Category: Gift & Estate; Individuals
Subject: Gratuitous Forgiveness of Mortgage Loan
Title: Inclusion of Accrued Interest in Taxable Gift/Inclusion of Accrued Interest in Income
IRC Sections: 61, 2501
Filename: 1180.html
Date Produced: 10/96

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Background
Cash basis taxpayer made a mortgage loan to his adult daughter. The loan was supported by a written note calling for monthly payments of principal and interest. The interest rate on the loan was at or above the AFR.

Taxpayer now plans to forgive some or all of the loan including existing accrued interest. Taxpayer has never recognized income with respect to such accrued interest.

Issues
1. Does the taxable gift to the taxpayer's child include the accrued interest?

2. Is the taxpayer required to recognize the accrued interest income?

Answers
1. The accrued interest is included in income.

2. Although not free from doubt, it appears that the taxpayer is not required to recognize the accrued interest income.

Discussion: Issue One
If a taxpayer makes a gift of a note with accrued but unpaid interest, the value of that note for gift tax purposes includes the accrued but unpaid interest. Reg. Sec. 25.2512-4. Rev. Rul. 77-299, 1977-2 CB 343, holds that the amount of the gift when debt is forgiven is the sum of (1) the amount of the principal forgiven plus (2) the interest accrued to the date of the forgiveness. Rev. Rul. 81-264, 1984-2 CB 185, provides the same conclusion.

Discussion: Issue Two
Oddly, I cannot locate any authority on point in this matter.

Under Section 61, gross income includes income from whatever source derived. The taxpayer in the case has received nothing and will receive nothing. Similarly, the daughter similarly has received nothing and will receive nothing. If income must be recognized by the donor in this case, it seems to me that the only theory under which that conclusion would be reached is the assignment of income doctrine.

The assignment of income doctrine requires a donor to recognize unreceived income when the property to which the income relates is donated to another party. This principal, however, seems only to apply to income to be paid to the donor by someone outside the transaction, i.e., someone other than the donee. For example, it is well settled that a gift of a bond with an attached interest coupon gives rise to interest income to the donor to the extent of the interest earned prior to the gift. I cannot locate any case in which the same principal was applied to income payable by the donee to the donor. In addition, the assignment of income doctrine requires the donor to recognize income only when the donee receives such income. In this case, that will never happen: obviously, the daughter will never pay interest income to herself.