The use of borrowed money is not free. A person pays for the use of another’s money by paying interest, and the amount of interest depends on the length of time the borrower does not repay the
borrowed money. The payment and receipt of interest have certain tax consequences. Payment of interest might be deductible from a taxpayer’s ordinary income. *See* § 163. The recipient
of interest realizes gross income. *See* 61(a)(4). Lenders and borrowers usually create loans with another transaction in mind, e.g., purchase of property, investment. *Those*
transactions generate certain tax consequences that may differ from the tax consequences of payment of interest, e.g., taxation of capital gains at a rate lower than the tax rate on ordinary
income (*see* chapter 10, *infra*), realization of gain or loss only upon sale or exchange of the underlying asset rather than on an annual basis (*see* chapter 9,
*infra*). The Code has certain provisions that create and carve out an interest element in various transactions.

Consider: (1) Clifton Corporation issued $10M worth of bonds on January 1, 2006. For each $10,000 bond that an investor purchased, Clifton Corporation promised to pay $15,007.30 on January 1, 2012. Taxpayer Linda invested $10,000 on January 1, 2006 in Clifton Corporation bonds. She held the Clifton Corporation bonds until their maturity on January 1, 2012 at which time Clifton Corporation paid her $15,007.30. Obviously, Linda realized $5007.30 of interest income. When? Obviously, Clifton Corporation paid $5007.30 in interest. When?

(1a) Suppose that Linda had sold the Clifton Corporation bond on January 1, 2009 for $13,000. Obviously (?) Linda realized a total of $3000 of income. When? How much of it was interest income and how much of it was gain derived from dealing in property? The Buyer would have a $13,000 basis in the bond. How should Buyer treat his/her/its eventual receipt of $15,007.30? When?

(2) Seller agreed to sell Blackacre to Buyer for $3,500,000. Seller’s basis in Blackacre was $2,500,000. The terms of the agreement were that Buyer would pay Seller $350,000 every year for ten years. The parties stated no other terms of their agreement. Assume that Buyer made all of the required payments. Upon fulfillment of all of his/her/its obligations, what is Buyer’s basis in Blackacre? How much interest income must Seller recognize in each of years 1 through 10? How much must Seller recognize as gain derived from dealing in property?

These transactions all involve the unstated payment and receipt of interest. Sections 1271 to 1288 and 483 1 deal with variations of the issues that these hypothetical fact patterns raise. Our concern is with basic principles and not the details of implementation. These provisions essentially “read into” the parties’ agreements the payment and receipt of interest annually and require tax treatment to track such an inclusion of interest. The effect of such requirements is that the parties must account for interest on a compounding basis. The amount of interest will increase over time; it will be less than the straight-line amount in the early years and more than the straight-line amount in the later years.

The terms of these arrangements all required performance of obligations at different times and thereby raised time value of money issues. The Code sections create an interest rate and prescribe
a certain compounding period – essentially semi-annual. We will note the compounding period that the sections relevant to this discussion requires, *but we will borrow from the tables in
chapter 2* that follow the *Bruun* case. Those tables reflect compounding interest on an annual basis.

- In the event you find working with formulas in a spreadsheet to be somewhat frightening, the following website (and certainly there are others) has links to several useful calculators: http://www.pine-grove.com/online-calculators/

*Examples (1) and (1a)*: Section 1272(a)(1) provides for inclusion of interest income in the gross income of a holder of a debt instrument as the interest accrues, i.e., taxpayer Linda
in Example (1) must include in her gross income interest as if Clifton had actually paid it and it was compounded semi-annually (§ 1272(a)(5)).

- Section 1273(a)(1) defines “original issue discount” to be the redemption price at maturity minus the issue price.
- In Example (1) above, the “original issue discount” would be $15,007.30 − $10,000 = $5007.30. This happens to be the interest that would be paid if the interest rate were 7%. Use that figure when working from table 1 in chapter 2. 2
- By using table 1, we learn that Linda’s should include $700 in her gross income one year after making her investment. Because she has paid income tax on $700, Linda’s basis in the bond increases to $10,700. § 1272(d)(2).
- Section 163(e)(1) provides for the same measurement of any allowable interest deduction for the Clifton Corporation.
- After two years, Linda’s interest income will total $1449. Because she already included $700 in her gross income, her interest income for year 2 that she must include in her gross income is $749. 3 Notice that it was more than it was in year 1.

After three years, Linda would have paid tax on a total of $2250 of interest income. She must include $801 of interest income in her gross income for year 3 – again, more than her interest
income in year 2. The basis in her bond would be $12,250. She would realize $750 of gain from dealing in property upon its sale for $13,000. *See* Example (1a).

- Buyer paid a “premium,” i.e., Buyer paid $750 more than Linda’s adjusted basis in the bond. Buyer will step into Linda’s shoes and recognize interest income on the bond. However, Buyer will reduce the interest based upon a similar calculation of the $750 premium spread over the time remaining to maturity of the bond. § 1272(a)(7).

*Example 2*: Section 1274 provides that when a debt instrument is given in exchange for property (§ 1274(c)(1)), the interest must be at least the “applicable federal rate” (AFR). If it
is not, then the debt payments are structured as if the interest rate is the AFR.

- The AFR depends on the term of the debt instrument – whether short-term, mid-term, or long-term. The Treasury Department determines AFRs monthly. § 1274(d).
- The
*imputed principal*amount of a debt instrument is the sum of the present values of all future payments. The present value is determined on the basis of the AFR compounded semi-annually. § 1274(b)(1 and 2). - In Example 2, assume again that the interest rate is 7%. Refer to table 3 in the materials following
*Bruun*, i.e., the table that gives the present value of a fixed annuity payment. The multiplier for ten years is 7.0236. The annual payment is $350,000. $350,000 x 7.0236 = $2,458,260. - Since Seller will receive a total of $3,500,000, the difference between that amount and $2,458,260 must be interest, i.e., $1,041,740. The parties will allocate it on the same yield-to-maturity principles of § 1272 applicable to OID.
- Even though Seller will have $1M of income from the transaction, Seller actually
*lost*money on the sale. Seller will realize substantial interest income – which is subject to a higher tax rate than long-term capital gain.

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