Deducting Prepaid Interest

[MJG CPA]

A banker friend has a cash-basis farm client who wants to prepay 2008 interest on a farm note in 2007 for an added deduction. From the research material I am finding, I don't think prepaid interest is deductible currently. Does anyone think differently?

I guess my thought is that the farmer would be better off prepaying his crop input costs which are deductible (up to 50% of farm expense).

Any thoughts?

[jainen]

>>A banker friend... <<

I'm surprised a banker would ask such a question. Generally extra payments on a note should be applied to principal, because there is no interest owing at the time. In the case of mortgage points, the prepayment actually lowers the interest rate. Any other prepayment of interest would mess up the truth-in-lending disclosures.

Payment for a bill to be incurred in the future is not currently deductible, even for a cash-basis taxpayer. Nevertheless, I would probably let it go unless the amount was way out of balance, say more than 1/2 of the regular annual cost. I would argue with him if it were more than three months worth. His side of the argument would need to show that there was a bona fide business purpose (other than tax avoidance) for the prepayment, and that the bank did not apply it to principal.

[OldJack]

Well, I suppose an argument could be made that the interest is owed but it is just not due, therefore prepayable. I don't think most would buy such an argument. I expect the bank, as Jainen says, would be required to apply the payment to principal under current banking rules (not that I know anything about the rules since I have not audited a bank in about 40 years).

But then isn't there an old 12 month rule on prepayments (that I find hard to apply) but says (in my simple brain) that if the prepayment of expense is not more than 12 months, or exceeding the next year-end, it may be allowed as an expense?

I note that 2006 Quickfinder 1040, page 5-11, says:

>>"Mortgage interest prepaid in 2006 that fully accrues by January 15, 2007, may be included in Form 1098, box 1. This prepaid interest is not deductible in 2006; it should be deducted in 2007. Note: Some lenders apply prepaid amounts to both interest and principal; others apply prepayments to principal; only.<<

You would think the IRS would make up their minds on how such should be handled!

[MJG CPA]

Thanks for your replies. I settled on the conclusion that prepaid interest is not deductible currently. It would have been too large of an amount to ignore and the banker was not comfortable accepting such a payment and having to explain to bank examiners why he had a negative interest amount on the client's account.