Peter wanted to know my thoughts on his tax post. Of course well written but I have to quarrel with some things. Generally not Peter's fault, but rather LC and Prosper's since it looks like they gave him incorrect information in several respects.
1099-OID – Now, your 1099-OID should accurately reflect your total earnings. Service fees are now deducted from the amount of your 1099 as well. Here is the exact formula for the number in box 1 of your 1099-OID as provided by Lending Club:
1099 Interest = (regular interest + regular late fee – service fee) + (recovery interest + recovery late fee – recovery service fee)
I'm bewildered that LC told you that. That is not OID plain and simple. From the LC prospectus:
...the Notes will have original issue discount, or OID, for U.S. federal income tax purposes because payments on the Notes are dependent on payments on the corresponding member loan. Further, a holder of a Note will be required to include the OID in income as ordinary interest income for U.S. federal income tax purposes as it accrues (which may be in advance of interest being paid on the Note),regardless of such holder’s regular method of accounting.
The amount of OID includible in a U.S. Holder’s income for a taxable year is the sum of the “daily portions” of OID with
respect to the Note for each day during the taxable year in which the holder held the Note. The daily portion of OID is determined by
allocating to each day of any accrual period within a taxable year a pro rata portion of an amount equal to the product of such Note’s
adjusted issue price at the beginning of the accrual period and its yield to maturity (properly adjusted for the length of the period). The
adjusted issue price of a Note at the beginning of any accrual period should be its issue price, increased by the aggregate amount of
OID previously accrued with respect to the Note, and decreased by any payments of principal and interest previously made on the
Note (net of the 1.00% service charge). A Note’s yield to maturity should be the discount rate that, when used to compute the present
value of all payments of principal and interest to be made on the Note (net of the 1.00% service charge) under the payment schedule
of the Note, produces an amount equal to the issue price of such note.
Cash payments of interest and principal (net of the 1.00% service charge) under the payment schedule on the Notes will not be
separately included in income, but rather will be treated first as payments of previously accrued but unpaid OID and then as payments
The quotes from the prospectus are accurate statements of law, and reflect that OID is an accrual-based
form of taxation. The cash payments you actually receive should not have any bearing on the amount of OID you include in a tax year.
Prosper's statement is similarly incorrect.
We have modified our OID methodology to use actual interest received...
That statement is, in the tax world, nonsensical. What the hell is Prosper's "OID methodology"? The way OID is calculated is set out in the regulations accompanying Code Section 1272. There is only one right way to calculate OID (one ring to rule them all...if you will). As before, OID has nothing to do at all with the "actual interest received." It is an accrual form of taxation, even if the taxpayer uses the cash method of accounting.
So why do we care. Well, first, there's the issue of a material misrepresentation in the prospectus; you can't tell people your securities are taxed one way, and then take a position that is inconsistent with that.
Second, calculating OID is important for a number of other issues that could pop up over the life of the bond. If you buy a note at issuance, hold it to maturity, and it pays on time, every time, then no there really won't be much difference tax wise. The difference will be between how LC calculates interest and how the Code and regulations tell you to calculate it, which for an individual note will be small. But in aggregate, it adds up.
Second, how OID is calculated directly affects the bond premium and sale/disposition rules. Whether a note is issued with premium for tax purposes depends on LC's accurate calculation of the notes stated redemption price at maturity. Further, if you sell a note, or it charges off, accurately calculating your gain or loss depends on accurate application of the OID rules because includible OID increases your basis in the note (I've discussed this issue at length in other posts).
Peter's discussion of how he's filing seems fine to me. A few nits:
All charged off debts are reported on Schedule D as short term or long term losses.
Per Code Section 166, non business bad debts are treated as short term capital losses, regardless of how long you've held the debt instrument. See generally, http://www.fool.com/school/taxes/2000/taxes000107.htm
for why that matters. If you have net short-term capital loss, you can deduct against ordinary income up to $3k per year.
Note that the mandatory short-term rule only applies to losses, not to gains. If you buy a note, hold it for a year, and sell for a gain over your adjusted basis, you get long-term capital gain (yippee!).
My final thoughts. LC and Prosper's structure is innovative, and the tax rules don't spell out everything perfectly. (Well, ok the rules spell out some things as clear as day and they just get it wrong). At the very least, they have an obligation to conform their reporting with their prospectus, which generally sets out the tax treatment of the notes correctly. My creeping suspicion is that a very good tax lawyer did their prospectus tax discussion, but less sophisticated parties are in charge of LC's tax reporting. Hence the disconnect. Not an excuse, but maybe a reason...
I see no reason why, to the investor, the tax reporting here should be any more difficult than if you had a Scottrade account or something. We may have a need for some innovation in this area.
If you made it all the way to the end, please reward yourself with a [large] glass of wine. If you have any questions please feel free to ask. If you actually enjoyed reading this, maybe no more wine for tonight...