Tax Hedging in a Volatile Interest Rate Environment

• April 3, 2024
• Courtney DeVane

Real estate companies often add significant debt loads to their balance sheets when acquiring rental properties. In a rising interest rate environment, a real estate company’s profit margins can quickly erode if the company has issued floating rate debt. Conversely, in a declining interest rate environment, a real estate company could suffer adverse P&L consequences if it issued fixed rate debt. To manage interest rates, real estate companies often execute interest rate derivatives with financial counterparties to achieve their desired cost of funds profile. When interest rates begin to normalize, it is common for real estate companies and their counterparties to terminate their interest rate derivatives. The tax treatment of interest rate derivatives can be just as complex as the financial instruments themselves. The purpose of this article is to present you with a case study illustrating the federal income tax implications of entering an interest rate swap to manage interest rates.

Case study 

Facts

• ABC Company is a domestic entity that owns and operates rental real estate.
• ABC Company files tax returns on a calendar year using the overall accrual method of accounting.
• To finance the recent acquisition of rental property, ABC Company borrowed $100 million from XYZ Bank.
• The loan requires ABC Company to pay interest on the 15^th day of each month at the 30-day SOFR (floating rate), with principal due upon the loan’s maturity in 10 years. The loan is referred to herein as the “XYZ Bank Loan”.
• At the end of the XYZ Bank Loan’s second year, ABC Company grows concerned that interest rates will rise over the next three years, making financing costs on its floating rate XYZ Bank Loan more expensive.
• To manage interest rate risk, ABC Company enters an interest rate swap with XYZ Bank. The interest rate swap requires on the 15^th day of each month that ABC Company pay XYZ Bank 0.5% (fixed rate) and XYZ Bank pay ABC Company 30-day SOFR calculated on a $100 million notional amount. The interest rate swap has a term of 3 years.
• ABC Company did not identify the interest rate swap as a hedge of the XYZ Bank Loan for tax purposes.
• By the end of first year of the interest rate swap (i.e., the third year of the XYZ Bank Loan) interest rates decline, and ABC Company pays $1 million to XYZ Bank to terminate the swap. The $100 million XYZ Bank Loan remains outstanding.

 

Key Federal Income Tax Considerations 

• Tax classification of interest rate swap
  • ABC Company’s interest rate swap is a type of derivative that falls within the definition of a notional principal contract (NPC).
  • Other types of derivatives that generally are treated as NPCs include currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, and similar agreements.

• Periodic payments
  • The monthly payments between ABC Company and XYZ Bank are called periodic payments because they are payable at intervals of 1 year or less during the entire duration of the NPC.
  • Periodic payments received (paid) on an NPC are treated as ordinary income (deduction) because they do not constitute the sale or exchange of a capital asset.
  • All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment for the taxable year to which that portion relates.
  • If an NPC period payment period crosses over a taxpayer’s year end, the taxpayer must accrue as income or expense the amount of the swap payment receivable or payable using the relevant swap rates in effect at year end.
  • Swap payments are reported on a net basis.  For example, if ABC Company owes $500,000 to XYZ Bank and XYZ Bank owes ABC Company $600,000, then ABC Company reports net income of $100,000 on its federal income tax return.

• Applicability of Section 163(j) business interest disallowance rules
  • Generally, Section 163(j) does not apply to NPC net periodic payments because NPCs generally are not treated as indebtedness for federal income tax purposes. Correspondingly, ABC Company’s net periodic payments made on its interest rate swap would not be reported as interest expense.
  • Exceptions exist for interest rate swaps that have significant nonperiodic payments or violate the interest anti-avoidance rule.

• Mark-to-market tax (MTM) accounting
  • ABC Company is not required to MTM its interest rate swap at year end because the company is not a dealer in securities under IRC Section 475(c)(1) and interest rate swaps are excluded from the Section 1256 MTM rules.

• Termination payments
  • ABC Company recognizes a termination payment received from (paid to) XYZ Bank as income (deduction) in the year the interest rate swap is extinguished, assigned, or exchanged.
  • The character of termination payments received (made) by ABC Company as ordinary or capital gain (loss) is unclear.
  • In ABC Company’s case, there is a strong likelihood the IRS would argue the interest rate swap is a capital asset – and treat the $1 million termination payment as a capital loss – because ABC Company failed to identify the swap as a tax hedge of the XYZ Bank Loan.
  • ABC Company may be able to argue for ordinary asset treatment – and deduct the $1 million termination payment as an ordinary loss – if it can successfully assert that its failure to identify the swap as a hedge of the XYZ Bank Loan was due to inadvertent error. Tax hedging is discussed in more detail in the next section.

• General tax hedging rules
  • In the context of this case study, the term “hedging transaction” (informally called a “tax hedge”) means any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily to manage risk of interest rate changes with respect to borrowings made by the taxpayer.
  • To qualify as a tax hedge, the transaction must be clearly identified as such in the taxpayer’s books and records before the close of the day on which it was acquired, originated, or entered into.
  • A transaction that is properly identified as a hedging transaction for tax purposes is excluded from capital asset characterization and, by default, is an ordinary asset. Thus, any gain (loss) recognized by a taxpayer on the sale, exchange or other disposition of such tax hedge is ordinary gain (loss).
  • A taxpayer that fails to identify an NPC as a tax hedge may assert such treatment if- (i) the NPC otherwise meets the requirements for hedging treatment, (ii) the identification failure was due to inadvertent error, and (iii) the NPC complies with the hedging rules on all original or amended returns for all open years. The IRS has ruled that inadvertent error may occur when a taxpayer fails to identify an NPC as a tax hedge due to “accidental oversight” or “carelessness.”  A taxpayer’s ignorance of the tax hedging rules does not equate to inadvertent error.
  • Based on the facts, it appears that ABC Company did not properly identify the interest rate swap as a hedge of the XYZ Bank Loan for tax purposes.
  • Further discussions between ABC Company and its tax advisor are needed to determine whether ABC Company qualifies for inadvertent error relief.

• Treatment of termination payments under tax hedging rules
  • The IRS likely would require ABC Company to report the payment made to XYZ Bank to terminate the interest rate swap as a capital loss, unless the company qualifies for inadvertent error relief as discussed above.
  • Assuming inadvertent error relief is unavailable, ABC Company would deduct the capital loss in year the swap contract was terminated.
  • Alternatively, if inadvertent error relief applies and the XYZ Bank Loan remains outstanding when the swap is terminated, ABC would characterize the loss as ordinary and amortize the loss over two years (i.e., the remaining term of the swap) using a constant yield methodology. If both the XBZ Bank Loan and interest rate swap are repaid or terminated, then the ordinary loss on the swap termination payment would be deductible immediately.
  • It is worth considering an alternative scenario where ABC Company realizes gain on the receipt of a swap termination payment. In this case the IRS likely would treat the gain as ordinary if ABC Company had no reasonable grounds for not identifying the swap as a tax hedge. If ordinary characterization is attained and the XYZ Bank Loan was outstanding when the swap termination payment was received, presumably ABC Company would be permitted to amortize the gain over two years (i.e., the remaining term of the swap) using a constant yield methodology. If both the XYZ Bank Loan and interest rate swap are repaid or terminated, then the ordinary gain on the swap termination payment would be recognized immediately.

 

Key takeaways

• Taxpayers engaging in interest rate swap derivatives should consider incorporating tax hedge identification procedures within their accounting policies and general ledger systems.
• By properly identifying interest rate derivatives as tax hedging transactions, taxpayers can avoid confusion over whether termination payments should be treated as ordinary or capital losses. Most taxpayers prefer ordinary loss treatment as there is more flexibility to deduct ordinary losses against other operating income.
• CLA is here to help you navigate the tax complexities of engaging in derivatives transactions. We invite you to contact us before executing your next transaction.

 

Thanks to Mike Smith for writing this blog post!

Sources: Internal Revenue Code, Treasury Regulations

Tags: Accounting, Commercial Real Estate, IRS, Real Estate, Tax Planning, Federal and state taxation, including proposed regulations, Industry best practices, Industry trends/analysis | No Comments »