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Interest Expense Limitations for Individuals

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1 Interest Expense Limitations for Individuals

2 Topics What is interest expense?
General overview to interest expense limitations and their rationale Basics of interest tracing rules of Reg. § T and related Notices Limitations: Personal interest Interest on education loans (IRC §221) Investment interest + interest related to tax-exempt activities Home mortgage interest

3 Interest expense – pre-classification issues
Possible tax issues: Is a prepayment penalty interest? If a closely-held corporation loans money to a shareholder/employee, is it a bona fide debt that could produce interest expense or is it a distribution or compensation? Debt v equity Non-recourse debt might warrant greater scrutiny (EX – Rev Rul ) Is market interest being charged and if not, must interest be imputed?

4 What is debt? Naguchi, 992 F2d 226 (9th Cir. 1993) – “To be deductible under section 163(a), the obligation on which interest is based must be an "existing, unconditional and legally enforceable obligation for the payment of a principal sum." Howlett v. Commissioner, 56 T.C. 951, 960 (1971). A debt must be an existing and genuine obligation in order to give rise to deductible interest payments. As we explained in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976), "a mere chance that a genuine debt obligation may arise ... is not enough to justify an interest deduction. To justify the deduction the debt must exist; potential existence will not do.“”

5 AWG Leasing Trust v. U.S., 592 F Supp 2d 953 (ND Oh, 2008)
“The Supreme Court has generally defined “interest” as “compensation for the use or forbearance of money.” See, e.g., Comm'r v. Nat'l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 145 (1974) (internal citation omitted). In order for a taxpayer to take such a deduction, however, the underlying debt on which the interest is paid must be genuine. Bridges v. Comm'r, 325 F.2d 180, 184 (4th Cir. 1963). See also Goldstein v. Comm'r, F.2d 734, 742 (2nd Cir. 1966), cert. denied, 385 U.S (1967) (holding “Section 163(a) does not “intend” that taxpayers should be permitted deductions for interest paid on debts that were entered into solely in order to obtain a deduction”). In deciding whether economic advances made to a corporation are true debt, courts must consider “whether the objective facts establish an intention to create an unconditional obligation to repay the advances.” Indmar Products Co. v. Comm'r, 444 F.3d 771, 776 (6th Cir. 2006) (citing Roth Steel Tube Co. v. Comm'r, F.2d 625, 630 (6th Cir. 1986).”

6 AWG - continued “The Sixth Circuit has embraced the Second Circuit's definition of “debt” for tax purposes as: [A]n unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof. While some variation from this formula is not fatal to the taxpayer's effort to have the advance treated as a debt for tax purposes, ... too great a variation will of course preclude such treatment. The question becomes, then, what is “too great a variation”? Indmar Products, 444 F.3d at 776 (citing Gilbert v. Comm'r, F.2d 399, 402–03 (2nd Cir. 1957) (internal quotation marks omitted).”

7 Who can potentially deduct interest expense?
Assuming it falls into a deductible category … Generally, the person legally liable and who pays it Reg. § (b) – “Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”

8 Clarification of §1.163-1(b)
Golder, Jr., 604 F.2d 34 (9th Cir. 1979) Excerpt: “Taxpayers do not challenge the Tax Court's conclusion that they were not directly liable on the Rancho Vistoso indebtedness. Nor do they dispute that a deduction for interest under section 163 cannot ordinarily be taken unless the interest was owed on the indebtedness of the taxpayer. They argue, however, that Treasury Regulation section (b) creates an "exception" to this rule which would entitle them to deduct the payments they made as guarantors of the corporate obligation. Reg. section (b) provides: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness ...." Taxpayers argue that while it is the intention of section 163(a) to deny an interest deduction where the taxpayer's liability is secondary or indirect, Reg (b) creates an exception to this rule where the secondary liability is secured by a mortgage on the taxpayer's real estate. We do not agree. Reg (b) must be read in its proper context, i.e. in light of its parent statute, section 163(a). Section 163(a) permits an interest deduction only on the taxpayer's own indebtedness. Reg (b) does nothing more than permit the deduction of interest in situations where the taxpayer-borrower is not personally liable on a mortgage of property which is used as security for a loan made to the taxpayer. For example, a taxpayer purchases land paying part of the purchase price in cash and the balance with a non-recourse note secured by a mortgage on the land; there, in the event of default, the creditor may look only to the property. Although the taxpayer is not directly liable on the debt—since the creditor may look only to the pledged property for repayment—Reg (b) permits the taxpayer to deduct interest payments since the default affects only the taxpayer and no one else. The taxpayer must pay the interest to avoid foreclosure of his ownership interest in the property. Thus Reg (b) does not create an "exception" to the statutory rule of section 163(a) that interest is deductible only with respect to the indebtedness of the taxpayer, but simply recognizes the economic substance of non-recourse borrowing. Reg (b) permits the taxpayer-borrower in such cases to deduct the interest on the loan even though the taxpayer is not personally liable on the loan.”

9 Overview to individual interest limitations
Why needed: §469 – to determine PAL, must know how much interest expense associated with the activity §163(d) – a limitation had been around even before TRA’86 After TRA’86 and new limitations for PAL and personal interest and home mortgage interest, needed to know what was investment interest and what was not To apply rule for disallowance of personal interest added by TRA’86

10 Authority to issue interest tracing regs
§469(l)(4) – “Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations— (4) which provide for the determination of the allocation of interest expense for purposes of this section” General authority under §7805

11 Interest tracing basics
Reg. § T (TD 8145; 7/1/87) Basic rule -8T(a)(3) – “Manner of allocation. In general, 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. This section prescribes rules for tracing debt proceeds to specific expenditures.”

12 What is included in interest expense?
T(c)(2)(ii)(C): Relevant provisions of the loan agreement OID rules Unstated interest per §§483,

13 Examples – categorize the following
Interest on auto loan from Ford Motor Credit Corporation for personal auto. Interest assessed by IRS upon audit of last year’s Schedule C. Interest on auto loan where car is used 60% for business, borrower is an employee Interest on Visa credit card where about 50% of each bill is for employee business expenses Same as (4) but borrower is an active partner in a partnership Loan proceeds are deposited in a non-interest bearing checking account.

14 Mechanics of Interest Tracing Rules
Somewhat complex and detailed. Special rules provided for: How the money was rec’d (in cash, in an account, seller-financing (no proceeds rec’d)) Special “pretend” rules – 15-day one in regs supplemented by 30-day rule in Notices Repayment ordering rules Change in loan proceeds rules More funds deposited into an account Refinancing Passthrough entities

15 Allocation period of -8T(c)(2)
Begins on date proceeds used or treated as used to make an expenditure and ends on earlier of date debt is repaid or reallocated to a different expenditure Start includes when the proceeds are sitting in borrower’s account. Label the interest expense based on how debt proceeds used. Does not matter if taxpayer pays interest late when the debt has been reallocated to a different use

16 Ways of borrowing money
Lender keeps the proceeds (seller financing) -8T(c)(3) Borrower received in cash -8T(c)(5) Funds deposited into borrower’s account -8T(c)(4)

17 Debt proceeds not disbursed to borrower
-8T(c)(3) Categorize by treating as if borrower did receive funds and used them EX – buy rental property and assume the debt on it. Assuming is a passive activity, have passive activity debt and interest expense Is no 15-day rule (or 30-day rule) applicable

18 Debt proceeds distributed in cash
-8T(c)(5) – generally, trace to use, otherwise, interest is assumed to be personal 15-day “pretend” rule – B may treat any cash expenditure made within 15 days of receiving the cash as made from the debt proceeds Notice modifies the 15-day rule to a 30-day before or after rule EX – B borrows $30,000 in cash on 5/1/08 and uses it to pay personal bills on 5/1. B should look to any other cash expenditure made between 4/1/08 and 5/31/08 that would produce deductible interest and “pretend” that the cash was really used for that expenditure. Document it!

19 Debt deposited into borrower’s account
-8T(c)(4) Deposit into account = investment expenditure Reallocate when debt proceeds used for another expenditure What if the account also has non-borrowed funds – which is presumed used first? -8T(c)(4)(ii) – debt proceeds treated as used before unborrowed funds and before any amounts deposited after the debt proceeds are deposited. 2 exceptions to general ordering rule: (1) – if account only has loan proceeds and interest income from the debt – may treat expenditures as from the interest income -8T(c)(4)(iii)(C) (2) 15 day rule which is modified to 30 day before and after rule by N89-35

20 Example from -8T(c)(4) modified for N89-35
Date Deposits Withdrawals 1/10 Debt A $500 Gift $1,000 1/11 Debt B 2/17 $800 personal 2/26 $700 PA 6/21 Debt C 11/24 Inv exp 12/20 $600

21 Additional rules for debt proceeds deposited into borrower’s account
-8T(c)(4)(iii) – multiple checks written on same day – treat as written in any order -8T(c)(3)(iii) – expenditure from checking account is treated as made when check written, provided check is delivered or mailed to payee within a reasonable period after writing the check What is a reasonable time?

22 More rules for funds deposited into B’s account
-8T(c)(4)(iv) – optional method for determining date of reallocation B may treat all expenditure made during any month from debt proceeds as occurring on later of: 1st day of the month, or Date on which debt proceeds deposited in the account Benefit – may calculate interest for the entire month, rather than treat change in use of debt proceeds as occurring during the month -8T(c)(4)(v) – simultaneous deposits – if 2 or more debt deposited into account at same time, treat as deposited in order debts were incurred. If truly simultaneously created, then B may chose which was incurred first. Debt on which interest accrues at different rates are treated as separate debt. For example, line of credit with fluctuating interest rate. If draw on credit on Feb 1 at 7% rate and draw again on April 1 at 7/5% rate, have 2 different debts.

23 Question Zena borrowed $40,000 and used it as follows (it was deposited into her checking account): $10,000 to pay off credit cards $10,000 to pay tuition for 7th grade daughter $20,000 to invest in Garden Villa Apts Ltd Partnership What type of the interest expense does Zena have and what information to you need from her to answer this question?

24 Debt proceeds used to pay borrowing costs or interest expense
-8T(c)(6)(ii) & (iii) If debt proceeds used to pay interest on another debt – categorize the interest on 2nd debt same as on 1st debt If debt proceeds used to pay borrowing costs of a different debt – categorize interest same as on other debt. If debt proceeds used to pay borrowing costs of that same debt (borrowing costs were added to the debt balance) – categorize same as for balance of the debt.

25 Debt repayment -8T(d) If debt repaid was a multi-use debt, and only part of the principal was repaid, then apply following ordering rule to determine which “use” of debt was repaid: Amounts allocated to personal expenditures Investment expenditures and passive activity (other than RRE-AP) – within this class, treat repayment as going towards whichever expenditure was made first. If made on same day, then taxpayer choice. RRE-AP Former passive activity expenditure Trade or business

26 Debt refinancings -8T(e)
If refinanced debt is only used to pay off part of the original debt, then apply the repayment ordering rules to determine character of interest expense, assuming original debt was a multi-use debt. If refinanced debt > original debt, categorize interest on excess debt under general tracing rules.

27 Reallocation of debt -8T(j)
General rule: debt allocated to an expenditure chargeable to a capital account must be reallocated to another expenditure at earlier of: Date original asset is sold and proceeds are used for something else Date on which use of the asset changes, such as from business to personal

28 Question In 2007, B borrowed $20,000 from her bank and used the proceeds to pay off $14000 of personal debts, $3,000 to buy a new computer for her Sch C business and the balance to invest in a ltd partnership which is a passive activity to her. In 2009, B makes first payment of principal, paying $15,000. What part of the debt has she paid?

29 Debt & Passthrough Entities
-8T(f) – (i) – “reserved” IRS provided the rules in Notices N89-35 provides rules on how to categorize interest expense when: A) owner borrows to acquire interest in p/s or S corp B) p/s or S corp borrows and distributes debt proceeds to owners

30 Debt related to acq of interest in passthru entity per Notice 89-35
“Contributions” “Purchases of Interests” Example: Borrow from bank and contribute proceeds to p/s or S corp to acquire an interest Borrow from p/s or S to acquire the interest Interest allocation method per N89-35 Any reasonable method Allocate among entity assets using any reasonable method Examples of reasonable methods Allocate among entity’s assets or trace to entity’s use of the funds. If the entity used funds to acquire RRE, owner would classify the interest as passive activity Allocate pro rate among assets of entity based on FMV, book value or adj basis, reduced by any entity or owner debt allocated to such assets already

31 Question William is a shareholder in an S corp and is also an employee of the corporation. William borrowed $50K to acquire stock in the corp. Is the interest expense trade or business or investment interest expense?

32 Question – p/s borrows and distributes
Partnership PQ’s property has greatly appreciated in value and there is no debt on it. General partner thinks it would be wise to borrow $500K against the property at 5% rate in order to make a distribution to the partners. PQ’s normal operating expenses are about $110K per year. Explain to general partner how the interest expense is to be reported on partners’ K-1s and what he should tell the partners about categorizing their interest expense.

33 Policy – why tracing? Could IRS have used an approach other than tracing for the -8T regs? Preamble to -8T regs notes that some taxpayers may attempt to manipulate the tracing rules and future regs might contain some anti-abuse or special rules Other approaches IRS could have considered: Pro rate allocation Problem – what base to use? If need to allocate based on FMV of borrower’s assets, would require appraisals How debt is secured “Carrying an asset” – similar to old prop reg at (b)(1)(iii) – similar to the interest capitalization rules where expenditures exceed traced debt – avoided cost method

34 How are late fees on debt treated?
Was the fee paid for the use or forbearance of money? Yes – likely is interest No – see if is a T or B expense under §162 fyi Rev Rul , 71-98, , Bailey, TC Memo , aff’d (11th Cir,1992) – struggling business incurred regular overdraft charges/fees; held not ordinary and necessary under §162

35 Borrowing from same lender
Query – has the borrower really paid anything? Arguably still in same position – owes $ to original lender Battlestein (5th Cir. 1980) Wilkerson (9t Cir. 1981) Also noted in IRS Pub 535 Exception where account where 2nd loan proceeds were deposited also had other funds: Burgess, 8 TC 47 (1947)

36 Personal interest expense
Non-deductible starting with TRA’86 Rationale: BB pg 263 Deductibility created incentive to borrow Also, because supported incentive to invest in consumer items rather than investments EX – tax law doesn’t require reporting of imputed rental value of owner-occupied housing But kept home mortgage int deduction because of “important policy goal” of home ownership Examples? Try to avoid via HEI (although are putting home at risk) and 30-day rule of the tracing rules

37 §221 Interest on education loans
Added by TRA’97 Rationale: “many students incur considerable debt in the course of obtaining undergraduate and graduate education. The Committee believes that permitting a deduction for interest on certain student loans will help to ease the financial burden that such obligations represent.” Several limitations: Overall: $2,500 Modified AGI limits Limits based on definition of “qualified education loan” and “qualified higher education expenses” No deduction if taken under some other provision

38 Investment interest limitation
§163(d) and Form 4952 Deduction cannot exceed “net investment income” NII = excess of investment income over investment expenses “Investment income” = “the sum of— (i) gross income from property held for investment (other than any gain taken into account under clause (ii)(I)), (ii) the excess (if any) of— (I) the net gain attributable to the disposition of property held for investment, over (II) the net capital gain determined by only taking into account gains and losses from dispositions of property held for investment, plus (iii) so much of the net capital gain referred to in clause (ii)(II) (or, if lesser, the net gain referred to in clause (ii)(I)) as the taxpayer elects to take into account under this clause. Such term shall include qualified dividend income (as defined in section 1(h)(11)(B)) only to the extent the taxpayer elects to treat such income as investment income for purposes of this subsection.” Amount not deductible in current year carries forward indefinitely subject to same limitation in subsequent years

39 Investment interest expense limitation example
Mr. and Mrs. Smith have following for They prefer to have any income tax can be taxed at a lower rate treated that way. Sch B interest income $23,000 Qualified dividends $1,000 Int exp to acquire int in ltd partnership X (80% of assets are rental and 20% are portfolio) $3,000 Margin account interest $37,000 AGI $133,000 Investment expenses $2,500 Other misc itemized deductions $3,300

40 Answer Investment income $23,000 Less: Inv expenses ( 2,500)
NII $20,500 Inv int expense: Margin loan $37,000 P/S ($3,000 x 20%) total $37,600 Excess to carryforward to $17,100

41 Tax-exempt interest expense
§265 T(m)(2)(i) – generally, “any limitation on the deductibility of an item (other than the passive loss and nonbusiness interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section.”

42 How to determine if interest expense is properly allocable to tax-exempt income
Reg. § (c) – “Allocation of expenses to a class or classes of exempt income. Expenses and amounts otherwise allowable which are directly allocable to any class or classes of exempt income shall be allocated thereto; and expenses and amounts directly allocable to any class or classes of nonexempt income shall be allocated thereto. If an expense or amount otherwise allowable is indirectly allocable to both a class of nonexempt income and a class of exempt income, a reasonable proportion thereof determined in the light of all the facts and circumstances in each case shall be allocated to each.” (d) – statement required to be included on tax return T(b) – QRI rules subject to §265(a). EX – borrow home equity loan and use ½ of proceeds to purchase tax-exempt bonds then ½ of interest expense is not deductible

43 Review Important to know type of interest expense an individual has
Generally – apply tracing rules of T and Notices If secured by PR or second home – ck if QRI in which case tracing n/a Unless elect under T(o)(5) to treat as NOT secured by residence Planning possibilities Recordkeeping important to prove type of interest expense you have at all times

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