Rev. Rul. 74-395

Advice has been requested whether, for Federal income tax purposes, the fee paid by the taxpayer under the circumstances set forth below is interest within the meaning of section 163 of the Internal Revenue Code of 1954, and, if so, over what period of time may the interest be deducted, and how should the amount of each yearly deduction be determined.

A taxpayer, who reports his income under an accrual method of accounting, proposed to construct an apartment building and negotiated a long-term loan with a lender bank for that purpose. Since the construction project qualified for assistance under section 236 of the National Housing Act, 12 U.S.C., section 1715z (1968), the lender bank entered into a commitment contract with the Federal National Mortgage Association (FNMA) pursuant to which the bank obligated itself to sell, and FNMA obligated itself to purchase, at face value, the outstanding principal amount of the loan upon completion of the construction.

In connection with the commitment contract, the bank paid to FNMA a commitment fee of one percent of the loan, and, pursuant to the loan agreement with the taxpayer, discounted such amount from the face amount of the loan proceeds advanced to taxpayer. No separate service was rendered by the bank or the FNMA in return for this fee; a separate service charge was paid by the taxpayer to the bank for title search, FHA examination, etc.

Section 163(a) of the Code provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

For tax purposes, interest has been defined by the Supreme Court of the United States as the amount one has contracted to pay for the use of borrowed money and as the compensation paid for the use or forbearance of money. See Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), XI-1 C.B. 274 (1932); Deputy v. DuPont, 308 U.S. 488 (1940), 1940-1 C.B. 118. A negotiated bonus or premium paid by a borrower to a lender in order to obtain a loan has been held to be interest for Federal income tax purposes. Whether the amount of the bonus or premium is withheld by the lender rather than being paid back to the lender is immaterial. L-R Heat Treating Co., 28 T.C. 894 (1957).

Rev. Rul. 69-188, 1969-1 C.B. 54, holds that a loan processing fee paid by a borrower to a lender prior to the receipt of the loan proceeds, and in addition to the annual interest rate, is interest. In that case the taxpayer was able to establish that the fee was not paid for any specific services that the lender had performed, or had agreed to perform, in connection with the loan.

Rev. Rul. 56-136, 1956-1 C.B. 92, involved commitment fees or standby charges incurred by a taxpayer pursuant to a bond sale agreement, under which funds for construction purposes are made available to it in stated amounts over a specified period and which vary with the period of time during which funds are held available by the lender. The conclusion reached in Rev. Rul. 56-136 is that such commitment fees were business expenses that were deductible under section 162 of the Code and not interest. Rev. Rul. 56-136 is distinguishable from this case, since here the purpose of the deduction of the commitment fee from the construction loan proceeds is for the use of money on an existing indebtedness rather than for having money made available on a when needed basis.

In the instant case, the fee paid by the taxpayer was a prerequisite to obtaining the loan and incidental to an unconditional and legally enforceable obligation of the borrower. Furthermore, no services in addition to the lending of money were rendered as a result of the fee paid by the taxpayer. Accordingly, the fee is interest deductible under the provisions of section 163(a) of the Code.

Section 461(a) of the Code provides that the amount of credit allowed by subtitle A of the Code shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.

Since the taxpayer employs the accrual method of accounting, and since the lending instrument is silent as to what portion of each payment is discounted interest, the deduction for the interest accrues ratably over the period of the loan. James Bros. Coal Co., 41 T.C. 917 (1964). If, however, the loan instrument required that prepaid interest was subject to the "Rule of 78's," that method of determining the amount of annual deductions would be used. See Rev. Rul. 72-100, 1972-1 C.B. 122.

Since the interest rate, maturity date, and outstanding principal amount of the note remained unchanged when FNMA purchased the obligation, and since no new loan was negotiated between taxpayer and FNMA upon completion of construction, the interest fee which the bank discounted from the taxpayer's loan should be ratably deducted over the entire period of the loan, and not just over the period of construction.

Rev. Rul. 56-136 is distinguished.