Beat The $3,000 Capital Loss Cap in Marketplace Lending

Because interest on platforms like Lending Club is counted as normal income and the losses as capital losses, you can only deduct a maximum loss amount of $3,000 if you don’t have capital gains from other investments. That can be an expensive mistake for an investor with a large portfolio who isn’t paying attention. For instance, if you earned $20,000 in income through Lending Club but had $10,000 in losses from defaults, you’d actually be taxed on $17,000, not on the difference between the two. In, Is the Premium Gone in Peer-to-Peer Lending?, I wrote that there’s a whole lot of risk in marketplace lending and not a whole lot of yield to compensate for it, especially when considering the poor tax treatment.

It’s surprisingly easy to rack up thousands of dollars in defaults in a single year even if you spread the risk around through small $25 increments. I know this because I’m teetering on the fence of it just on Lending Club alone. I had approximately $2,600 in charge-offs so far for 2015 at the end of October. Anything beyond $3,000 I can’t offset against my gains so there’s little sense in investing any more money.

Unless…

There is one way to build a significant portfolio without breaking the threshold, invest in the low risk loans. Of the 246 A-grade loans I’ve invested in, so far none of them have ever defaulted. Of the 675 B-grade loans, only 9 of them have already defaulted. Compare that to the 52 G-grade loans I’ve participated in where 11 have defaulted. It might interest you to know that the average time remaining to maturity on those G-grade loans is about 3 years. That means 21% of them have already gone bad and there’s still another 3 years left to go. While these stunningly high risk loans might return in yield for what they lack in performance, they’re a great way to build a capital loss mountain, something that could cause significant damage once you exceed $3,000.

By investing in low risk loans and staying below the capital loss cap, you can invest substantially more. Illogical as it may seem, a big lower yielding portfolio can earn more than a higher yielding one because of the tax treatment if you do not have outside investments with capital gains.

If you are a small investor looking to play with $5,000, none of this will likely be relevant to you, but if you were looking to place $100,000 or more, you might want to remember this phrase in marketplace lending, lower yield is more.

Read more about the capital loss rules and Lending Club on the LendAcademy blog.

Sean Murray is the President and Chief Editor of deBanked and the founder of the Broker Fair Conference. Connect with me on LinkedIn or follow me on twitter. You can view all future deBanked events here.