Three years ago I concluded that the tax treatment of LC notes was so awful they weren't worth holding in a taxable account and shuffled my money so that my LC allocation was in an IRA. 2011 was not a great year for LC notes so I'd like to run the logic by this esteemed group and see if my logic checks out.
These numbers are round for the simplicity of discussion, but I think they are valid for discussion. Let's assume a $10,000 portfolio of Grade C notes. Rounding off the numbers, grade C has an average rate of 15% and a default rate of 5%. Let's also assume that my tax rate on ordinary income is 30% and 15% on capital gains. Here is how I see this playing out after tax.
Interest income = $1,500
Charge offs = $500
Net cash = $1,000
Pre-tax gain = 10%
OID Income = $1,500
Income tax = 30% x $1,500 = $450
Offsetting capital loss (assumes I have other cap gains) = 15% x $500 = $75
After tax cash = $1,000 - $450 + $75 = $625
After tax return = 6.25%
And if I was in a max bracket at 45% combined fed + state (California) and 20% on cap gains it would look more like this:
Income tax = 45% x $1,500 = $675
Offsetting capital loss = 20% x $500 = $100
After tax cash = $1,000 - $675 + 100 = $425
After tax return = 4.25%
This is for Grade C notes, for Grade D/E/F notes it is much worse since the taxable OID income goes up much faster than the charge off cap loss offset.
Does this example look pretty accurate to you guys?
I'm no tax expert or math whiz, but I'll take a crack at it...
Where are you getting the 30% tax rate? If your tax rate is that high, you likely don't qualify for an IRA. Your effective tax rate is highly dependent on any other income and will be less than the tax bracket you might fall in. That is because your income is taxed in tiers by the IRS. In 2013, for single filers, the first $8,925 earned is taxed at 10%. Income from $8,926 to $36,250 is taxed at 15%. $36,251 to $87,850 is taxed at 25%. And so on. Let's say my adjusted gross income is $75k for the year. Subtract the single standard deduction of $6,100 for a taxable income of $68,900. Looking at the tax tables, my tax is $13,160 making my effective tax rate less than 18%. I'm not even going to get started on state taxes as I am in a different state.
Charge-offs = capital loss and are used to offset capital gains. If there are no capital gains, then they are essentially subtracted from your income to give you your AGI. Capital losses are not taxed.
Let's say I received a W-2 for $74k. I add my $1500 OID interest income. I fill out the Schedule D, with my $500 charge-off/capital loss. That brings my AGI to $75k. $1000 net gain x 18% tax rate = $180. So after taxes, I made $820. Divide that into $10k, and my after-tax return is 8.2%.
Welcome to new America.
Thank you for your confirmation on the basic numbers.
As you point out, essentially any retirement funds can be rolled into an IRA when you leave a company. My IRA contains funds from a variety of different types of retirement plans during my career.
The top rate in California is 9.6% and is reached at $50K of taxable income. Adjusting for the deduction on max Fed taxes ((1-.4)*9.6) the top marginal rate is thus closer to 46%.
Of more relevance is that the combined marginal tax rate for a California resident with taxable income of $50K is (.25 + ((1-.25)*9.6) = 32.2%.
The bottom line is that most investors here probably have a marginal rate over 25% and 30% is not a wild number.
My point was that taking charge offs as cap losses, which is not the way that LC calculates Adj Net Return, has a significant impact on after tax income. Further, the impact worsens in the lower grade loans (D-E-F) as the percentage of loans charged off rises.
Additionally, there is a $3K / yr cap on deducting capital losses. If for example an investor placed $50K in a portfolio that had 7% charge offs, the resulting $3,500 of capital losses would not be fully deductible without capital gains from some other investment.
Investing in LC is not like buying a bond.
Exactly, Boatguy! I just realized this myself this year as I was entering my tax info last month. If you have no other capital gains and your account is small enough that you can avoid going over $3000 per year of charge offs, then your write-offs for losses will happen at your marginal tax rate. Or if you have short term capital gains to offset and you have no long term gains then you are fine.
But if you have long term gains that would be taxed at a low rate, your losses will wipe them out.
I started an IRA with LC last year and contributed already for this year, even though my income is too high to write off the contributions. I think I can withdraw funds from my work 401(k) and roll them to an IRA and I may consider doing that at some point. I'm waiting on that to see how the industry shakes out...if it becomes impossible for the little guy to invest it may not continue to be worth it.
Your point on higher risk loans being more likely to have this adverse tax effect is something I didn't ever think of. I had been focusing on higher risk loans, but I may adjust this strategy. Many of the loans that p2p-picks.com selects in its "Profit Maximizer" model are C grade loans....I may increase my weight there.
So thanks for your insightful post!
Yea, I wish it wasn't true either! It's definitely better than having money languish in a CD but you are going to pay taxes immediately as your balance grows. I do like the idea of holding notes in an IRA. My goal is to have my taxable account generate my IRA contribution each year, and then continue to grow my balance in a tax sheltered way.
I have been afraid to dabble in Folio trading as the rules for accounting for OID when notes are bought at a premium or discount seem to be a nightmare...way too much record keeping for a $25 note. I don't understand how Folio users here manage to do their taxes.
I thought that it would make sense to do Folio trading in my IRA account, but according to posts on here, that is questionable as well as Folio is not approved as a custodian apparently. I'm hoping that eventually clears up.
An IRA is definitely the best place for LC investing. You can trade with Foliofn from an IRA, not a problem.
Trading from the IRA avoids the tax inefficiencies of the LC model and sidesteps the non-existent basis tracking by LC and Folio
My sense is that LC income/losses are being reported in a broad variety of "creative" methods and that P2P transactions are currently below the IRS radar. One day they'll wake up clarify the treatment and allow LC to take all the weasel words and ambiguity on taxes out of their prospectus.
The PPM for Peter's fund sets it up as a partnership so everything will flow through, there is no reconfiguration of income.
What I don't understand is why P2P notes would be treated differently than any other bond. If a corporate bond defaults, it's a cap loss, not ordinary loss. These are just junk bonds; high interest rate and high default rate. Interest on bonds is taxed on a cash basis, discounts are OID income spread over the term of the bond and premiums are amortized over the life of the bond. Why the accrual accounting at LC?
LC prospectus or Lend Academy PPM?
Do I treat losses from selling bad loans on Folio different that losses sustained for charge offs?
I don't know exactly where it gets reported, but I'm sure there is a line or form somewhere.
The tricky part is that LC does not report defaults to the IRS at all (see the note on the 1099B). The IRS has no way to verify the number we would insert as an ordinary loss (or as a cap loss for that matter) which seems like an invitation to an audit.
Very different than a brokerage 1099 which clearly shows the ST and LT cap gains/losses.
This section from IRS publication
http://www.irs.gov/publications/p1212/ar02.html#en_US_201312_publink1000206288 suggests that previously reported interest due to accrual accounting can be taken as a loss, but the principal is a capital loss. It also says that if you take the CPDI approach, trading gains are also ordinary income:
Treatment of gain or loss on sale or exchange. If you sell a contingent payment debt instrument at a gain, your gain is ordinary income (interest income), even if you hold the debt instrument as a capital asset. If you sell a contingent payment debt instrument at a loss, your loss is an ordinary loss to the extent of your prior OID accruals on the debt instrument. If the debt instrument is a capital asset, treat any loss that is more than your prior OID accruals as a capital loss.
May the force be with you.
From the same IRS publication 1212:
"Including OID in income. Generally, you include OID in income as it accrues each year, whether or not you receive any payments from the debt instrument issuer.
Exceptions. The rules for including OID in income as it accrues generally do not apply to the following debt instruments.
U.S. savings bonds.
Tax-exempt obligations. (However, see Tax-Exempt Bonds and Coupons, later.)
Obligations issued by individuals before March 2, 1984.
Loans of $10,000 or less between individuals who are not in the business of lending money. (The dollar limit includes outstanding prior loans by the lender to the borrower.) This exception does not apply if a principal purpose of the loan is to avoid any federal tax."
Why doesn't the bold exception cover all we little guys?
Did anyone else look into CPDI?
That's how I filed... adjusted my OID interest with chargeoffs