Mark to market accounting: A Promising tax tool for specialty lenders
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Specialty finance companies operate in a tough environment. Their subprime customers are, by definition, poorer credit risks than those served by most banks. The industry rule of thumb holds that such companies will typically write off loans at a much higher rate than “prime” rate lenders.
For financial accounting purposes, specialty finance companies must estimate the bad debts incurred in their loan portfolio and record this estimate by providing an adequate allowance for loan losses. Generally, these losses will be realized the following year or shortly thereafter, depending on the nature and form of the underlying portfolio. Prior to a tax law change in 1986, taxpayers, including specialty finance companies, were allowed to deduct reasonable additions to the allowance for loan losses. Under the 1986 change, the allowance for loan losses is not deductible for tax purposes. This generally creates a significant unfavorable book-to-tax accounting temporary difference.
However, specialty lenders often overlook a useful tax-planning opportunity called mark to market accounting. Companies that originate or purchase loans have an option that effectively allows them to accelerate the deduction for the bad debts they will incur based upon market conditions. This article discusses the opportunities of the mark to market tax accounting option and gives examples of how it can work to create tax-planning advantages for specialty lenders.