Rev. Rul. 70-647

Advice has been requested as to the proper method of determining when and how much interest is paid by an individual who makes cash payments on his indebtedness under a borrowing arrangement, whereby the lender accepts the individual's note as (1) payment of the balance due and interest on an existing indebtedness plus (2) evidence of a new indebtedness, under the circumstances described below.

The individual, who filed his returns on a calendar year basis and used the cash receipts and disbursements method of accounting, borrowed 100x dollars in January of 1969 which was evidenced by his note. By December of 1969, the individual had made payments of 75x dollars on the note leaving a balance on the lender's records of 25x dollars plus 5x dollars of accumulated interest.

Under the lender's internal regulations, of which the individual had notice at the time he borrowed the 100x dollars, the payments that the individual had made during 1969 were applied first against the principal of the loan, then against the accumulated interest.

When the note fell due in December of 1969 the lender accepted the individual's new note for 80x dollars in "payment" of the 25x dollars of principal and the 5x dollars of interest remaining from the first note, and as evidence of a new advancement of 50x dollars. The lender, who is an accrual basis taxpayer, sent the individual a year-end statement for tax purposes indicating that for the taxable year 1969 5x dollars of interest had been "paid by new loan."

Section 163 of the Internal Revenue Code of 1954 provides that there shall be allowed as a deduction "all interest paid or accrued within the taxable year on indebtedness." Section 1.461-1(a)(1) of the Income Tax Regulations states the general rule that under the cash receipts and disbursements method of accounting, amounts representing allowable deductions are to be taken into account for the taxable year in which paid.

While the lender's records indicated that the first loan and interest thereon had been "paid" and that the individual now owed 80x dollars of principal on a new note, the individual is not considered as having "paid" the interest where the payment is made with his own note. The "payment" required as a basis for the deduction by a cash basis taxpayer is the payment of cash or its equivalent, and the giving of the taxpayer's own note is not equivalent of cash entitling the taxpayer to the deduction. James W. England v. Commissioner, 34 T.C. 617 (1960); Guy T. Helvering v. Julian Price, 309 U.S. 409 (1940), Ct. D. 1451, C.B. 1940-1, 134.

The general rule relating to the treatment of payments on an indebtedness requires that partial payments in satisfaction of indebtedness be applied first toward the reduction of interest, then toward principal. Estate of Paul M. Bowen v. Commissioner, 2 T.C. 1 (1943), acquiescence, C.B. 1943, 3. This rule does not apply, however, when from the circumstances it can be inferred that the parties understood that a different allocation of the payments would be made. George S. Groves v. Commissioner, 38 B.T.A. 727 (1938), acquiescence, C.B. 1939-1, 15.

Because the lender's records do not indicate when and how much interest is actually paid by the individual for purposes of deduction under section 163 of the Code, it is incumbent on the individual to keep his own record of loans, interest, and payments. Under the facts of the instant case the individual would initially record a loan of 100x dollars. The 75x dollars in repayments made during 1969 would be applied against the principal of this loan. However, when the individual issued the new note in payment of the outstanding principal of the old loan and interest on the old loan, and as evidence of a new advancement, he was not permitted for Federal income tax purposes to treat the interest as having been "paid by new loan."

In the instant case, after issuing his new note, the individual's records should indicate 25x dollars principal remaining to be paid on the first note, 5x dollars of accumulated interest on that note, and 50x dollars of principal due on the new loan. When the individual makes payments on the second note there is no need or requirement that the individual follow the lender's regulations with respect to the interest on the old loan because the lender's records now indicate only an outstanding loan of 80x dollars principal, without differentiation between interest on the old loan and principal. The result is that payments should go first toward reducing the interest on the first note (under the general rule that requires that partial payments be applied first toward the reduction of interest), then toward the reduction of the remaining principal (under the lender's internal regulations), and then toward reduction of interest on the second note.

Assuming that the individual makes payments of 60x dollars in 1970 on his second note, he should apply these payments first against the 5x dollars of interest on his first note and then against 55x dollars of the remaining 75x dollars of outstanding principal. This will reduce the principal balance on the second note to 20x dollars. As the interest on the first note is actually paid in 1970, it is deductible in that year.

If the individual issues a new note in 1971 for 64x dollars, covering the principal balance of 20x dollars on the second note, interest of 4x dollars on the second note and a new advancement of 40x dollars, he will be required to follow the same pattern for allocating payments on the third note.