Loans with interest rates that step up over time create tax complications.

Many project finance loans have such a feature as a way to encourage the borrower to repay the loan before the interest rate increases.

The lender may have to report the potential increases in the interest rate as income over the full life of the loan. They are considered contingent interest for tax purposes since the loan may be repaid before the interest rate increases. Contingent interest must be reported by the lender as “original issue discount,” meaning the lender is considered to start earning the stepped-up portion of the interest rate from the start of the loan. Determining how the contingent interest accrues requires complicated calculations. 

The lender can avoid reporting the contingent interest as original issue discount only if the odds are remote that the loan will remain outstanding beyond when the interest rate increases.

The borrower deducts the additional interest at the same time the lender reports it as income.

By Keith Martin and Dick Leder