reduction in the liability due, so that the net of the borrowing remains zero going forward.
As in other areas of the law, in the tax area, the standard view has long served as the factual substrate to which legal rules governing borrowing transactions apply. In the tax case, the main rules are as follows:[1]
- The borrower has no inclusion in income on receipt of the loan proceeds, and the lender has no deduction;
- Notwithstanding the preceding rule, the borrower has full basis in the loan proceeds, while the lender has full basis in the borrower’s note;
- Repayment of the loan likewise triggers neither a deduction for the borrower nor an inclusion for the lender; and
- Cancellation of the debt typically triggers an inclusion for the borrower and either a loss or a bad debt deduction for the lender.
Despite the fixity of the rules, plenty of controversy has arisen over the years about whether they are correct. On reflection, it is not hard to see why. Ordinarily, the receipt of untaxed value triggers immediate income to the recipient, while an uncompensated outflow reflects some kind of loss.[2] Moreover, in most of the relatively uncommon cases in which Congress has provided an exception to the usual rules for inclusion and deduction, special rules apply that preserve pre-transaction basis in assets involved in the transaction: Recipients of appreciated gifts are not taxed on the gift but take the donor’s basis;[3] parties to “like-kind” exchanges are not taxed on the exchange but generally assign a basis in the property they receive equal to the basis in the property they parted with in the deal.[4]
These principles might suggest a follow-the-cash approach under which the borrower is treated as having income on receipt of the loan proceeds and a deduction on repayment. Or they might suggest that if a non-taxation regime applies, the borrower at least should not receive basis credit in the loan proceeds. Parallel treatment should apply on the lender side in either case.
I began puzzling about these matters because the tax rules seem both intuitive – Would we really want to include loan proceeds in the base and deduct their repayment? – and hard to defend. Ultimately I came to the conclusion that the problem lies not in our understanding or application of tax principles, but in our understanding of the loan transaction itself, a conclusion that has ramifications beyond the issue of how to tax debt. In a recent paper,[5] I argue that the operative tax rules are mostly correct – and the critical commentary mostly misguided – but that the standard view is wrong. A loan is not a swap of the loan proceeds for promises to pay interest and to return the funds at the term; this description mistakes the facts on the ground for the operative legal relations. Rather, a loan is closely akin to a lease. When so conceived, the tax rules previously described make perfect sense. (Other tax rules don’t, but I won’t dwell on them here.[6])
Before getting to the reasons that support the lease analogy, it is useful to think about leases and the tax rules that apply to them. For the most part, these rules are straightforward. Although the lessee takes possession of the property at the onset of the leasehold and must vacate at the term, no one thinks she has received the underlying property in exchange for an offsetting promise to return it. Rather, the possibility of the lessee’s retention of the asset beyond the term, though entirely real, is incidental to the parties’ deal, which is use of the property during the term in exchange for rent. In terms of the legal relations, what is transferred are use and rent. That is, the sale is of a time slice of the subject property.
Consistent with this basic understanding, the lessee, assuming she pays cash rent, has no income on receipt of the leasehold; rather, because she receives only the use for the term (and not the underlying property) and pays for that use in ongoing, arm’s-length cash transactions (rental payments), she has no gain or loss realized.[7] Further, she has a basis in the leasehold equal to its cost, which by hypothesis is equal to the value of the leased property for the periods (and only the periods) for which she pays rent.[8] Finally, the end of the lease is considered an extinguishment of the legal interest, not a repayment of the underlying property to the lessor, so there is no “transfer” or “outflow” at that time.
Now consider a loan. Although a loan differs from a lease in some respects, the basic legal incidents are roughly the same. The borrower purchases a time-slice of the cash (“liquidity”) for “rent” consisting of interest. Because the borrower pays for the liquidity on a contemporaneous basis with after-tax dollars, the transaction does not differ for tax purposes from any other cash purchase: no income (or loss) on receipt and full basis credit in the property purchased, which in this case is basis in the cash for the periods for which interest is paid (and only for those periods). That basis is face amount because interest represents the fair market value of the use of the funds for the period to which it relates, assuming the borrowing is an arm’s-length transaction. Finally, if the loan is canceled because of uncollectability, the borrower has income in the form of an immediate accession to the “remainder,” just as would a lessee in the unlikely event the lessor abandoned the property at the end of the lease term. That is, cancellation does not represent a failure to transfer back to the lender, but a new transfer from the lender to the borrower.
Finally, consider the strength of the analogy. Is a loan really like a lease of cash? The main issue is whether the principle that there is no transfer and retransfer of legal ownership of the underlying property on commencement and termination of the lease applies to a loan. To see why the answer is yes, begin with a riskless loan. For such a loan, there is by definition no chance that the borrower will not return the proceeds at the term, which means the borrower acquires literally no interest in the loan proceeds beyond the term. That means, in turn, that as a legal matter, the “remainder”—the use of the proceeds beyond the loan term—remains at all times with the lender. In such a case, there is no reason to treat the deal as anything other than interest for use of the funds during the loan term. There is no obligation to return because there is nothing to return. At least in this case it is clear that the deal is nothing more than use for interest.
In almost any operative loan, of course, the risk of non-return is real, but this complication doesn’t change the fundamental nature of the arrangement any more than the prospect of damage to or destruction of the underlying property in a leasehold changes the essential nature of the lease as a time-slice purchase. Rather, the parties to a loan account for risk of loss by means of other contemporaneously created incidents to the transaction. These may include the provision of collateral, limitations on the borrower’s conduct, or a right of monitoring by the lender; most typically however, and most significantly, they include a higher interest rate (a risk premium), which functions not technically as payment for liquidity but rather more like insurance. Focusing again on the tax rules, the prospect of risk of loss should have no effect because, just like liquidity, it is paid for contemporaneously with after-tax cash. That is, the risk premium is just another cash purchase. The same basic tax analysis applies.
Are there lessons to be learned beyond the tax treatment of borrowing? Because the tax analysis follows from the reconsideration of the underlying legal relations, the answer may well be yes. The paper’s most significant conclusion is that it does not really make sense to speak of a “transfer and transfer back” of legal rights when the second transfer is legally required at the time of the first. Such an arrangement is really a transfer only of the use between the two endpoints. That use can be largely unfettered, as in most consumer credit, or it can be something less than that, as when loan proceeds are required to be used for a particular purpose (think “green lending”) or the parties agree that leased property is to be used for one purpose rather than another. In all events, the deal concerns what happens between the two physical transfers, and not beyond.
ENDNOTES
[1] For a discussion of the basic regime and its history, see, for example, Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts ¶ 7.1. A separate set of rules applies to the treatment of interest expense, which, roughly speaking, is deductible when paid on debt incurred for business reasons and not when paid on debt incurred for personal reasons. § 163(a), (h). All section citations are to the Internal Revenue Code of 1986, as amended.
[2] §§ 61(a) (income includes income from any source derived), 165(a) (permitting a deduction for certain losses).
[3] §§ 102(a) (no income to recipient of a gift); 1015(a) (donee takes donor’s basis in appreciated property).
[4] § 1031(a) (non-taxation of party to a like-kind exchange); 1031(d) (exchanged basis in property received in the exchange).
[5] 12 Columbia J. Tax Law 89 (2021).
[6] The most significant problems lie in the disparate tax treatment of cancellation of recourse and nonrecourse debt and the rules for basis allocation of partnership debt. See id., at 109-14 (cancellation of debt) & 117-23 (partnership debt).
[7] See § 1001(a).
[8] § 1012(a).
This post comes to us from Professor David Hasen at the University of Florida’s Levin College of Law. It is based on his recent article, “Debt and Taxes,” available here. The author thanks his colleague Peter Molk for valuable insights.