Rev. Rul. 74-607

Advice has been requested concerning when, under the circumstances described below, points charged by a corporation in connection with making first mortgage and construction loans are to be included in its income.

The taxpayer, a domestic corporation using the accrual method of accounting, is engaged in the business of making first mortgage construction and development loans for periods from eighteen to thirty-six months. The loans are repaid in a single payment upon completion of the project when the borrower obtains permanent financing.

As additional compensation for making the loan, the taxpayer charges the borrower a certain number of points, each point representing one percent of the face amount of the loan. No rebate of points is provided for in case of repayment of the loan prior to the due date.

The term "points" as used in this Revenue Ruling refers to a charge made by the lender (mortgagee) to the borrower (mortgagor) that is in addition to the stated annual interest rate and is paid by the borrower to the lender as an adjustment of the stated interest to reflect the actual cost of borrowing money. The amount of the "points" charged is determined by the lender upon consideration of the factors that usually dictate an acceptable rate of interest and is not paid for specific services performed or to be performed by the lender. Thus, "points" as used in this Revenue Ruling are for the use or forbearance of money and are considered to be interest. See Rev. Rul. 69-188, 1969-1 C.B. 54.

In most cases, the taxpayer withholds the entire amount of the points from the initial disbursement of funds to the borrower. However, in some situations the gross amount of the loan funds is disbursed and the taxpayer receives a check for the full amount of the points either at the time the loan is made or at the time the loan is repaid.

As stated in Situation 2 in Rev. Rul. 70-540, 1970-2 C.B. 101, the points represent interest that is discounted from the face amount of the loan at the time the loan is made. If the taxpayer uses the accrual method of accounting, Rev. Rul. 70-540 states that interest in the form of discount is includible in income as payments on the note are due, or as actually received if earlier.

Section 1.451-1(a) of the Income Tax Regulations provides, in part, that under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.

All the events that fix the right to receive income occur when (1) the required performance occurs, (2) payment therefor is due, or (3) payment therefor is made, whichever happens earliest.

In applying this rule to the accrual of interest income, performance occurs when the lender allows the borrower to use his money. When he has done this for one day, one day's performance has occurred and one day's interest accrues (assuming the payment has not already been made or come due). Thus, unless interest is paid or such payment is due earlier, interest accrues ratably over the term of the loan.

Accordingly, it is held that when loans are repaid in a single payment at the end of the loan the points that are discounted from the loan proceeds must be reported ratably by the taxpayer on a straight-line basis over the life of the loan. It is further held that in those situations in which the points are not discounted from the loan proceeds, such points are also includible in gross income ratably on a straight-line basis over the life of the loan unless they are received or become due earlier.

Rev. Rul. 72-100, 1972-1 C.B. 122, considered a situation in which the portion of interest earned on installment loans in the event of their prepayment was computed under the Rule of 78's method. It holds that such method fixes the lender's right to receive such interest and that such interest accrues accordingly. The Rule of 78's, as used in the context of Rev. Rul. 72-100, is merely a method of applying the effective interest rate to the unpaid balance of the indebtedness. Therefore, the holding in Rev. Rul. 72-100 is in effect a holding that interest accrues ratably over the period of the loan.

Rev. Rul. 72-100 is clarified and Rev. Rul. 70-540 is amplified.