Rev. Rul. 58-226

Advice has been requested whether the provisions of section 1341 of the Internal Revenue Code of 1954 are applicable where at the close of an escrow arrangement prepaid interest is received on a note and in a subsequent taxable year, due to the prepayment in whole or in part of the principal amount of the note, the taxpayer credits the payer with any portion of such prepaid interest.

The taxpayer sold real property for 25 x dollars. The consideration received therefor consisted of cash, the assumption of a first trust note, and a second trust note due in ten years years with interest at a stipulated rate per annum. The cash and the first and second trust notes were deposited with an escrow agent, pending purchaser's approval of the title and fulfillment of certain other conditions. At the close of escrow, the purchaser, through the escrow agent, prepaid the interest for ten years on the second trust note. It was agreed that if the purchaser should prepay any part of the principal of such second trust note, credit would be given by the taxpayer for the portion of the prepaid interest applicable to the period from the date of the prepayment of the principal to the date to which the interest was prepaid.

Section 1341 of the Code provides rules for computing the tax for a taxable year during which the taxpayer is entitled to a deduction because of the restoration to another of an item which was included in the taxpayer's gross income for a prior taxable year. It reads, in part, as follows:

(a) GENERAL RULE.-If-

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

(3) the amount of such deduction exceeds $3,000, then the tax imposed by this chapter for the taxable year shall be the lesser of the following: * * *

In the instant case, the taxpayer had what not only `appeared' to be, but which was in fact and in law, an unrestricted right to receive the total amount of the prepaid interest on the second trust note in the year in which the escrow was closed. Thus, if due to prepayment of the principal amount of the second trust note, or any part thereof, the taxpayer in a subsequent year credits the payer with any of the prepaid interest, it will not be because it is established after the close of the prior taxable year in which the prepayment of interest occurred that the taxpayer did not have an unrestricted right thereto in such prior year, but because a liability on his part has later accrued which does not in any way establish that he had no right to the interest when received.

It is held, therefore, that a credit by taxpayer of any of the prepaid interest in the manner shown above will not constitute a transaction meeting the requirements of section 1341 of the Code and, accordingly, the provisions of that section will not be applicable in the computation of taxpayer's income tax liability for the taxable year in which the credit is given.