Debt and Taxes

The federal income tax conceptualizes the standard loan transaction as an exchange of cash for promises to pay interest and to repay the amount borrowed by the term. This formulation is subtly wrong in ways that have led to a weaker foundation for existing tax rules than they merit. Conceptualizing loans instead as closely akin to leases places most of the tax rules for debt on sounder footing because it clarifies that the consideration paid for the use of the loan proceeds is interest. If interest is the cost of the use of money, then simple borrowing is a fully-paid-for transaction, full basis credit in the loan proceeds for the period for which interest is paid is appropriate, and cancellation of debt is a straightforward accession to wealth in the period in which it occurs. These conclusions hold whether the interest is deductible or not and are consistent with current law, which has come under fire from some quarters.Although the proposed reconceptualization of loan as lease supports a number of longstanding income tax rules, one area in which it counsels significant reform is the taxation of partnerships. If loans are like cash leases made in exchange for interest qualifying as rent, Treasury should provide for allocation of basis credit among partners for the partnership’s debt based on who bears the economic burden of interest expense. The rule should apply regardless of whether the debt is recourse or nonrecourse and regardless of who would have discharge of indebtedness income on default. Such an approach differs markedly from the existing rules for recourse obligations but is closer to the rules for certain nonrecourse obligations. A modification of the rules applicable to partnership debt consistent with the loan-as-lease theory therefore would remove a significant discontinuity in the current tax treatment of partnership deb