When to report real estate investment income

[Scooter1971]

What is the name of your state? Indiana

Hello. I have a tax question with which I am hoping you can assist me. I recently entered into an arrangement whereby I lent money to a real estate investment company for a period of four months (ending December 15, 2007). At the end of that period I earned some interest on that principal. However, the real estate investment company did not be pay me the interest, as they instead immediately reinvested both the principal and the interest into another four-month real estate investment. Thus, neither the principal nor the interest have been returned to me, nor will they be for the foreseeable future. In light of that, the real estate investment company does not plan to send me a 1099-INT unless they materially transfer a portion or all of the funds back to me. My question: Am I to report the interest gained on the four-month investment or is that deferred until the time when I physically receive the proceeds from it and the investment company reports it on a 1099-INT? I read where the investment company cannot deduct the interest they are paying me until they have actually paid me (pub. 550, chap. 3), so I wondered whether I needed to report that gain until I was also actually paid.

I contacted the IRS regarding this a couple months ago, and their representative seemed to indicate that the interest should be reported in the year that it is "constructively received," meaning when it is credited to my account or made available to me. Technically, my funds are "made available" at the end of the four-month investment period but are then immediately locked up again in a subsequent investment. Also, the IRS representative stated that I don't need to have physical possession of it in order for it to be "constructively received." So, if I understand that properly, it sounds like the investment company needs to reflect the interest gained on my 1099-INT, and I will subsequently need to report that amount on my tax statement as well. I have included the response from the IRS below for your review.

[BEGIN IRS CORRESPONDENCE]

Dear Taxpayer,

Thank you for your inquiry. I apologize for the delayed response. From your inquiry, I understand that you are trying to determine if you would have to report interest earned on a loan to a real estate investment company that is for a period of four months, but will be reinvested in another four month investment.

In order to answer your question, I will have to make a few assumptions. First, I will have to assume that you are a US Citizen, over age 18. I am assuming that you are the sole owner of the account, and the 1099-INT will be issued in your name. I am also assuming that you are using the cash method to report your income. Based on the information you provided in your inquiry, I am assuming that you are constructively receiving the income in December of 2007, even though the interest and principal is being reinvested into another investment immediately upon maturity.

Based on the information that you provided and the assumptions that I have stated, you should receive a 1099-INT for 2007. You should report this amount of interest income that you received with all of your taxable interest income on your 2007 Form 1040, line 8a; 2007 Form 1040A, line 8a; or 2007 Form 1040EZ, line 2. You cannot use Form 1040EZ if your total interest income is more than $1,500. Instead, you must use Form 1040A or Form 1040. If your taxable interest income is more than $1,500, be sure to show that income on Form 1040, Schedule B, or on Form 1040A, Schedule 1. Even if your taxable interest income is $1,500 or less, you need to show that income on the Form 1040, Form 1040A, or Form 1040EZ.

According to Publication 550, Investment Income and Expenses, when to report your interest income depends on whether you use the cash method or an accrual method to report income. Most individual taxpayers use the cash method. If you use this method, you generally report your interest income in the year in which you actually or constructively receive it.

You constructively receive income when it is credited to your account or made available to you. You do not need to have physical possession of it. For example, you are considered to receive interest, dividends, or other earnings on any deposit or account in a bank, savings and loan, or similar financial institution, or interest on life insurance policy dividends left to accumulate, when they are credited to your account and subject to your withdrawal. This is true even if they are not yet entered in your passbook. You constructively receive income on the deposit or account even if you must: make withdrawals in multiples of even amounts, give a notice to withdraw before making the withdrawal, withdraw all or part of the account to withdraw the earnings, or pay a penalty on early withdrawals, unless the interest you are to receive on an early withdrawal or redemption is substantially less than the interest payable at maturity.

Publication 550, Investment Income and Expenses, discusses the tax treatment of investment income and expenses. It explains what investment income is taxable, what investment expenses are deductible, and how to show them on your tax return. Publication 550 is available directly from our web site at [url]http://www.irs.gov[/url].

Thank you again for using our e-mail service. Should you need any further information, you may call customer service at 1-800-829-1040, and request to speak to the Income Tax Law area."

[END IRS CORRESPONDENCE]

I have two concerns regarding this. 1) I am afraid if I follow the lead of my real estate investment company and opt not to pay taxes on these investments until I physically receive the funds, I might be pushed into a higher tax bracket and face a large tax bill. For this reason, I would prefer to pay the tax as I go. This would seem to be what the IRS indicates I should do, anyway. 2) On the other hand, I fear that if I report the income and pay the tax, but my investment company does not issue a 1099-INT that reflects the same, that when I eventually DO request the funds from the investment company, that I will have to again report the income that will be reported on the 1099-INT that the investment company files. So I end up paying the tax twice or I risk getting in hot water with the IRS. Whichever way I go, it appears that I need to be on the same page as the investment company, would you agree?

Kind regards,
Scooter1971

[tranquility]

The problem comes up in the description of what you did. When you say, "arrangement whereby I lent money to a real estate investment company for a period of four months" what do you mean? Did you get a note? Is it a simple loan? *Could* you have asked for your investment, including interest, at four months. If so, you had constructive receipt at the end of the four months. If you did ask and the company refused, that gets into swampy area and you would need to see a tax professional to go over the facts with you.

Simply list the interest on your schedule B (or just in the proper place on the front of your return if appropriate) and keep track of it because someday you will get the 1099 and you will have to explain why you aren't paying on the whole thing. In the year of the 1099, I'd attach a statement listing the tax paid and the year of which portions of the interest and subtract that from the 1099 total and list only the resulting amont on your return.

[Scooter1971]

Thank you for the quick response, tranquility.

In answer to your question, this was just a simple loan. I loaned money to the investment company, which turned around and invested it in a commercial construction project. The company guaranteed me a certain percentage return on my loan, collectible (if I chose to do so) at the end of the 4-month period. They issued me a promissory note with the details of the investment and expected return.

I did not request the principal or interest at the end of the four-month period, but I certainly could have, and they would have returned it to me. Instead, I instructed them to roll the funds into another investment.

Your advice about how to report the income once I finally receive the 1099 makes good sense, and that's probably what I will do if the company decides not to issue the 1099 this year. Thanks again.

[abezon]

Originally Posted by Scooter1971

Instead, I instructed them to roll the funds into another investment.

That's the key fact. You exercised control over the interest by instruction the REIT to reinvest it. This is like when your bank compounds the interest in your savings account. It's taxable even if you don't withdraw it before the end of the year.

You need to report the interest as 2007 income, & the REIT needs to send you a 1099-INT.

[tranquility]

If it is truly a REIT, I think the OP should reconsider his investment. While I've heard the argument why it could be a good thing for a REIT to invest loaned money, it seems to me the better argument is that it can only be good if the REIT can otherwise obtain similarly-priced money through the credit of the REIT's investors and can close the debt if need be. I think this unlikely.