Hedging allows investors to cover their risks by investing in derivatives and other instruments. Some of these derivatives help them mitigate the risks associated with interest payments. While interest rate swaps are the most prevalent type, interest rate caps can also provide similar features. It is also crucial to understand how their tax treatment and accounting work.

## What is an Interest Rate Cap?

An interest rate cap is a derivative that limits the interest accrued on variable-rate loans. Essentially, it protects the borrower from paying excessively high interest. However, both parties must agree to the cap before the contract commences. Interest rate caps are crucial in floating interest rate contracts. It comes with a specific level and lasts for a specified period within the loan agreement.

Interest rate caps are a derivative within loan contracts. The borrower may have to pay an up-front fee or premium to avail of this feature within their agreement. Once the interest rate cap is in place, it protects the borrower from significant interest rate rises. Since this applies to floating-rate loans, interest rate caps are crucial in helping reduce the losses incurred by the borrower.

## What is the difference between Interest Rate Swap and Interest Rate Cap?

Both interest rate caps and swaps can be a part of a borrower’s hedging strategy. These allow the borrower to limit the losses they bear on floating-rate borrowings. However, interest rate swaps are more common than caps. Nonetheless, it does not make one form of the hedging strategy superior. Both interest rate swaps and caps can have their advantages and disadvantages in specific contexts.

The primary difference between the two types of derivatives is their structure. In an interest rate swap, two parties exchange their interest payments on loans. Usually, it involves fixed and floating rate interest instruments. On the other hand, interest rate caps come on floating-rate interest borrowings only. It does not require exchanging payments on the underlying instruments.

## What is the Interest Rate Cap Tax Treatment?

The basic premise of an interest rate cap is that it involves an agreement between two parties. One party agrees to compensate the other if the interest rate on a variable loan goes above a specific rate. In exchange, that party receives a fee for the services provided. The interest rate cap tax treatment accounts for both aspects of this transaction.

Any payments paid in exchange for the interest rate derivative by the borrower become an interest expense. The borrower can report this expense as a part of the interest-related charges on loans. Similarly, the interest on that loan is an allowable deduction when calculating trading or rental income. Therefore, the premium paid on the interest rate cap is also an allowed deduction.

The interest rate cap tax treatment also accounts for the compensation made by the lender to the borrower. The IRS does not consider such payments as rent. Therefore, these payments are not included or taxed as rental income. Instead, the lender can deduct these payments from their rental profits for the period.

## What is the accounting for Interest Rate Cap?

The accounting for the interest rate cap is straightforward. It involves transferring the loan balance on which the borrower takes the interest rate cap to a different account. However, this transaction occurs off-balance sheet. The journal entry to record it is as follows.

Dr | Interest rate derivative – Cap account |

Cr | Interest rate derivative – Cap (contra) account |

If the interest rate goes above the specified level, the counterparty must pay the buyer the difference between the interest rate and the capped rate. The buyer can record this amount as follows.

Dr | Cash or bank |

Cr | Interest cap premium |

## Conclusion

An interest rate cap allows buyers to mitigate the risks associated with their interest payments. It helps them to set an upper limit for the interest rate they can pay on their loans. Although similar to interest rate swaps, they work differently. The tax treatment and accounting entries for interest rate caps are also crucial when considering these derivatives.

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