Tracing of Interest Expense Related to Debt-Financed Distributions
By Rachel Lawent, Supervisor, Tax & Business Services
When proceeds are received from a loan, there are various tax consequences depending on whether the borrower is the taxpayer or an entity owned by the taxpayer, and what is done with the proceeds. Following is a discussion of when and how interest expense may be deducted by a taxpayer, in general. Next, the treatment of interest expense when debt proceeds are received through a distribution from a pass-through entity, known as a debt-financed distribution, is addressed.
Deductibility of Interest
When a taxpayer takes out a loan, the deductibility of interest expense on the loan depends on how the proceeds were utilized. Interest on a business loan is a deductible expense of the business, while interest on a personal loan (such as a car loan) is not deductible. If the proceeds of a loan are used for multiple purposes, the interest expense must be allocated among those different expenditures to determine the amounts that may be deducted.
There are also special rules for debt secured by the taxpayer’s home. For all other debt, three categories of expenditures permit interest expense to be deducted:
- If the proceeds are used to invest in a passive activity, such as the purchase of a limited partnership interest, the interest expense is considered a passive expense that can be deducted if there is sufficient passive income (or carried forward, if there is not).
- If the proceeds are used to purchase an investment other than a passive activity, such as stocks or bonds, the interest expense is considered to be an investment expense, deductible to the extent of net investment income.
- If the proceeds are used for expenditures associated with a trade or business, the interest expense is a deductible expense of the business.
Uses of debt proceeds that don’t fall into one of these three categories would generally be considered personal expenditures, and the interest expense would not be deductible on the tax return.
Interest Tracing Rules for Debt-Financed Distributions
The interest tracing rules have unique implications for pass-through businesses that distribute debt proceeds to their owners. For example, a real estate partnership may decide to “cash out” an appreciated real estate property by refinancing a mortgage and distributing the proceeds to the partners. In this scenario, the partnership is responsible for determining the portion of the distribution considered to be from debt proceeds (a debt-financed distribution) and reporting to the partners their allocated interest expense. The partners are responsible for determining whether the interest expense is deductible on their personal tax returns (and if so, the type of deduction), based on how the debt-financed distribution is utilized.
In reporting to the owners the amount of separately stated interest expense subject to tracing, the pass-through entity must determine the portion of the debt proceeds considered to be debt-financed distributions. This amount is not necessarily the full amount distributed to the owners. The entity has the option of electing to allocate debt proceeds to expenditures made in the same year, limited to total expenditures. With this election, the total debt-financed distributions would be total distributions during the year, less total entity expenditures during the year. If total expenditures exceed the distributions, none of the distributions would be considered debt-financed, as they would instead be considered to have been made from other revenue or cash on hand prior to the loan.
Once the entity determines the total amount of debt-financed distributions (if any), the interest subject to tracing can be determined. For example, if the total debt proceeds were $10,000 and the amount used for debt-financed distributions was $1000, 10% of the interest expense is subject to tracing and separately reported to owners on the Schedule K-1. The remaining 90% of interest expense would be included with other expenses of the entity on the applicable line of the K-1.
The owners’ deduction of the separately stated interest will depend on how they used their debt-financed distribution. Based on this use, they may determine that it is a passive expense, investment interest, or a business expense, or they may determine it is not deductible, if the distribution was used for personal expenses. If used for multiple purposes, the interest expense must be allocated proportionally among these different categories.
In the event that a debt-financed distribution is not immediately spent or invested, it is important that the partner not allow it to be commingled with other funds, in order to preserve the ability to trace the interest expense to a deductible purpose. A best practice is to deposit debt-financed distributions in a separate account dedicated to that function and transfer funds intended for investment directly from that account to the applicable investment.
As the loan is paid down by the entity, the portion of the remaining loan balance attributed to debt-financed distributions decreases. Accordingly, the portion of interest expense required to be separately stated as interest subject to tracing decreases. As this happens, the partner’s allocation of interest expense, if the original distribution was used for multiple purposes, will change. This can introduce complexities in calculating deductible interest.
For example, imagine an owner receives a $1000 debt-financed distribution. She spent it as follows: $200 for a personal expense, $200 on an investment expense, and $600 on a business expense. Thus, in the first year, the separately stated interest reported to her on Schedule K-1 is 60% deductible on schedule C, 20% on Form 4952/Schedule A (if itemizing), and 20% nondeductible. In year 2, the pass-through entity begins repaying the loan and thus both the total loan balance and the traced balance decrease. The owner’s K-1 reports $800 of the debt-financed distribution still subject to tracing.
The tracing rules state that, in repaying a loan, the portion used for personal expenditures is considered repaid first, followed by investment and passive activity expenditures, followed by trade or business expenditures. Thus, the owner’s interest allocation changes. The $200 personal expenditure is no longer considered. The separately stated interest is now allocated 75% ($600/$800) to business expense and 25% to ($200/$800) investment interest expense.
When debt proceeds are received, whether or not in the form of a distribution from a pass-through entity, there are many considerations in determining the proper treatment of interest expense on the associated loan. If you have any questions about debt-financed distributions or interest tracing, please contact your Marcum tax professional for assistance.