Rev. Proc. 84-29

SECTION 1. PURPOSE

The purpose of this revenue procedure is to provide a simplified procedure for individual borrowers to compute current and future years' interest deductions with respect to certain loans, when they have been reporting interest deductions in accordance with the Rule of 78's computation.

SEC. 2. SCOPE

.01 This revenue procedure may be used only if all of the following conditions are met:

(1) the borrower is an individual taxpayer who uses the cash receipts and disbursements method of accounting and who reports income on a calendar year basis;

(2) the proceeds of the loan were used for personal items (that is, not for investment purposes or to purchase items in connection with a trade or business);

(3) the amount of principal originally borrowed on the loan did not exceed $50,000;

(4) the taxpayer has claimed interest deductions based upon the Rule of 78's method on a federal income tax return;

(5) the interest deductions claimed by the taxpayer during any tax year did not exceed the amount of payments made on the loan during the tax year;

(6) the loan was in existence on January 1, 1984, and the loan requires periodic payments at least annually; and

(7) the loan was not a short-term consumer loan described in Rev. Proc. 83-40, 1983-1 C.B. 774. See section 3.04 of this revenue procedure for a brief discussion of Rev. Proc. 83-40.

.02 Taxpayers who meet all the requirements set forth in section 2.01 of this revenue procedure may choose either to follow the procedure in this revenue procedure or to follow the procedure in either Rev. Proc. 84-27 or Rev. Proc. 84-28, whichever is applicable. Rev. Proc. 84-27 provides a mandatory procedure for changing an accounting method from the Rule of 78's method for loans that are not described in Rev. Proc. 83-40 and for which the interest computed under the Rule of 78's does not exceed the loan payments during any year of the term of the loan. Rev. Proc. 84-28 provides a mandatory procedure for changing an accounting method from the Rule of 78's method for loans, for which the interest computed under the Rule of 78's exceeds the loan payments during any year of the term of the loan.

.03 Taxpayers who do not meet all the requirements set forth in section 2.01 of this revenue procedure must follow the procedure in Rev. Proc. 84-27 or Rev. Proc. 84-28, whichever is applicable.

.04 Taxpayers whose loans come within the administrative exception contained in Rev. Proc. 83-40 may continue to use the Rule of 78's method for computing their deductions for interest expense with respect to those loans. If taxpayers want to change their method of accounting for such loans, they must do so by complying with the provisions of Rev. Proc. 84-30.

SEC. 3. BACKGROUND

.01 The Rule of 78's is described in Rev. Rul. 83-84, 1983-1 C.B. 97, as a method of allocating interest on a loan among time periods during the term of the loan. Under this method, the amount of interest allocable to each period is determined by multiplying the total interest payable over the life of the indebtedness by a fraction, (a) the numerator of which is the number of periods remaining on such indebtedness at the time the calculation is made and (b) the denominator of which is the sum of the periods' digits for the term of the indebtedness.

.02 Rev.Rul. 83-84 indicates that the Rule of 78's represents a purely mechanical formula for allocating interest among periods. Because interest is earned by the lender by application of the effective rate of interest over the term of the loan, any agreement between a borrower and a lender that provides that interest is earned in another manner, such as under the Rule of 78's computation, lacks economic substance because it fails to reflect the true cost of borrowing. Rev.Rul. 83-84 indicates further that no tax effect will be given to the Rule of 78's provision.

.03 Rev.Rul. 83-84 states that an agreement between a borrower and a lender with respect to any one year of a loan is not independent of the agreement with respect to any other year of the loan. In general, the substance of a loan agreement is that the same rate of interest applies to each tax year of the loan, regardless of any contrary formulas that may be stated in the agreement. The amount of interest attributable to the use of money for each period between payments is determined by applying the "effective rate of interest" on the loan to the "unpaid balance" of the loan for the period. The unpaid balance of a loan is the amount borrowed plus interest earned minus amounts paid. The effective rate of interest is a measure of the cost of credit, expressed as a yearly rate, that relates the amount and timing of values received to the amount and timing of payments made, and is thus a reflection of the cost of the amount borrowed for the time it is actually available. See Conf.Rep. No. 97-760, 97th Cong., 2d Sess. 553 (1982), 1982-2 C.B. 600, 639; S.Rep. No. 97-494 (Vol. 1), 97th Cong., 2d Sess. 209 (1982); Supplement I to Regulation Z issued by the Federal Reserve System, 12 CFR Sections 226.6 and 226.40 (1979). Therefore, the effective rate of interest, which is a uniform rate over the term of the loan and is based on the amount of the loan and the repayment schedule provided in the loan agreement, when applied to the unpaid balance of the indebtedness for a given period, will produce the true cost of that indebtedness for that period. This true cost of borrowing is sometimes referred to as the economic accrual of interest.

.04 Rev. Proc. 83-40 states that in a typical short-term consumer loan transaction, the Service will accept the Rule of 78's method for computing the borrower's interest deduction and the lender's interest income as a matter of administrative convenience. The administrative exception for short-term consumer loans applies only when 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 when the loan agreement between the borrower and the lender provides that interest is earned, or upon the prepayment of the loan interest is treated as earned, in accordance with the Rule of 78's method.

.05 Rev. Proc. 84-27 and Rev. Proc. 84-28 provide mandatory procedures for taxpayers to change their method of accounting for interest on indebtedness when they have been reporting interest income or deductions in accordance with the Rule of 78's. These revenue procedures apply to lenders and borrowers on loans which are not short-term consumer loans covered by the administrative exception contained in Rev. Proc. 83-40.

.06 Some individual taxpayers, who previously reported interest expense based upon the Rule of 78's method, may have difficulty computing the amount of interest that economically accrues in order to comply with the provisions of Rev. Proc. 84-27 and Rev. Proc. 84-28. Therefore, the Service will accept, as a matter of administrative convenience, an alternative procedure for computing current and future years' interest deductions.

SEC. 4. APPLICATION

.01 The alternative procedure for computing deductions for interest expense is as follows:

(1) take the total amount of finance charge over the life of the loan that was disclosed to the borrower by the lending institution at the beginning of the loan;

(2) subtract from (1) the total of the amounts of interest that the lender has reported to the borrower to have been paid through December 31st of the year prior to the year the change is made;

(3) find the column on the table in section 5 of this revenue procedure that corresponds to the number of years (full and partial) remaining in the loan term as of January 1st of the year the change is made; and

(4) determine the amount of interest deduction in the year of change and each subsequent year by multiplying the appropriate figure from the table in section 5 by the amount computed in (2) above.

.02 The taxpayer can choose to begin using this procedure either for the 1983 or 1984 tax year, by claiming the interest deduction computed in the manner described in section 4.01 on the taxpayer's timely filed federal income tax return for the year chosen. However, the taxpayer may begin to use the alternative procedure for the 1983 tax year on an amended return for such year filed no later than August 15, 1984. The taxpayer cannot use the alternative procedure if the taxpayer has previously complied with the provisions of Rev. Proc. 84-27 or Rev. Proc. 84-28.

.03 In the year of change and each subsequent year, the taxpayer must indicate near the claimed interest deduction on the taxpayer's federal income tax return: "Interest computed under Rev. Proc. 84-29."

SEC. 5. TABLE

                             NUMBER OF YEARS REMAINING IN LOAN TERM

On January 1, 1979, an individual taxpayer borrowed $10,000 to purchase a boat that the taxpayer will use for pleasure. The loan is payable in equal annual installments of $1,770 on December 31st of each year for ten years. The terms of the loan state that interest is earned in accordance with the Rule of 78's method. The total finance charge over the term of the loan is $7,700. The lender has previously informed the taxpayer that the taxpayer's interest was $1,400 for 1979, $1,260 for 1980, $1,120 for 1981, and $980 for 1982. Thus, the total interest deduction that the taxpayer has claimed through December 31, 1982, is $4,760. The taxpayer can choose to use the alternative procedure beginning in either 1983 or 1984. The taxpayer chooses to use the alternative procedure for computing the taxpayer's interest deductions beginning in 1983. Using the alternative procedure, the total finance charge of $7,700 minus previously deducted interest of $4,760 leaves a balance of $2,940. There are six years remaining in the loan term. Using the figures from the column for six years, the interest deductions are computed as follows:

                               Interest Remaining