FEDERAL TAXATION

April 2000

INTEREST EXPENSE ON DEBT-FINANCED ACQUISITIONS OF PASS-THROUGH ENTITIES

By Richard Greenfield, CPA, Reminick Aarons and Company, LLP

When an individual borrows the funds necessary to acquire an interest in a pass-through entity such as a partnership or S corporation, the correct classification of the interest expense incurred on the debt must be determined. The interest expense could generally be classified as investment interest, passive interest, or active interest expense. In addition to these three categories, interest expense also includes qualified residence interest and personal interest. How interest expense is classified determines its deductibility. The first three categories of interest expense are the most likely to be associated with pass-through entities.

Investment Interest

IRC section 163(d)(3)(A) defines investment interest as interest that is paid or accrued on indebtedness properly allocable to property held for investment. It does not include qualified residence interest or interest incurred in connection with a passive activity. Property held for investment is any property that produces portfolio income such as interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes an interest held by a taxpayer in a trade or business that is not a passive activity and in which the taxpayer does not materially participate. Property does not have to currently produce portfolio income in order to be classified as investment property; however, it must be the type of property that normally produces such income.

Investment interest expense is deductible to the extent of net investment income. Net investment income is the excess of investment income over investment expenses. Investment income is defined as the total gross income from property held for investment and the gain attributable to the disposition of such property to the extent that such amounts are not derived from the conduct of a trade or business. An election is available to include all or part of long-term capital gains in investment income. If such an election is made, the portion of the long-term capital gain included in investment income is not eligible to be taxed at the generally more favorable capital gains tax rate. Investment expenses are deductions that are directly connected with the production of investment income such as investment advisory fees and custodial fees. When reducing investment income by investment expenses to calculate net investment income, the investment expenses must first be reduced by the 2% of adjusted gross income floor for miscellaneous itemized deductions.

Passive Interest

Interest expense incurred in connection with a passive activity is classified as passive interest expense. Passive interest expense is subject to the passive loss limitation rules of IRC section 469 and not subject to disallowance as personal interest.

Generally, a passive activity is a trade or business in which the taxpayer does not materially participate. Rental activities are passive regardless of the degree of participation except for certain real estate professionals and C corporations. If an individual actively participates in a rental activity, a special $25,000 loss allowance is available if the taxpayer's modified adjusted gross income does not exceed a specified threshold amount.

Subject to those exceptions, an individual can only deduct passive losses against passive income. In addition, if the passive activity is disposed of, the current, as well as the suspended, passive losses from prior years are fully deductible. Thus, if interest expense is classified as passive, it is subject to the same loss limitations as other passive losses and deductions.

Active Interest Expense

Active interest expense is interest incurred in connection with a trade or business activity in which the taxpayer materially participates and which is not a rental real estate activity. Active interest expense is not subject to the investment interest limitations or the passive loss limitations. It should be noted that active interest incurred in connection with performing services as an employee is classified as nondeductible personal interest. Otherwise, active interest will generally be deductible.

Allocation of Interest Expense

IRS Notice 89-35 provides guidance on how to allocate interest expense in connection with debt-financed acquisitions of pass-through entities. It states that when the debt proceeds are allocated under Treasury Regulations section 1.163-8T to the purchase of a pass-through entity (other than by contributing the proceeds to capital of the entity), the debt proceeds and the related interest expense are allocated among all the assets of the entity using any reasonable method. Reasonable methods include a pro rata allocation based on the fair market value, book value, or adjusted basis of the assets, reduced by any debt of the pass-through entity or the owner allocated to such assets.

The notice also states that interest expense on debt proceeds allocated under section 1.163-8T to the contribution to capital of a pass-through entity are to be allocated using any reasonable method. Reasonable methods include allocating the debt among all the assets of the entity or tracing the debt proceeds to the expenditures of the entity under the rules of section 1.163-8T as if the contributed debt proceeds were the proceeds of the debt incurred by the entity. The purchase of an interest in a pass-through entity is treated as a capital contribution to the extent that the proceeds of the debt are received by the entity.

The determination of whether a method (either purchasing an interest in or making a capital contribution to a pass-through entity) of allocating debt proceeds is reasonable depends upon the facts and circumstances, including whether the method is applied consistently.

Interest expense will be classified depending on how the assets of the pass-through entity to which the debt is allocated are used. If the tracing method of section 1.163-8T is used, the interest expense will be classified depending on how the debt proceeds are expended by the pass-through entity.

For example, if the debt is allocated to assets held for investment, such as stocks and bonds, the interest expense will generally be classified as investment interest expense. If the debt is allocated to equipment used in the conduct of an active trade or business in which the taxpayer materially participates, the interest expense will be classified as active interest expense. If the debt is allocated to assets used in an activity in which the taxpayer does not materially participate, it will be classified as passive interest expense.

The classification of interest expense can change from time to time because reallocation of debt proceeds among the pass-through entity's assets is required if the nature or use of the entity's assets changes.

Reporting Interest Expense

Individuals report deductible interest expense incurred in connection with debt-financed acquisitions of pass-through entities on either Schedule A or Schedule E, depending on how the interest expense is classified.

Investment interest expense is first reported on Form 4952, Investment Interest Expense. To the extent that investment interest expense is deductible, it is reported on Schedule A as an itemized deduction not subject to the overall limitation on itemized deductions that affects taxpayers with adjusted gross incomes above a specified threshold. Any investment interest expense disallowed on Form 4952 is carried forward to subsequent years. The election to include all or part of net long-term capital gains in investment income is made by including the amount on the applicable line on Form 4952. The amount of net long-term capital gain included in investment income must be deducted from the total net long-term capital gain eligible for the more favorable capital gain tax rate on Schedule D. Once the election is made for a particular year it may not be revoked without IRS consent.

Treasury Regulations section 1.469-1T(e)(6) states that taxpayers in partnerships whose activity consists of trading personal property, such as stocks, bonds, and other securities, are not involved in a passive activity.

The K-1s from these trading partnerships generally state that the activity is neither passive nor portfolio. If the partner does not materially participate in such a partnership's activity, the individual is advised that interest expense passed through is subject to the investment interest expense limitations on Form 4952 but is then deductible on Schedule E rather than Schedule A.

Passive interest expense is deductible on Schedule E after applying the passive loss limitation rules of IRC section 469. Form 8582, Passive Activity Loss Limitations, and its supporting worksheets are generally used to determine the deductibility of passive activity losses.

Active interest expense is deductible on Schedule E, along with losses from pass-through entities of trades or businesses in which the taxpayer materially participates. *