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jgordosea, Enrolled Agent
Category: Tax
Satisfied Customers: 3161
Experience:  I've prepared all types of taxes since 1987.
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My client loaned a friend $100x to buy the friends ...

Resolved Question:

My client loaned a friend $100x to buy the friend''s principal residence 2 years ago. Accrued interest of $14k on the loan has been added to the principal balance. The accrued interest has not been paid, so was not deducted by the friend or included as taxable income by my client. In 2008 interest will be paid on the loan as well as some of the loan principal. Will the loan principal be 100% taxed up to the accrued interest, or taxed on some part only? If some part only, is taxable part $14k/($100k+$14k), or something else?
Submitted: 9 years ago.
Category: Tax
Expert:  jgordosea replied 9 years ago.


There is no general formula for the situation which you descirbe because the terms of the note will dictate the amount of principal and interest of any particular payment. Generally it is not possible to change the terms of a promissory note for tax purposes without changing the agreement.

It could be all interest or could be 14K interest or could be some other amount depending on the terms of the note. Most notes are written so that all of the paymnet will go to pay the accrued interest until the interest payments are up to date. If you can not justify any of the payment being principal from the terms of the note then it will be all reportable as interest.

I hope this helps for determing the interest portion of hte late payments.


jgordosea and 2 other Tax Specialists are ready to help you
Customer: replied 9 years ago.
Your experience is that the IRS will follow the term of the note in determining taxation of accrued interest? Or is it enought that my client and friend are consistent in their reporting?
Expert:  jgordosea replied 9 years ago.

Hello again,

Yes, it is the written agreement and not some later unwritten corroboration that will rule (especially if a court becomes involved).

Consistent treatment by both parties does not consitute correct treatment for tax purposes. The area with the most cases, for an example, would be that agreement between an employee and the employer to be treated as an independent contractor has no bearing on the determination from the facts and circumstances if there was or was not an employee/employer relationship. Saying it is does not make it so.

If the client wants to renogiatate the terms of the loan going forward then a different result can apply to payments received after the renegotiation.

I hope this helps to clarify for you. Best regards.


Customer: replied 9 years ago.
Because I doubt the note addresses this issue, I'll suggest my clients add an addendum to the note to clarify treatment of principal repayment.