By Jeffrey Clayman, CPA, JD, LLM, Withum
Borrowing from a bank during a time of rising interest rates may seem counter-intuitive and potentially come with risk. One of the most effective ways to manage that risk is to enter a tax hedge with a third party.
In a traditional tax hedge, a taxpayer borrows money from a bank at a variable rate. Subsequently, it enters a “swap” with a third party. Under the terms of the swap, both parties agree to make periodic payments computed by applying a specific rate to a notional amount. In most cases, the notional amount would be equal to the loan the taxpayer took from the bank. In a tax hedge, the taxpayer who is paying the variable rate to the bank would pay the counterparty a fixed rate based on that loan amount. The counterparty to the swap would pay the taxpayer the variable rate which the taxpayer would then remit to the bank. When the taxpayer nets the payments, the cumulative effect is for the taxpayer to wind up paying a fixed rate on the loan borrowed from the bank. The following examples detail the above stated rules.
The Swap
Sandor is an interest rate speculator and believes that interest rates are on the rise. Arya is also an interest rate speculator and believes that interest rates will decrease. Both need cash. Sandor decides to enter an interest rate swap with Arya. He will pay her a fixed interest rate on a stated amount while she will pay him a variable interest rate on that same stated amount. At the end of the year, based on the cash flows, one of them will win and the other will lose. The loser will remit to the winner the necessary amount of cash to cover the swap. Because Sandor did not enter an underlying loan, the transaction would not be considered a tax hedge. It would be considered speculative. Only swaps entered along with an underlying loan will receive beneficial tax treatment from the IRS (discussed below). As speculators, both Sandor and Arya would be taxed at less preferential rates.
The Hedge
Jon decides he wants to purchase a property and goes to his local bank. Jon is unable to obtain a loan paying a fixed interest rate. The bank does offer Jon a loan with a variable rate of interest. Jon consults his friend Sam who informs Jon that interest rates may increase within the next few years. So, agreeing to a variable interest rate could prove risky. Jon decides to enter an interest rate swap with Ramsay. Ramsay believes that interest rates will decrease. He agrees to pay Jon a variable interest rate while accepting Jon’s remittance of the fixed interest rate. So, Jon essentially winds up paying a fixed interest rate on the loan borrowed from the bank. When the loan and swap are taken together, this transaction will not be considered speculative. Because this transaction is considered a tax hedge, Jon will receive preferential tax rates. Jon must be aware that there is a specific identification requirement for tax hedges. If this requirement is not followed, taxpayers can be taxed at less preferential tax rates. If properly identified, Jon can terminate his swap through cancelation, assignment or offset. If not properly identified, Jon could be subject to very harsh “whipsaw” rules that can impute capital loss treatment, as opposed to ordinary loss treatment.
Jeffrey Clayman, CPA, JD, LLM is senior tax manager at Withum.
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