Interest Tracing Rules and Debt Financed Distributions
By Igor Bochenkov, Director, Tax & Business
When a partnership received loan proceeds or a mortgage and distributes some or all of the proceeds of such borrowing to its partners, the distribution is called a debt financed distribution. Interest tracing rules require the recipients of the debt financed distributions (not the partnership that made the distribution) to “trace” the expenditures that were made with such distributions in order to properly allocate interest expense. To determine if the interest expense is deductible, each partner who received debt financed distributions needs to trace how the funds were spent and then classify these expenditures into the following categories:
- Trade or business expenditures-interest expense allocated to such activity is deductible (with some limitations) by such trade or business.
- Passive activities expenditures-interest expense allocated to such activity is deductible (with some limitations) by such passive activity, for example, rental real estate.
- Investment activities expenditures-interest expense allocated to such activity is deductible (with some limitations) against the income generated by such investment activities.
- Personal expenditures-personal interest expense is generally not deductible.
For example, the purchase of a boat for pleasure is a personal expenditure and no interest expense deduction will be allowed. Further, if a partner bought an investment, such as stock in a public company, then the interest will be classified as investment interest and deductible (with some limitations) up to the amount of income generated by such investment property. The partner can also start a business with the funds and the interest expense will be deductible against the income generated by such business.
To summarize, interest expense on a debt financed distribution is subject to tracing rules. The burden of deductibility is up to the individual partner (not the partnership) who will be required to individually trace the expenditures made with the proceeds of such distributions to determine if such interest expense is deductible. Expenditures can be classified as either trade or business, personal, investment or passive activities expenditures. The rules applicable to each expenditure category will govern how, when and if the interest expense allocated to such category is deductible. The partnership will be required to report the partner’s share of the interest expense allocable to each partner on schedule K-1. From there, the deductible nature of the expense will be the partners’ responsibility.
If you are a partner who has received such a distribution, contact your Marcum Tax Advisor for guidance on the deductible nature of the interest expense.