One of the more complicated, misunderstood and often-violated tax issues is the interest tracing rules. Even though you can encounter some complicated situations, the tracing rules are generally summed up as follows:
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. (Reg Section 1.163-8T(a)(3))
Interest expenses fall into five basic categories, and the treatment of the interest for tax purposes depends upon which category it falls in:
Personal interest - is not deductible. Typically this includes interest from personal credit card debt, personal car loan interest, home appliance purchases, etc.
Investment interest – Typically paid on debt incurred to purchase investments such as land, stocks, mutual funds, etc. However, interest on debt to acquire or carry tax-free investments is not deductible at all. The annual investment interest deduction is limited to “net investment income,” which is the total of taxable investment income reduced by investment expenses (other than expenses related to investments that produce non-taxable income). The investment interest deduction is only allowed to taxpayers who itemize their deductions. (IRC Sec 163(d)(5)(A)) Tip: If you have a ClientWhys Big Book of Taxes, see chapter 7.07 for additional details.
- Home mortgage interest – includes the interest on a taxpayer’s primary and a single second home. However, the debt for which the interest is deductible is generally limited to $1 million of home acquisition debt (debt used to purchase or substantially improve the home(s)) and $100,000 of equity debt between the first and second homes. Both the acquisition debt and equity debt must be secured by the home(s) to be deductible as home mortgage interest. In addition, home mortgage interest is only deductible by those who itemize their deductions. (IRC Sec 163(h)(3)) Note: There is an irrevocable election to treat a home mortgage loan as unsecured by the home, thus allowing the use of the funds to be traceable.
Tip: If you have a ClientWhys Big Book of Taxes, see chapter 7.05 for additional details.
- Passive activity interest – includes interest on debt that's for business or income-producing activities in which the taxpayer doesn’t “materially participate” and is generally deductible only if income from passive activities exceeds expenses from those activities. However, for rental real estate activities there is a special passive loss allowance of up to $25,000 for taxpayers who are active participants in the rental. The $25,000 phases out for taxpayers with adjusted gross income between $100,000 and $150,000.
- Trade or business interest – includes interest on debts that are for activities in which a taxpayer materially participates. This type of interest can generally be deducted in full as a business expense. (IRC Sec 163 (h)(2)(A))
When determining when, where and how much interest is deductible a practitioner must apply the rules that pertain to each category of interest, and where required, apply the tracing rules. Here are some examples:
- Example 1: A taxpayer takes out a loan secured by his rental property, and uses the proceeds to refinance the rental loan and buy a car for personal use. The taxpayer must allocate the interest expense on the loan between rental interest and personal interest for the purchase of the car, and even though the loan is secured by the business property, the personal loan interest portion is not deductible.
- Example 2A: The taxpayer borrows $50,000 secured by his home to be used in his consulting business. He has no other equity debt on his home. He deposits the $50,000 into a checking account that's devoted to his business, and he uses the money in that account only for his business. He must deduct the interest as home equity debt interest on his Schedule A since the debt is secured by his home and the debt is less than the $100,000 limit for equity indebtedness.
- Example 2B: As an alternative to example 2A, the taxpayer can make an irrevocable election to treat the $50,000 equity debt as unsecured by the home, in which case the interest on the loan would be deductible on his business schedule.
- Example 3: The taxpayer wants to acquire an additional rental so she refinances one of her existing rentals to obtain the down payment. The interest on the loan must be allocated between refinancing the existing rental loan and the portion of the debt used to acquire the new rental.
- Example 4: The taxpayer owns a rental property free and clear and wants to purchase a home. So he obtains a loan on the rental to purchase the home. Under the tracing rules the taxpayer must trace the use of the funds to their use, and since the debt was not used to acquire the rental, the interest on the loan cannot be deducted as rental interest. The funds can be traced to the purchase of the taxpayer’s home. However, for interest to be deductible as home mortgage interest the debt must be secured by the home, which it is not. Result: the interest is not deductible anywhere.
- Example 5: The taxpayer wants to purchase a lot and build a rental on it. He plans to purchase the lot with cash and the build the house with a construction loan. Once the construction is complete he intends to refinance the construction loan and pull out the money he used to originally purchase the lot. Under the tracing rules he must trace the interest based upon the use of the refinanced loan proceeds. The portion of the loan used to refinance the construction loan can be traced to rental and thus deductible as rental interest. The portion reimbursing the taxpayer for the cost of the lot must be traced to the use of those funds, and assuming the taxpayer banked those proceeds that portion of the interest would be treated as investment interest.
- Example 6: The taxpayer borrows $20,000 on a margin account held by his broker. He uses the $20,000 to buy additional securities. The interest he pays on the margin account is treated as investment interest.