SECTION 5. PRINCIPAL-REDUCTION

METHOD OF ACCOUNTING

Under the principal-reduction method of accounting for discount —

.01 As of the date each loan in a category is acquired, the taxpayer’s basis in the loan is deemed to be the loan’s stated principal amount. All the gain represented by the discount on the loan is recognized solely under the principal-reduction method described in this revenue procedure.

.02 The required computations must be made monthly. Thus, the computation period referred to in this revenue procedure is the month (or that portion of a month that falls within a short taxable year).

.03 At the start of each computation period, the taxpayer must record and retain

the following information for each category of loans for which the taxpayer is using the principal-reduction method:

(1) Unpaid stated principal as of the end of the prior period of all loans in the category that were held at the end of the prior period (Starting Principal); and

(2) Unrecognized discount as of the end of the prior period (Starting Discount).

For the initial computation period, Starting Principal and Starting Discount are zero.

.04 During each computation period, the taxpayer must record and retain the following information for each category of loans for which the taxpayer is using the principal-reduction method:

(1) The stated principal amount at the time of acquisition of all loans in the category that were acquired at origination by the taxpayer at any time during the period, whether or not they are still held by the taxpayer at the end of the period (Current Principal). This amount includes loans in the category that are acquired as refinancings of, or in exchange for, loans previously held by the taxpayer. Thus, if a loan (whether or not in the category) is modified and the modification results under § 1001 in a deemed sale or exchange of the old loan for a new one that is in the category, the stated principal amount of the new loan is included in Current Principal.

(2) The aggregate discount (including discount attributable to points) at the time of acquisition on all loans described in section 5.04(1) of this revenue procedure (Current Discount).

(3) The unpaid stated principal amount of all loans in the category that are still held by the taxpayer at the end of the period (Ending Principal). Thus, Ending Principal does not include the stated principal amount of loans disposed of in refinancings or exchanges during the period. Ending Principal does not include rights (such as mortgage servicing rights) that are retained on the sale of a loan, except to the extent that those rights represent a participation interest in the stated principal amount of the original loan. Ending Principal does not include the stated principal amount of any loan to the extent charged off by the taxpayer during the period. Except as provided in the following sentence, if

R = (DStart + DCurrent) x ([PStart + PCurrent – PEnd] / [PStart + PCurrent])

where — PStart = Starting Principal DStart = Starting Discount PCurrent = Current Principal DCurrent = Current Discount PEnd = Ending Principal R = Recognized Discount

.06 The unrecognized discount at the end of the period (Ending Discount) is the excess of the sum of Starting Discount plus Current Discount over Recognized Discount. This amount must be used as Starting Discount for the next period. This can be restated as:

DEnd = DStart + DCurrent – R where — DEnd = Ending Discount

.07 Ending Principal for the current period must be used as Starting Principal for the following period.

.08 The discount recognized as gain during a taxable year is the sum of the Recognized Discount for all computation periods comprising the year.

.09 For each period, the amounts referred to above must be recorded and sep

the taxpayer has foreclosed on the property securing a loan, neither the unpaid stated principal on the loan nor any remaining deficiency on the loan is counted as part of Ending Principal. If property securing a loan is acquired in a transaction governed by former § 595 and the property has not been disposed of before the end of the period, Ending Principal includes the unpaid stated principal of the loan immediately before the transaction in which the property was acquired.

.05 The discount taken into account as gain (Recognized Discount) during each computation period is the portion of total discount that corresponds to the portion of principal recovered during the period. For this purpose, Recognized Discount is the product of the sum of Starting Discount plus Current Discount times a fraction the denominator of which is the sum of Starting Principal plus Current Principal and the numerator of which is the excess of the denominator over Ending Principal. This can be restated as:

1997–33 I.R.B. 49 August 18, 1997

arately retained as part of the taxpayer’s tax books and records. See § 6001 and the regulations thereunder. These records must be maintained as separate tax records and not merely as a set of adjustments to book figures. These records must affirmatively demonstrate the period-to-period consistency required by sections 5.06 and 5.07 of this revenue procedure.