Interest rate swaps are a derivative investment in which two parties agree to swap interest payments. One side exchanges its fixed-rate interest payment with the other side for its variable-rate interest payment. While interest rate swaps are typically used to decrease the amount of risk a company faces from its debts, investors could use them to speculate on the direction of interest rates. Although swaps have been around since 1983, the Internal Revenue Code does not directly address them.
Structure of a Swap
Under an interest rate swap, two parties enter into a contract agreeing to pay each other the interest payments from their own debt. Each remains responsible for the debt but pays out either a fixed or variable rate of interest on the nominal amount of the debt. The contracts are negotiated directly between participants and they either expire at the end of the specified time or are sold to a new party.
When a taxpayer participates in an interest rate swap, she undertakes several transactions that could affect her tax bill. First, she has a debt for which she pays or receives interest. That interest might be deductible if the debt is to purchase a business or investment asset or can be considered interest income. Second, she has entered an agreement to make and receive payments with a third party; because that agreement is not based on any principal debt, those payments are not interest related. Third, she can allow the contract to expire or sell it to another party, qualifying it as an intangible asset. The conclusion of an interest rate swap could result in a gain or loss.
Capital or Ordinary
Most interpretations point to treating payments made on an interest rate swap as the purchase price of an asset and payments received as income. The tax treatment of the income depends on whether the swap is an investment or a hedge against business risk. If it is an investment, payments received are treated as investment income and might be taxed at preferential rates. Hedges, on the other hand, are part of managing ordinary income streams and so are taxed as ordinary income. When the purpose is mixed, the taxpayer might be able to argue that the income should be treated as investment income.
Gain or Loss
The amount that a party pays out on an interest rate swap is considered the purchase price, or basis, in the swap. Payments received, then, are a return of investment and decrease the taxpayer’s basis in the swap. Income from the swap should be tax free as long as it doesn’t exceed the amount of money paid into the swap. When the contract terminates or is sold, the taxpayer will either have a net gain or a net loss, depending on the relative amounts received and paid out.
Investors might take part in an interest rate swap to speculate on the direction of the interest rate market. Tax treatment for interest rate swaps for individual investors is similar to the way it works for corporations. The main difference is in the treatment of the underlying debt: Individuals have less latitude to deduct interest expenses than businesses do. Income from an investor's interest rate swap is always treated as investment income, taxable at the preferential rates.
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