Interest Deduction on Debt-Financed Distributions

Editor: Kevin F. Reilly, J.D., CPA

Although the real estate market has cooled off in many areas, the value of commercial properties seems to have been less affected than that of residential properties. In fact, many commercial properties continue to be worth substantially more than their historic cost. Most commercial and investment properties are owned by partnerships, limited liability companies (LLCs), or S corporations. The owners are often tempted to cash out on the appreciation and equity of the properties through refinancing and assume that the mortgage interest is deductible by the passthrough entity. This is not always the case; deductibility depends on how proceeds are used at the owner level.

Example: Partnership P owns a shopping mall rented to various commercial tenants. It has a $2 million existing mortgage and its operation breaks even with $1 million annual rental income and expenses. P would like to refinance a new mortgage for $10 million. After paying off the existing mortgage of $2 million, P distributes the remaining $8 million to the partners.

P cannot deduct interest associated with the $8 million distribution. Instead, the interest expense is separately disclosed on each partner’s Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., and deductibility depends on how each partner uses the proceeds.

Generally, under Temp. Regs. Sec. 1.163-8T(a)(4), if the proceeds are used for items of a personal nature (e.g., a sports car, vacation, or home upgrade), the related interest expense is not deductible. Conversely, if the proceeds are used in income-producing activities or investments, the related interest expense would be deductible. In addition, the deduction for interest expense is limited to net investment income; the excess investment interest expense can be carried forward to future years. Net investment income generally includes interest, dividend, annuities, and royalties; it does not include qualified dividends and net capital gain. However, a taxpayer can elect to include qualified dividends and net capital gain as investment income. The election can be made by completing a specific line on Form 4952, Investment Interest Expense Deduction. If the taxpayer chooses such treatment, qualified dividend income and net capital gain are not eligible for lower capital gains tax at 15%, but the net investment income can be offset by investment interest expense.

Many practitioners confuse investment expense with investment interest expense. Investment expense, such as brokerage management fees, is subject to 2% of the adjusted gross income (AGI) floor and is reported on the “other expenses” line (in the “Job Expenses and Certain Miscellaneous Deductions” section) of Form 1040, Schedule A, Itemized Deductions, while investment interest expense is not subject to the 2%-of-AGI floor and is reported on the “investment interest” line (in the “Interest You Paid” section) of Schedule A.

To increase the interest deduction available to their clients, practitioners should be aware of how the general and optional allocation rules work. Unless optional allocation rules provided by Notice 89-35 are used, debt proceeds and related interest expense are allocated according to the general allocation or interest tracing rules under Temp. Regs. Sec. 1.163-8T.

Interest Tracing Rules Under Temp. Regs. Sec. 1.163-8T

Generally, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures by partners (i.e., trade or business, investment, passive, etc.). The related interest ex-pense takes on the character of that expenditure and is treated under the appropriate set of rules. For example:

1. If proceeds are used for personal purposes, the interest expense is not deductible.

2. If proceeds are used in passive activities, the interest expense is subject to passive activity loss (PAL) limitation rules. Taxpayers need to determine if the interest expense can be deducted based on Form 8582, Passive Activity Loss Limitations. Deductible interest expense relating to passive activity should be reported in Part II of Schedule E, Supplemental Income and Loss. Generally, PALs are generated when total passive loss exceeds passive income. PALs cannot be used to offset nonpassive income.

3. If proceeds are used in investment activities, the interest expense is treated as investment interest expense, is reported on Form 4952, and is potentially deductible as an itemized deduction on Schedule A.

4. If proceeds are used in nonpassive (trade or business) activities, the interest expense is deductible in computing income or loss.

Notice 89-35 prescribes rules for determining the treatment of debt incurred by a passthrough entity and used to make distributions to partners. To the extent the partnership has not already allocated other debt to specific operating expenditures, it can allocate the debt actually used for distributions to such expenditures. There is no re-striction on when the expenditures were incurred. Thus, the optional allocation can be made for expenditures incurred at any time during the tax year. In the above example, P can choose to allocate $1 million of the distribution to partnership business expenditures; therefore, P can deduct interest associated with the $1 million.

If P uses the optional rule to allocate distributed debt proceeds and associated interest expense, the entity’s interest expense on debt proceeds allocated to such other expenditures should be reported on Schedule K-1 in a manner consistent with the allocation of the debt proceeds. For example, if P allocates distributed debt and the associated interest expense to expenditures in connection with a rental activity, the entity should take the interest expense on the debt into account in computing the income or loss from the rental activity reported to the owner on Schedule K-1.

To the extent the expenditure election is made, interest tracing is not required. The distributions are deemed to be made from the partnership’s revenue. This technique can be expanded to distributions over two or more tax years to maximize revenues and expenditures.

Conclusion

While the mortgage interest rate is still at the low side of the historic average, many owners of passthrough entities are tempted to cash out. It is prudent to identify planning opportunities before distributing proceeds of any type. While the optional allocation under Notice 89-35 is a useful tool, one should be mindful that the distributed debt proceeds must be allocated under the general allocation rule, to the extent that such proceeds exceed the partnership’s expenditures for the tax year to which debt proceeds are not otherwise allocated.