Section 1221 defines a capital asset as all property held by a taxpayer unless specifically excepted. Section 1221(a)(4) treats accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in section 1221(a)(1) as ordinary assets.

Congress enacted section 1221(a)(4) in 1954 to correct a character mismatch problem. Before its enactment, the value of accounts or notes receivable acquired for rendering services or selling inventory was taken into account by a taxpayer as ordinary income, but gain or loss on a later disposition of the receivables was given capital treatment. Section 1221(a)(4) corrected this mismatch by treating the accounts or notes receivable as ordinary assets.

The legislative history confirms this limited focus by referring explicitly to accounts and notes receivable acquired “in payment for” inventory or services rendered by the holder. The specific problem being addressed by the enactment of section 1221(a)(4) was described in the House Report:

H. R. Rep. No. 1337, 83d Cong., 2d Sess., A273-74 (1954).

The longstanding regulation interpreting section 1221(a)(4) also confirms this limited focus. Section 1.1221-1(a) of the Income Tax Regulations states that the term capital assets includes all classes of property not specifically excluded by section 1221. Section 1.1221-1(d), which addresses the section 1221(a)(4) exclusion, repeats the statutory language of section 1221(a)(4) and then interprets it to apply as follows:

Notwithstanding the above, section 1221(a)(4) has been applied more expansively. The initial expansion occurred with respect to notes obtained in loan originations. In Burbank Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963), acq. sub nom. United Assocs., Inc., 1965-1 C.B. 3, aff’d. in part and rev’d. in part on other grounds, 335 F.2d 125 (9^th Cir. 1964), the Tax Court held that mortgage loans originated by a savings and loan association in the ordinary course of its business were, in the hands of that association, ordinary assets under section 1221(a)(4) because they were notes receivable acquired for the service of making loans. In addition to acquiescing to the decision, the Service relied upon Burbank Liquidating in a series of revenue rulings treating loans made by commercial lenders (including banks and REITs) as ordinary assets under section 1221(a)(4) when held by the original lender. See Rev. Rul. 72-238, 1972-1 C.B. 65; Rev. Rul. 73-558, 1973-2 C.B. 298; Rev. Rul. 80-56, 1980-1 C.B. 154; Rev. Rul. 80-57, 1980-1 C.B. 157. See §601.601(d)(2) of this chapter.

Historically, a lending transaction was sometimes thought of as rendering a service to the borrower. See Rev. Rul. 70-540, 1970-2 C.B. 101; Rev. Rul. 69-188, 1969-1 C.B. 54; Rev. Rul. 68-6, 1968-1 C.B. 325. That characterization, however, does not justify treating notes acquired by an originator in a lending transaction as ordinary assets under section 1221(a)(4). That treatment strains the language of the statute because the notes are not issued by borrowers solely or even predominantly for services rendered. Rather, the notes are, for the most part, issued by the borrower to the lender in exchange for money.

Subsequently, the Tax Court further extended the application of section 1221(a)(4) in Federal National Mortgage Association v. Commissioner, 100 T.C. 541 (1993) (FNMA), by applying that provision to notes that were purchased in transactions that the court considered closely associated with the process of origination. Although FNMA was not an originator, the court used the Burbank Liquidating analysis to extend section 1221(a)(4) treatment to mortgages purchased by FNMA. The court justified this result by pointing out that FNMA’s purchasing activity was undertaken in accordance with its statutorily defined purpose “to provide supplementary assistance to the secondary market for home mortgages by providing a degree of liquidity for mortgage investments.” FNMA, 100 T.C. at 545 (quoting the Housing Act of 1954, ch. 649, title II, section 201, 12 U.S.C. 1716(a)). Because of this purpose, the court concluded that the purchases were “a service to the mortgage lending business and the members thereof.” Id. at 578.

The expansion of section 1221(a)(4) cannot be reconciled with Congress’ stated purpose for enacting the statute. Acquisition of notes or mortgages using consideration other than services or section 1221(a)(1) property generally does not trigger current ordinary income and so does not create a potential for the character mismatch that concerned Congress when it enacted section 1221(a)(4).

The proposed regulation reflects a conclusion by the Treasury Department and the IRS that the extension of section 1221(a)(4) to notes acquired by a creditor in a lending transaction or to notes purchased in the secondary market is inconsistent with Congressional intent and is unsound as a matter of tax policy. In addition, the interpretation of section 1221(a)(4) set forth in Burbank Liquidating and FNMA impedes effective administration of the tax laws by causing the status of the notes to hinge on judgments as to whether the lending transaction or a subsequent secondary market purchase of the notes provides a service to the borrower or the mortgage lending industry. Reliance on judgments such as this fosters uncertainty and disputes.

Accordingly, the proposed regulation clarifies that an account or note receivable is not described in section 1221(a)(4) if, in exchange for the account or note receivable, the taxpayer provides more than de minimis consideration other than services or property described in section 1221(a)(1), or if the account or note receivable is not issued by the party acquiring the services or property described in section 1221(a)(1). In particular, a note is not acquired for services within the meaning of section 1221(a)(4) on the grounds that the taxpayer’s act of acquiring (including originating) the account or note receivable constitutes, or includes, the provision of a service or services to the issuer of the account or note receivable, to the secondary market in which accounts or notes receivable of this sort may trade, or to the participants in that market.

* * * * *

(e)(1) An account or note receivable is not described in section 1221(a)(4) if—

(i) In acquiring the account or note receivable, the taxpayer provides more than de minimis consideration other than services or property described in section 1221(a)(1); or

(ii) The obligor under the account or note receivable is a person other than the person acquiring the services or property described in section 1221(a)(1).

(2) In particular, an account or note receivable is not described in section 1221(a)(4) on the grounds that the taxpayer’s act of acquiring (including originating) the account or note receivable constitutes, or includes, the provision of a service or services to the issuer of the account or note receivable, to the secondary market in which accounts or notes receivable of this sort may trade, or to the participants in that market. If a lender, however, separately invoiced reasonable fees for services that the lender rendered to the borrower in connection with a lending transaction and if the lender received as evidence of the obligation to make payment of those fees an account or note receivable that is separate from the debt instrument that was originated in the lending transaction, then this paragraph (e)(2) does not prevent the separate account or note receivable from being described in section 1221(a)(4).

(3) This paragraph (e) applies to accounts or notes receivable acquired after the date the final regulations are published in the Federal Register.

* * * * *