Rev. Rul. 86-42

1986-1 C.B. 82, 1986-13 I.R.B. 33.

INTEREST; PREPAYMENT OF RULE OF 78'S LOAN

Published: March 31, 1986

Section 163.-Interest 26 CFR 1.163-1: Interest deduction in general. (Also Sections 61, 451, 461; 1.61-7, 1.451-1, 1.461-1.)

  Interest; prepayment of Rule of 78's loan. An individual borrower who prepays a loan subject to the Rule of 78's, and who has been using the economic accrual method to account for interest expense, may deduct as interest the difference between the final payment based upon application of the Rule of 78's and the final payment based upon the economic accrual of interest. An individual borrower who uses the Rule of 78's to account for interest expense, in circumstances where it is still permitted, may deduct as interest the amount allocated to interest using the Rule of 78's when the loan is prepaid. The same rules apply to lenders.

  If a loan agreement provides that interest is earned in accordance with the Rule of 78's method, what portion of the last payment may be deducted as interest if the loan is prepaid?

FACTS

  SITUATION 1

  On November 26, 1981, an individual, A, borrowed $10,000 from a bank to use for home improvements.  The terms of the financing agreement provided for a self-amortizing loan with level monthly payments of $222.44 for five years. The amortization schedule implies an effective rate of interest of 12 percent. The agreement further stated that interest was to be earned and principal to be amortized in accordance with the Rule of 78's method.

  On May 26, 1984, A prepaid the loan in full. In accordance with the loan agreement, the last payment totaled $6,045.53. This amount included the monthly payment of $222.44 and the loan balance of $5,823.09, which was determined by the application of the Rule of 78's.

  If the loan had been amortized using the effective interest rate of 12 percent instead of the Rule of 78's, the last payment would have totaled

$5,963.38. This amount includes the monthly payment of $222.44 and the loan balance of $5,740.94, determined using an amortization schedule based upon the effective interest rate for the loan. Using the Rule of 78's, A's total payment to the lender is $82 .15 greater ($6,045.53 - $5.963.38). See Table 1 for an annual summary of the loan.

Loan Amount         :$10,000

Term                :5 years

Effective Interest  :12 percent

Rate

Monthly Payment     :$222.44

                       ANNUAL AMORTIZATION USING

                     ECONOMIC ACCRUAL OF INTEREST

                          Interest       Principal      Balance

Dec. 31, 1981           $  100.00       $  122.44     $9,877.56

Dec. 31, 1982            1,100.92        1,568.36      8,309.20

Dec. 31, 1983              901.99        1,767.29      6,541.91

May 26, 1984               311.23          800.97      5,740.94

                       ANNUAL AMORTIZATION USING

                             RULE OF 78'S

                          Interest       Principal      Balance

Dec. 31, 1981           $  109.73       $  112.71     $9,887.29

Dec. 31, 1982            1,174.07        1,495.21      8,392.08

Dec. 31, 1983              912.44        1,756.84      6,635.24

May 26, 1984               300.05          812.15      5,823.09

NOTE: The final payment is determined by adding the monthly payment

       ($222.44) to the loan balance on May 26, 1984, based upon the

       application of the Rule of 78's.

  During the time the loan was outstanding, A used the effective interest rate for the loan as the basis for determining interest expense for federal tax purposes.

  SITUATION 2

  The facts are the same as in Situation 1 except that B was the borrower and, during the time the loan was outstanding, B used the Rule of 78's as the basis for determining interest expense for federal tax purposes.

LAW AND ANALYSIS

  Section 163(a) of the Code provides that all interest paid or accrued within the taxable year on indebtedness shall be allowed as a deduction in computing taxable income. Interest has been defined as compensation for the use or forbearance of money. Deputy v. duPont, 308 U.S. 488, 498 (1940), 1940-1 C.B. 118, 122; Old Colony Railroad v. Commissioner, 284 U.S. 552, XI-1 C.B. 274 (1932).

  In General American Life Insurance Co. v. Commissioner, 25 T.C. 1265 (1956), acq., 1956-2 C.B. 5, the Tax Court held that prepayment charges for a loan are an additional fee for the use of money. Similar conclusions are reached in Rev. Rul. 57-198, 1957-1 C.B. 94, which considers a mortgage prepayment penalty, and Rev. Rul. 73-137, 1973-1 C.B. 68, which considers a prepayment charge under a retail installment contract.

  Rev. Rul. 83-84, 1983-1 C.B. 97, considers the use of the Rule of 78's as a method to allocate interest to periods during the term of a loan. The ruling concludes that the borrowers with loans subject to the Rule of 78's may not deduct interest that exceeds the amount economically accrued using the effective rate of interest for their loans.

  Rev. Rul. 83-40, 1983-1 C.B. 774, provides an exception to Rev. Rul. 83-84. It states that the Internal Revenue Service will accept the Rule of 78's method for computing a borrower's interest deductions for certain consumer loans as a matter of administrative convenience. The exception applies only when (1) there is a self-amortizing loan that requires level payments, at regular intervals at least annually, over a period not in excess of five years (with no balloon payment at the end of the loan term), and (2) the loan agreement expressly provides that interest is earned, or upon prepayment interest is treated as earned, in accordance with the Rule of 78's method.

  In Situation 1, when A prepaid the loan on May 26, 1984, the final payment  ($6,045.53) included the regular monthly payment ($222 .44) and the balance due ($5,740.94) based upon amortizing the loan at its effective interest rate. The final payment also included an 'additional' amount ($82.15), which was the difference between the balance due based upon the Rule of 78's and the balance due based upon the economic accrual of interest ($5,823.09 - $5,740.94). This 'additional' amount is similar to the prepayment charges for the loans in Rev. Rul. 57-198 and Rev. Rul. 73-137, because it is a fee for the use of money that became payable in the year of prepayment. Accordingly, A may deduct this sum ($82.15) as interest in 1984, as well as the amount of the regular monthly payment allocated to interest using the effective interest rate.

  In Situation 2, Rev. Proc. 83-40 permits B to use the Rule of 78's. Thus B's interest deduction equals the amount of the regular monthly payment allocated to interest under the Rule of 78's. Using this allocation method, the final payment ($6,045.53) includes the regular monthly payment ($222.44) and the balance due ($5,823.09) based upon the application of the Rule of 78's. The 'additional' amount described in Situation 1 does not exist in Situation 2. In Situation 2, because B used the Rule of 78's method to allocate payments between principal and interest, the difference between the balance due and based on the Rule of 78's and the balance due based on the economic accrual of interest had already been allocated to interest over the term of the loan prior to prepayment.

  It should be noted that if a lender is using the economic accrual method to account for interest income for a loan subject the the Rule of 78's, the additional amount received upon prepayment, in excess of the loan balance computer using the economic accrual method, is interest income in the year of payment.

HOLDING

  In Situation 1, A may deduct as interest for 1984 the difference between the final payment based upon application of the Rule of 78's and the final payment based upon the economic accrual of interest, in additional to the amount of each regular monthly payment allocated to interest using the economic accrual method (including the last such payment).

  In Situation 2, B may deduct as interest for 1984 the sum of the amount of each monthly payment allocated to interest based upon the Rule of 78's.

Rev. Rul. 86-42, 1986-1 C.B. 82, 1986-13 I.R.B. 33.